Transfer Pricing and Inflation: Why Timing is Everything
Global inflation can add a layer of complexity to your transfer pricing documentation, especially if you’re using transaction-based methods to conduct your analyses. When relying on the sales of product or services to third parties as your comparables via the comparable uncontrolled price (CUP) or comparable uncontrolled transaction (CUT), cost plus (CP), or resale minus (RM) methods, the pressure of rising costs will come into play, big time. Traditionally, seasonality has always been a major comparability factor for commodities and other cyclical goods. But with the current inflationary environment, all goods and services should be compared to third-party comparable transactions that occurred at a similar time—otherwise, inflationary pressures on input costs can arguably skew the comparison significantly.
The same goes for intercompany service transactions. If you benchmark against a service performed for a third party in an inflationary economic environment, you’ll need to consider the duration of the service engagement/project. As costs rise, it becomes more important to ensure that your comparables have similar start and end dates, whereas traditionally we would put less emphasis on this, as long as the benchmark transaction occurred during the same fiscal year as the intercompany service being performed.
For intercompany financing transactions, benchmarking against comparables that have a similar, if not identical, origination date becomes critical, too. Along with the inflationary pressures we see, interest rates and bond yields are fluctuating. Arguably in the past, the comparability factor considered the most critical was the borrower’s credit rating, while other terms like the loan’s currency and duration were considered less critical but still important. Given today’s environment, I’d argue identical origination timing becomes as critical as the borrower’s credit rating.
Lastly, for transactional net margin method/comparable profits-method-based (TNMM/CPM) analyses, the tested party’s and comparables’ margins (PLIs) are impacted by inflation. Whether you are benchmarking tangible goods or services transactions, inflationary pressures affect inventory and labor costs, respectively. As a result, it becomes more important to ensure that you are comparing like time-periods between your tested party and comparables.
Indeed, inflation can present challenges for transfer pricing analyses. But if you make timing a critical comparability factor in your analyses, hurdles posed by rising costs and interest rates won’t be insurmountable.