Economic and political megatrends: shaping transfer pricing policies in an increasingly disruptive world

November 2021  |  SPECIAL REPORT: CORPORATE TAX

Financier Worldwide Magazine

November 2021 Issue

The period from 1990 to 2015 will likely be considered the golden era of globalisation. During this period, many multinational enterprises (MNEs) moved toward a strategy of centralising their global operating and transfer pricing models. Robust global growth (supported by sound macroeconomic policies), the ongoing elimination of trade barriers and capital flow controls, cross-border M&A activities, the acceptance of international rule of law and the protection of intellectual property rights as key drivers of multinationals’ performance, let them expand their operations on a global scale. Stable economic and regulatory environments embracing tax competition allowed MNEs to invest massively in emerging markets, stimulating global economic developments.

A stable economic and regulatory environment greatly facilitated international value chain structuring and tax planning for multinationals. For example, a widely applied practice has been the establishment of tax effective central principal models. This entails a principal entity that concentrates a group’s key intangibles and decision making in a low-tax jurisdiction, while local operational entities (such as manufacturers and distributors) contractually perform low-risk operations on behalf of the principal at both ends of the internal supply chain.

Centralised transfer pricing policies leave such operational companies with low but stable operating margins, while the core of the consolidated entrepreneurial profit is captured by the principal company. This allowed leading multinationals to lower their effective tax rate, and the resulting increase in shareholder value allowed them to fuel their international expansion and relative market share, through both internal and external growth.

Global political and macroeconomic disruptions

The 2007-09 global financial crisis undermined the credibility of the global benefits of Western-style capitalism in societies of developed as well as developing countries, and the subsequent economic recovery masked increased tensions within and between countries. While the economies recovered, belief in the benefits of globalisation and free and competitive markets has diminished in many countries. The European Union (EU) did not expand but, on the contrary, showed signs of disruption highlighted by the UK Brexit vote in 2016. With the advent of the Trump administration, the old US-driven global free market order was largely abandoned in favour of a more protectionist policy symbolised by the ‘America First’ slogan and the deliberate erosion of the role of the World Trade Organization (WTO) as the recognised neutral arbiter for solving international trade disputes. Traditional historical US allies and supporters of globalisation in Europe, Asia and the Americas have been confronted with unseen trade disputes and protectionist measures across a broad range of industries.

During the golden era of globalisation, many multinationals put China at the core of their globalisation strategy. However, China, while still the greatest source of global growth and profit for many multinationals, has in the view of many leading Western politicians transformed itself from a land of great opportunities to the largest global threat to Western economies.

An assertive China has – like Russia before it – turned inwards to reassert the Communist Party’s control over its own private sector (notably in the tech industry) and increasingly plays hardball with its neighbours, the Americas and Europe, both politically and economically. If the current chilly relations between China and the West were to degrade into something worse – a possibility that cannot be excluded – the economic effects for multinationals could be not only disruptive but cataclysmic.

COVID-19 and environmental disruptions

Political disruptions have been exacerbated by the COVID-19 pandemic which, over time, has affected all countries since the end of 2019. The global economic downturn in 2020 was harsh, and the recovery (so far in 2021) has been slower than expected. The world experienced a series of overlapping global and regional demand fluctuations (e.g., due to lockdowns) and supply chain bottlenecks (e.g., semiconductors), impacting a broad range of industries.

Even if the COVID-19 pandemic were to be contained in the foreseeable future, it is to be expected that the pandemic will lead to lasting structural changes in consumer (e.g., leisure, international travel, retail industry) and organisational (e.g., home office work through digital innovations) behaviour patterns.

Additionally, in 2021, natural disasters (e.g., heat, droughts, fires, floods) on an unprecedented global scale have convinced large numbers of sceptics that climate change is indeed happening and growing worse, with the potential to disrupt entire economies.

The significant rise in public debt that has emerged to deal with these emergencies generates further macroeconomic and political risks impacting multinationals.

Digital transformation and tax regulatory disruptions

With regard to technology, digital transformation has been the largest disruptive factor for the world economy for many years. While challenging all traditional industries, during the COVID-19 crisis it has been a macroeconomic boon both from a demand (e.g., home delivery and customer relations) and supply (e.g., home office and virtual organisations) perspective. At the firm level, the fact that digital advances allow virtual organisations to operate from any place connected to the internet is a driver for further globalisation and an asset in the global war for talent. Key employees no longer need to work in a location they dislike – they can lead virtual functional units of multinationals from anywhere. This creates tax compliance issues for multinationals, both from a personal income tax perspective (where does an employee pay income tax?) and a corporate transfer pricing perspective (to which territories should group functional profits be assigned?).

The Organisation for Economic Co-operation and Development’s (OECD’s) base erosion and profit shifting (BEPS) project initiated in 2013 underlined tax authorities’ concerns that digital transformation was a further step toward facilitating multinationals’ efforts to reduce their international tax burden, which was clearly against the anti-capitalist political megatrends and fiscal needs arising after the 2007-09 global financial crisis.

The OECD’s 2017 transfer pricing guidelines resulting from the BEPS 1.0 initiative, at their core, explained that entrepreneurial profits of multinationals should be assigned to the entities that functionally create intangible value (the so-called development, enhancement, maintenance, protection and exploitation (DEMPE) functions), rather than to lean principal companies which, by tax and legal design, are contractually assigned intellectual property and economic risk.

This regulatory milestone against multinationals’ tax-optimising patterns was deemed insufficient to capture the challenge of tax-optimising patterns from digital transformation, where markets can, by means of technology, be functionally served from different (and potentially low-tax) territories. As a response, tax legislators in many jurisdictions introduced local digital taxation rules targeting the large global tech companies.

To prevent global regulatory chaos and trade disruptions that would arise from double taxation through uncoordinated and inconsistent local taxation of digital business models, the OECD – strongly backed by the G7 and G20 – is in the process of delivering a major regulatory package (BEPS 2.0) that consists of two pillars. Pillar 1 assigns a certain amount of entrepreneurial profits to market territories irrespective of where value has been created. Pillar 2 establishes a system of global minimum taxation for multinationals to stop the race to the bottom in the effective taxation of multinationals.

As a consequence, many if not most principal structures that multinationals established during the golden era of globalisation are likely to become less tax effective or even obsolete.

Implications for intragroup transfer pricing of multinationals

The described political, economic, technological and regulatory megatrends imply that many established tax structuring and transfer pricing models are no longer useful to manage multinationals’ overall financial objectives. Not only will they be challenged by a new and more aggressive tax regulatory environment, but multinationals are confronted with a deteriorated political and economic environment that has led to an overlapping of large global and local risk clusters that were unheard of in the golden era of globalisation. From a business perspective, prevailing in such an environment will require a high degree of business agility and alternative solutions in all key aspects of business. On the tax financial front, the corollary to this business agility is system flexibility in terms of transfer pricing. Rigid transfer pricing systems guaranteeing certain margins for operational companies irrespective of global and local market swings and shocks will not allow multinationals to control their effective tax rates.

Fortunately, this quest for transfer pricing flexibility is fully in line with regulatory developments established in the 2017 OECD transfer pricing guidelines. From a regulatory perspective, the right transfer pricing response can be flexible profit split solutions that adjust to new business realities and, if properly designed, should properly reflect how value is being created within a multinational enterprise.

Per design, a profit split solution can be a natural stabiliser for the effective tax rate in a high-risk business environment as, depending on the group’s bottom line, it either leads to the sharing of profits or the dilution of losses across a range of countries, thereby balancing out the financial tax burden for the multinational in a crisis. Aligned with the new regulatory developments, profit split solutions can also help to reduce increasing tax audit risks, facilitate the settlement of tax disputes, and prevent double taxation in an increasingly confrontational world.

 

Dr Yves Hervé is a managing director and Ronald Bernstein is a principal at NERA Economic Consulting. Dr Hervé can be contacted on +49 (69) 710 4475 08 or by email: yves.herve@nera.com. Mr Bernstein can be contacted on +49 (30) 700 1506 01 or by email: ronald.bernstein@nera.com.

© Financier Worldwide

BY

Dr Yves Hervé

Ronald Bernstein

NERA Economic Consulting

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