Transfer pricing in situations involving changes in the business model
Due to business reasons, there are often significant changes in the operations of related parties that concern functions, companies’ assets and the risks borne by the parties. The terms and conditions of the transactions applied in change situations must be at arm's length and the compensation the related party is paid must correspond to that what an independent enterprise would have been paid in similar situation.
Changes in business operations must be assessed in light of the arm's length principle
Changes in business operations are typically related to, for example, expansion of business activities, changes in contractual relationships or transfer of intangibles, significant risks, individual functions or activities (ongoing concern) within a multinational enterprise (MNE).
When there are changes in business operations, the parties involved must evaluate in light of the arm's length principle whether there have been transfers of any valuable assets between the parties for which a compensation would have been paid if the transfer had taken place between independent enterprises. On the other hand it is necessary to assess the transactions between the parties in the new position after the change.
If a group company expands its business operations in a manner that involves transfer pricing considerations, it is crucial to consider the possibility of higher risks related to the operations. An example of this is a progression from an early-stage marketing service provider into an independent full-risk business operator. Higher risk-taking leads to higher profit expectations in business operations. As the operations are expanding and becoming more complex, consideration should also be given to the intangibles possibly utilized by related parties and the ownership of the intangibles. Significant changes in functions, assets and risks often lead to a situation where the transfer pricing methods applied earlier and the assumptions made during implementing them may have to be revised or even amended fundamentally so that the arm’s length transfer pricing can be ensured.
For business reasons, contracts between group companies may be changed or in some cases the contracts may be even terminated. For example, as the group is restructuring its sales operations, there may be major changes made to the distribution contract made with the distribution company or the distribution contract may be terminated. The manufacturing contract between a manufacturing company and the group parent company may be terminated and a corresponding contract may be made with a group company located in a country with lower production costs.
In such situations, it must be evaluated whether independent enterprises would have agreed on compensation to be paid to the party to which the changing contract is detrimental. In transfer pricing, the parties involved must evaluate the compensation that may have to be paid and the circumstances and the practices applied in the sector must be considered in the process. When the compensation is determined, consideration should be given to the following:
- Has the group company, to which the changing contract is detrimental, made major investments during the effect of the terminated contract?
- Which party do such investments benefit?
- If the contract is de facto proceeded with another group company, does the group company continuing the operations benefit from the investments made by the company ceasing the operations or its intangibles, such as important and long-term customer relationships?
In addition to the compensation possibly arising from the changes in contractual relation, the parties involved should also analyse the situation after the change from the perspective of transfer pricing. The functions, risks and assets may be divided between the group companies in a new manner, if there are significant changes made in the contractual terms. This may impact the selection of the most suitable transfer pricing method and its practical application such as comparables. There are number of different methods for verifying that transfer pricing is at arm's length and they are described in the transfer pricing guidelines of the OECD. The OECD guidelines are internationally accepted and an important source of interpretations when the arm's length principle is applied.
OECD Transfer Pricing Guidelines (www.oecd.org)
Business restructuring means a transfer of functions, assets or risks between group companies. Business restructuring may mean a transfer of a function, such as the sales unit or the research and development unit, from one group company to another. On the other hand, it may also mean a group-wide restructuring, in which the business model of the group is crucially changed.
From transfer pricing perspective it is important to identify what is actually happening the business restructuring. The change can be evaluated from the following perspectives:
- Which party has made the decision regarding the restructuring and whom it is expected to benefit?
- How will the restructuring affect the functions of the Finnish company?
- Which asset items, such as fixed assets, inventory, patents or trademarks, are transferred in the restructuring?
- Are any intangibles transferred from one related party to another as part of the restructuring?
- Will there be any changes in the risks borne by the Finnish company, such as market, inventory, bad debt or warranty risks?
- How will the restructuring change the future profit expectations of the companies involved?
Like in essential contractual amendments, the parties involved in a business restructuring must also evaluate whether independent enterprises would have agreed on compensation to the party whose functions, assets and risks are transferred. Paying such a compensation may be justifiable if something of value has been transferred from one related party to another.
There is rarely any reliable comparable data available on the application of the comparable uncontrolled price (CUP) method in business restructurings as it is often impossible to find comparable transactions between independent parties. Therefore the arm's length compensation paid in connection with business restructurings is often determined utilizing other methods that would also have been used by independent enterprises. One of the most common of such methods is the discounted cash flow method. In a business restructuring, the arm's length compensation can be determined by making comparison between the cash flows that the company would have generated had it continued its previous operations and the cash flows that the company is expected to generate after the restructuring.
The changes taking place in the restructuring must be considered in the transfer pricing after the restructuring. Typically there are changes also in the transfer pricing model applied in the group. For example, in a business restructuring, a fully-fledged manufacturer may be converted into a low-risk contract-manufacturer. As a starting point it can be said that the application of the transfer pricing methods must be revised after the restructuring.
Occasionally, business restructuring may involve a transfer of a business activity. In such cases, the transfer includes an integrated business unit that can perform the functions to be transferred and manage the risks arising from them. The assets of the unit are also transferred. The parties involved in such restructurings must have realistic resources to continue their operations and assume risks related to them. In these situations, it is essential to examine whether the transfer of a business activity will include a transfer of business value in addition to the transfer of profit potential.
In transfer pricing, an arm's length compensation for the transfer of a business activity is generally determined using the same methods that independent enterprises would use in the sale of business operations. In these situations it is emphasized that the operations are expected to continue indefinitely (ongoing concern) even though isolated assets have a specific economical life span. The value of a business activity is rarely the sum of the value of the isolated assets. It is important to consider the future profit expectations and future risks concerning the business activity. When the discounted cash flow method is applied, the future profit expectations and the risks are reflected in the discount rate used.
Accuracy in documentation is beneficial
Changes in business operations may result in substantial changes in the functions, risks and assets of the related parties. The changes will often necessitate changes in the transfer pricing model used in the group for ensuring that the transfer pricing is at arm's length. When determining the compensations that may have to be paid in the restructurings, the information about how the functions, risks and assets are divided between the related parties before and after the restructuring is needed. Therefore, it is important that the functions and operations of the group companies and the changes in them are carefully documented using up-to-date information.