MNEs Face Transfer Pricing Hurdles in Supply Chain Restructuring

Holly Glenn, Jukka Karjalainen, and Moiz Shirazi of Baker McKenzie discuss how multinational enterprises should reevaluate their transfer pricing strategy when adapting their supply chains to shortages of goods and price inflation.

During the Covid-19 pandemic and the related shortages of goods and price inflation, we heard daily about supply chain issues surrounding the ability to manufacture and ship parts, subcomponents, and finished products between world markets. Semiconductor shortages affected many industries; labor shortages due to lockdowns slowed production lines and international shipping. We saw rising trade tensions and punitive tariffs come into effect.

There was also a global trend toward required transparency in responsible sourcing of inputs such as precious metals and gems, humane labor practices, collection and deployment of data cross border, use of new technologies like blockchain and artificial intelligence, and evolving tax and regulatory requirements.

This “perfect storm” led companies all over the world to reevaluate and adapt their supply chains. The choice of jurisdiction for physical product flows, capital, and labor is a key issue companies are facing, creating both opportunities and challenges—which include transfer pricing hurdles.

As multinational enterprises remap their supply chains, a range of transfer pricing implications arise, including:

Opening/Closing Operations. MNEs are on-shoring, near-shoring, or friend-shoring operations that had been more geographically dispersed or located in jurisdictions that are no longer perceived as politically friendly.

Many US-based companies conducted manufacturing in China for goods to be sold throughout the world. Given the challenges Chinese operations faced during Covid-19, and potential punitive tariffs and responsible sourcing issues, many MNEs are selecting new manufacturing locations, including more diversified regional models, and/or bringing manufacturing to the US.

With these changes, the tax and transfer pricing team should work in cooperation with supply chain and operations teams to ensure changes made are in line with tax and transfer pricing legal and regulatory requirements.

If a manufacturing operation is closed, any changes to and termination of existing arrangements must comply with the operative intercompany agreements. Verifying what is transferred to a new manufacturing location—such as raw materials, finished goods inventory, and equipment—is essential. Transfers could include technology or know-how created by the closing manufacturer, customer lists/relationships, and similar intangible property.

Many countries apply the OECD Guidelines’ provisions on business restructurings, requiring taxpayers to consider each item of value transferred between related parties and determine whether an arm’s-length transfer would require compensation.

For new operations, it is essential to determine what tangible and intangible assets are required to conduct its operations and to establish intercompany agreements addressing related-party transactions. These agreements should address both one-time transactions (such as relocating equipment and inventory) and ongoing transactions that will occur once the new facility is operational.

Some may seek to engage third-party manufacturers to perform manufacturing that previously had been conducted in-house. The transfer pricing team should be aware that the contractual relationship could provide arm’s-length evidence of prices for goods, services, or intellectual property exchanged between other related parties.

Expanding/Changing Existing Operations. MNEs relocating operations may do so by changing or expanding the scope of existing operations. In Southeast Asia, companies are moving production from China to Taiwan, Vietnam, Thailand, Malaysia, and the Philippines.

When the mandate for existing operations is expanded, the transfer pricing team needs to be involved, pricing and documenting new product flows, reviewing any transfers or new use of intellectual property, addressing changes in risk allocation, revisiting the provision of services among related parties, and looking into financing arrangements that are arranged.

Sometimes operations personnel may visit the expanding operations to train employees, get new production lines prepared, and assist efficient expansion. In these cases, the intercompany relationship should be documented and priced at arm’s length.

Altering Flows of Goods. Relocating sourcing and/or manufacturing usually translates into different parties in the multinational group supplying affiliates (or customers). These transactions should be carefully addressed from a transfer pricing perspective with intercompany flows mapped, reviewed, and documented.

Customs should always be considered when transfer pricing is reviewed. New or different product flows require a review of customs obligations. One relevant issue is which party is the importer of record, because the importer of record is responsible for trade compliance—whether classification, reporting, and payment of customs duties—or other matters such as certifications for environmental responsibility and humane labor practices. Transfer pricing teams may not know who the importer of record is, or the implications, such as penalties or fines for noncompliance.

Knowing which parties in the supply chain are the importers of record is an important risk factor to consider for transfer pricing purposes. If a related-party distribution affiliate is intended to be a limited-risk participant, the transfer pricing team should consider adding trade compliance indemnification provisions to the intercompany agreement if this affiliate is an importer of record.

Dealing with Inflation. While inflationary pressures arise at the macro level and between unrelated parties, the transfer pricing team should consider how rising prices should be filtered through intercompany transactions. If a manufacturing affiliate sells its output to related parties at a transfer price calculated on the basis of manufacturing costs plus a profit mark-up, this affiliate is essentially insulated against inflation, and it passes on the higher costs it incurs to the affiliates downstream.

If the downstream affiliate isn’t able to pass on all these cost increases to customers, it will suffer an erosion in its profit margin. While this may be consistent with arm’s-length results reported by comparable companies, it may not be consistent with the characterization of the affiliate if the downstream party is constituted as a limited risk distributor. While “limited risk” doesn’t mean “no risk,” it may be that the effects of inflation should be shared among members of the related group to avoid unintended operational effects—for example, in relation to working capital requirements.

Employing Next Generation Technologies. Value chains are evolving in response to technological innovations. Companies are building smart factories that rely heavily on data and are leveraging blockchain for smart contracts and tracking products. These technologies raise novel transfer pricing questions around the characterization of transactions and arm’s-length pricing.

This article does not necessarily reflect the opinion of Bloomberg Industry Group, Inc., the publisher of Bloomberg Law and Bloomberg Tax, or its owners.

Holly Glenn is a principal economist at Baker McKenzie in Washington.

Jukka Karjalainen is a partner at Baker McKenzie in London.

Moiz Shirazi is a principal economist with Baker McKenzie in Palo Alto.

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