In the face of inflationary pressures, businesses must review their functional analysis of entities.

To manage the impact of rising inflation and supply chain disruption, companies must recognize TP business risks and revise their functional analyses.

According to TP directors, taxpayers must ensure that their transfer pricing (TP) policy identifies business risks and that their functional analyses of their entities are reviewed as they bear the rising cost of goods and supply chain disruption.

"A robust transfer pricing policy should identify and locate key business risks, and the pricing used should reward each entity based on the value each adds and the risks each takes," says Duncan Nott, a partner at RSM UK.

Each entity should have appropriate management responsibility as well as the financial capability to bear the risk of supply chain pressures on businesses. According to Nott, additional costs incurred as a result of shipping delays should be borne by the entity responsible for the risk.

Businesses must examine their functional analysis of entities to determine where the risk is and how it is being addressed. They do this by identifying and comparing the relevant activities in a transaction, as well as the responsibility assigned to each of them.

"They should confirm where the TP policy locates the risk – both through intercompany agreements and the operational aspects of how intercompany pricing works through their financial systems. These should all align ," Nott says.

Taxpayers must assess whether the functional analysis for the various entities has changed due to business circumstances, according to Gaspar Lopes Dia, a partner at London-based advisory firm Taxand.

This is critical to comprehending what is going on in the company and how these parties deal with change if they are unrelated. If the benchmark analysis has changed or if the entities are no longer comparable, this is something to consider.

According to Andrius Tamosiunas, TP manager at professional services firm TMF group in Luxembourg, the first step is to identify the differences in the environment to those facts supporting the outdated economic comparables.

"In addition to the documentation, intercompany agreements must be analysed to understand if unusual risks have been covered and how they should be allocated between related parties," he says.

According to Nott, there are three main areas where TP risks are likely to occur.

The first is the location of extra costs that do not correspond to the functional analysis and entity characterisation. A change in the business model caused by a supply chain disruption, for example, could result in a TP risk, necessitating a review and update of the policy.

Companies must also consider the TP risks associated with specific transactions. A change in a supply chain's route could result in new transactions that need to be tracked through financial systems.

Nott says, "Transactions will need to be priced accordingly and reflected in the documentation."

TP risk can also be found in everyday activities like logistics, human resources, and information technology.

"In this case, the level of return attributed to them might be considered. It is likely that a routine return remains appropriate ," Nott says, "but this may need greater explanation and support in transfer pricing documentation."

Both tax directors agree, however, that each TP risk will be unique to the industry. Inflationary pressures and supply chain disruptions may not affect all businesses equally. Some may even be able to profit from the disruption.

Middle-market companies are expected to have the most difficult year, as the Russian invasion of Ukraine continues to affect commodity prices and raise the cost of goods.

The COVID-19 pandemic's supply chain disruption continues as a result of country-specific restrictions, such as those imposed this week in parts of Beijing in response to an increase in Omicron cases.

In response to the pandemic, the Organization for Economic Cooperation and Development (OECD) acknowledged that taxpayers should include loss-making companies in comparable studies. This trend has been adopted by a number of countries, including Italy.

The Italian Revenue Agency has issued a TP circular that complies with OECD comparables standards. As businesses face increasing inflationary pressure, this trend may continue to grow.

"The same principle could apply to supply chain disruption. The approach taken will need to be supported in the context of the market and fact pattern of the tested party, however," Nott says.

"It will be important not to simply ‘chase a number’ with the benchmarking analysis in isolation from the substance of the activities under review," he adds.

Meanwhile, an RSM Middle Market study released in April found that 46% of businesses with supply chain issues experienced significant increases in the price of goods. 44 percent of the businesses in this sample saw an increase in operating costs, while 43 percent saw a decrease in profitability.

In the midst of the market turmoil, TP teams will have to carefully examine the existing TP policy, identifying risks and determining where changes are required.

"Care will be needed here, as well as robust presentation in TP documentation," Nott adds.

Through their functional analysis, tax directors will need to keep a close eye on their business to understand where the disruption occurs and how it will affect TP. Businesses must remain vigilant and prepare for future increases in inflation.

By fLEXI tEAM