One of the most difficult aspects of transfer pricing involves the use of comparable data and its application to attribute profits to related parties. In the best of times, finding comparables is onerous, but the challenges brought about by the Coronavirus Disease (“Covid-19”) and the resulting pandemic have made finding these comparables even more difficult on two levels.
First, a transfer pricing analyst must rely on historical comparable company data, which presents a timing/matching challenge. Testing profits in a related-party setting requires that we test the profits in the current taxation year against historical comparable data from the last three taxation years. Given that price setting requires that pricing be set contemporaneously, testing profits for a tested party in 2023 would rely on data from the 2020 through 2022 taxation years because 2023 data isn’t publicly available in 2023. The challenge is that in 2023, the pandemic was notably coming to an end, while the prior three years were largely marked by the pandemic. As a result, transfer pricing would test profits in 2023 against data that is largely driven by comparables in an unstable Covid-19 environment. This is problematic as the economic environment based on 2023 data is vastly different compared to 2020-2022 data.
A second issue that must be addressed relates to “range” matters that are driven by the comparables. During the pandemic, many companies performed poorly, putting downward pressure on industry profits, while other companies performed remarkably well. The reason for this phenomenon is that stronger companies were able to obtain a competitive advantage through their ability to adapt to protocols put in place to stop the spread of Covid-19, whereas smaller, less savvy companies saw profits diminish due to weak market positions and the inability to adapt as well as their larger counterparts. Unsurprisingly, when looking at years that have been directly impacted by the pandemic, we are witnessing comparable ranges that are wider and more variable, which may impact how we use and interpret the range within a transfer pricing analysis.
Issue #1: Immediate impact on comparables
For related-party transactions, setting prices and allocating profits typically involves benchmarking the returns of one party for a particular year against the historical returns of a set of comparable companies. Given that the financial data reported by comparable companies is published following the current year transaction(s), the current year margins of a tested party will be tested against the historical data of a set of comparables.
When testing the validity of the arm’s length nature of related-party profits during the 2023 taxation year, a transfer pricing analyst would generally have to determine the reasonableness of these margins using data from prior years, namely the 2020 through 2022 taxation years. This situation is problematic, however, as margins reported by the tested party for the 2023 taxation year will likely be less materially impacted by the pandemic, while the three-year data of the comparable companies would incorporate the market impacts of the pandemic.
Going forward, this mismatch of economic circumstances and the use of less reliable comparable data will continue until the pandemic is well behind us and the economic circumstances of the tested party are comparable to the multiyear data provided by the selected comparables.
Issue #2: Structural shift
A second issue that one must consider in the post-Covid-19 environment revolves around the interpretation of ranges. Comparable companies, relative to the tested party, can fall between very large and well diversified companies that “gained” during the pandemic, and those that, while larger than our tested party, are weaker than their superior counterparts. The pandemic taught us that while some companies were able to adapt to the changing environment, others were less successful in doing so. Some companies were not only able to maintain their pre-pandemic sales levels, but were able to gain a stronger footprint by restructuring their operations -- adopting online technologies, moving to a hybrid environment, etc. – to meet the financial challenges created by the pandemic. This fact has seemingly strengthened the margins of the companies that best handled the challenges of the pandemic, while weakening the margins of those that were not able to adapt as well. The implication of these findings is two-fold.
First, for those years in which the Covid-19 pandemic was deemed a global emergency, transfer pricing analysts may see more volatility in the ranges provided by the comparable data. Second, there may be a structural change in the competitive landscape as a result of the pandemic and how firms handled the associated challenges. Transfer pricing analysts might experience greater variability in the returns determined by a set of comparables. For instance, companies that achieved more market dominance during the pandemic may experience longer-term success well after the pandemic fades from our collective memory, while other companies, though surviving, will be more economically fragile, emerging from the pandemic in less robust condition. At the very least, structural change issues may make ranges wider and more volatile in short run.
Conclusion
The pandemic has impacted the role of the transfer pricing analyst in many ways, especially as it relates to comparable selection and the interpretation of ranges. Transfer pricing requires that analysts rely on historical comparable data, testing intercompany profits against comparable data that is two to three years behind. The challenge with this approach in our current environment, however, is that it requires analysts to benchmark the profits of the tested party, against a set of comparable data that is more heavily biased on the “economics of Covid-19.”
The second issue involves the range provided by third-party companies. While some companies benefited and experienced success during the pandemic, others saw their margins shrink. As a result, analysts could expect to see greater variability in the margins/profits reported by a set of comparables. The Pandemic impacted the economic landscape by creating very strong companies and very weak companies, with certain industries seeing drastic consolidation. This may have a long term impact on the economy and the margins of comparables used for transfer pricing purposes.
Jamal Hejazi
BDO in Canada
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