How Tariffs Disrupt Transfer Pricing Strategies and Challenge Tax Rate Targets for Multinationals

The imposition of new tariffs creates a complex web of challenges for multinational corporations (MNCs), significantly impacting their transfer pricing policies and their ability to achieve targeted effective tax rates (ETRs) across jurisdictions.

Keeping up with tariffs as they continuously shift is easier said than done. Here, we discuss tariff impact and how to navigate a landscape where the cost of goods sold, intercompany profitability, and overall tax liability are undergoing change.

Understanding Tariffs and Their Impact on Transfer Pricing

On February 1st, the President of the United States signed an executive order imposing international tariffs on imported goods. The countries these tariffs apply to–and the amounts–are regularly in-flux, causing complications for global organizations. And the additional cost must be absorbed somewhere within the value chain–by the exporting entity, the importing entity, or ultimately, the end consumer. These costs directly influence the profitability of related parties within an MNC involved in cross-border transactions.

ShapeTransfer pricing, the mechanism by which MNCs set prices for goods, services, and intangibles exchanged between their constituent entities, is profoundly affected by tariffs in several ways:

1. 1. Distortion of Existing Models
      Established transfer pricing methodologies, such as the Comparable Uncontrolled Price (CUP), Resale Price Method, or Cost-Plus Method, can be skewed by tariffs. For example:
      • A cost-plus arrangement for a manufacturing entity selling to a related distributor will see the distributor’s costs rise due to tariffs, potentially eroding its arm’s-length profit margin if the transfer price isn’t adjusted.
      • Finding comparable uncontrolled transactions becomes more difficult as historical data may not reflect the impact of new tariffs.
   2. Pressure to Adjust Transfer Prices
      MNCs may be tempted to lower the transfer price of goods subject to high tariffs to reduce the customs dutiable value and lower the tariff burden for the importing entity. However, this has direct tax consequences:
      • A lower transfer price for the exporter means lower profits in its jurisdiction.
      • The importer in the high-tariff jurisdiction will show higher profits, potentially leading to increased income tax liability.
   3. Increased Scrutiny and Conflicting Objectives
      Customs and tax authorities often have conflicting objectives:
      • Customs authorities scrutinize declared values to ensure they are not artificially low to evade duties.
      • Tax authorities examine transfer prices to prevent profit shifting to lower-tax jurisdictions.

Adjusting transfer prices to mitigate tariffs can trigger scrutiny from both, especially if the adjustments are not aligned with the arm’s-length principle.

4. Supply Chain Restructuring Considerations
   In response to tariffs, MNCs might re-evaluate their supply chains, including:
   • Shifting production.
   • Changing sourcing locations.
   • Altering the functions, assets, and risks (FAR) profile of entities in different jurisdictions.

These changes necessitate a corresponding realignment of transfer pricing policies to reflect the new economic realities and ensure compliance.

Impact on Achieving Target Tax Rates

The interplay between tariffs and transfer pricing adjustments directly influences an organization’s ability to achieve its desired ETR in specific jurisdictions:

1. Shifting Profitability
   • Lowering transfer prices into a high-tariff jurisdiction to reduce customs duties increases taxable profit in that jurisdiction. If this jurisdiction has a higher corporate income tax rate than the exporting jurisdiction, the overall group ETR could increase, even if customs duties are saved.
   • Conversely, if the exporting entity absorbs the tariff cost (through a lower ex-works price), its profitability and tax liability decrease.

2. Unintended Tax Consequences
   A strategy focused solely on minimizing customs duties could inadvertently shift significant profits to a high-tax jurisdiction, increasing the global income tax burden and moving the MNC further from its target ETR.
3. Increased Compliance Burden and Risk
   Navigating the dual requirements of customs valuation and transfer pricing in a tariff-laden environment increases:
   • Compliance costs.
   • The risk of disputes, adjustments, penalties, and potential double taxation.
     This uncertainty makes ETR planning more precarious.
4. Impact on Advance Pricing Agreements (APAs)
   MNCs with existing APAs may find that the economic assumptions underlying these agreements are no longer valid due to new tariffs. This could necessitate renegotiating APAs, adding another layer of complexity to tax planning and ETR management.

The Need for a Coordinated Approach

To effectively manage the impact of tariffs, MNCs must adopt a coordinated approach that integrates customs planning, transfer pricing, and overall tax strategy. This involves:

• Scenario Modeling
  Analyzing the impact of tariffs on different parts of the supply chain and under various transfer pricing scenarios.
• Reviewing and Documenting Policies
  Ensuring that transfer pricing policies are robust, commercially justifiable, and clearly documented to withstand scrutiny from both customs and tax authorities.
• Inter-departmental Collaboration
  Fostering close collaboration between tax, customs, legal, and supply chain departments to ensure a unified strategy.
• Considering the Full Tax Impact
  Evaluating the combined impact of customs duties and income taxes when making decisions about transfer prices and supply chain adjustments. Tariffs act as a significant disruptor to the carefully calibrated transfer pricing strategies of multinational corporations. They introduce new costs, create pressure to adjust intercompany pricing, and highlight the often-conflicting objectives of customs and tax authorities. Consequently, achieving a target effective tax rate in any given jurisdiction becomes a more dynamic and challenging endeavor, requiring a proactive, well-documented, and holistically managed approach. How can you tick off the boxes you need to better navigate the changing transfer pricing landscape?

Longview Transfer Pricing and Longview Tax Provision by insightsoftware connect enterprise strategy and tax policy with transfer pricing execution, enabling customers to modernize your tax function, mitigate risk and deliver new ways to improve their tax function effectiveness. During this time of rapid change, don’t be caught up with tedious, manual processes. When you need to monitor transfer pricing more frequently, use Longview Transfer Pricing to manage transfer pricing complexities with a standardized, single source of truth that reduces cycle times and doesn’t require technical knowledge to manage.

With Longview Transfer Pricing and Longview Tax Provision, you can:

• Compare and contrast current and historic data to understand how tariffs have impacted the distribution of profits.
• Understand how existing transfer prices and profitability are impacted by higher tariff costs.
• Review historic and current jurisdiction and group effective tax rates.
• Use scenario modelling to test the impact of altering transfer prices on profit split and effective tax rates.
• Load forecast data to see the effect of evolving tariff rates on profit distribution and effective tax rates.

Being able to forecast changes to tax liability across multiple jurisdictions is something Longview Tax Provision and Transfer Pricing offers, along with the ability to monitor operational transfer pricing more closely. Watch our video on how to transfer pricing with the help of technology.

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