Guess who's back, back again?

When I started in transfer pricing, a long, long time ago, I learned about asset-intensity adjustments. In fact, we had a lot of discussions about them. More recently, not so much. What's changed? Two things: 1. interest rates, that are used to calculate the adjustments, came down quite a bit from the early-to-mid nineties; 2. companies have gotten much better at managing their net working capital, such that the absolute net amounts are smaller. Both of these changes led to the working capital adjustments not being as significant as they were when I started in my profession. And while we still routinely do them, they often have little impact on the analysis.

That may be changing. And inflation is the big driver. As anyone that spends money knows, prices have gone up across the board. US inflation rates has reached levels not seen since the early 1980ies. And the US isn't alone - inflation is up everywhere.

Inflation doesn't only affect working capital adjustments, it affects many other elements of transfer pricing. After all, inflation is about rising prices, and transfer pricing ... well, it's in the name. Prices are the central coordinating mechanism of the free market. If prices change more rapidly, it affects every part of the economy, including transfer pricing.

Here is the US inflation rate since 1970:

As shown above, inflation was running relatively high in the 1970ies, peaking in 1980 at 13.5 percent. Since then, it has steadily dropped. In the 1990ies it was hovering around 2.5 percent and in the aughts it dropped even below that after it briefly went negative in 2009 as a result of the Great Recession. Suddenly, there was an inflation of articles about deflation. But the pandemic, resulting supply chain disruptions and associated fiscal stimuli changed all that. The line above ends with a strong spike. The time series doesn't reflect the very latest data. That spike only went higher in the last few weeks.

Another aspect of inflation that should be somewhat evident from this picture is that inflation volatility also declined as the absolute rate fell. It's a well observed fact that inflation volatility increases with increases in the absolute rate. This means that as the price level rises faster, the change becomes harder and harder to predict. This directly impacts transfer pricing, since most companies set transfer prices based on budgeted costs or third-party prices. The harder it is to budget cost or third party prices. the harder it becomes to set transfer prices that adhere to the transfer pricing policies, such as target margins or actual mark-ups. Some industries have seen so little price changes, that transfer prices could be set annually with a good chance of hitting the target without any further adjustment throughout the year. This won't be that easy in a more inflationary environment. Even quarterly price adjustments may no longer be sufficient, depending on the sector. I predict that year-end 2022 may bring more and larger year-end transfer pricing adjustment than many companies have seen in a while.

Fishy Rates

The Fisher equation links inflation and interest rates. For a given real interest rate, r, a rise in inflation, π, will have to correspond with an equivalent rise in the nominal rate, i. But this is very much an ex-post truism. Since interest rates are forward looking, it's really about expected inflation. If a rise in the price level was just expected to be a short term thing, i.e. transitory, interest rates wouldn't adjust much. But if the rise is viewed as a more persistent change, then interest rates will rise much more. So how have inflation expectations fared? There's a graph for that based on the University of Michigan Consumer Survey:

Consumer inflation expectations have gone up notably in the last year and are at the highest level in 40 years. And, corresponding with that, we see a rise in interest rates:

But note two things: 1. Interest rates started to drop in the last few weeks which corresponds with reports of easing supply chain woes and lower commodity prices. 2. If we zoom out a bit, the recent rise is not as big as it first appears.

So we are still well below where interest rates were when I started in transfer pricing. Forecasting inflation or interest rates is exceedingly difficult. Yogi Berra's famous words come to mind: "It's tough to make predictions, especially about the future." Hopefully we are lucky, inflation will moderate, and interest rates will remain low.

Since we are talking transfer pricing, we also have to consider the international impact of inflation and interest rate changes. In particular, via the international Fisher effect, changing interest rates will impact exchange rates. And as interest rates become more volatile due to increased inflation volatility, so do exchange rates become more volatile. This will further exacerbate the difficulty of forecasting transfer prices. Exchange rate risk will be a bigger issue for companies to deal with. Some companies that are more strongly affected by a growth slow-down may want to attribute exchange rate risk to otherwise low-risk entities. Whether that makes sense will depend on the particular facts. Understanding that dynamic will be important in considering transfer price adjustments.

In summary, a rise in inflation increases macroeconomic and therefore financial planning uncertainty, making it harder to plan and set transfer prices. The issue is exacerbated, if the pricing is based on long-term forecasts, for example IP valuations. IP valuations will often make assumptions about long-term growth rates. Typically, such long-term growth rates are set equal to the expected growth rates of a particular economy or industry. However, these are nominal growth rates. If inflation is expected to increase permanently or at least for a longer-term period, historical growth rate assumptions will have to be adjusted upward. This will impact valuations. That may be off-set by the assumption of higher discount rates due to higher interest rates. The exact impact will depend on the cash flow distribution over the forecast horizon. In any case, IP valuations will become more uncertain and more difficult, likely leading to more controversy.

Even if companies manage through all the forecasting challenges and achieve the expected policy outcomes, there will also be a number of transfer pricing documentation considerations. As mentioned in the initial paragraph, rising interest rates could increase the importance of working capital adjustment. This would be amplified if companies feel the need to build up more inventory stock to deal with supply chain disruptions.

Another adjustment that has faded a bit in importance is the LIFO/FIFO adjustment. Under US GAAP companies can report their inventory values on LIFO basis. LIFO is particularly attractive in inflationary times as it increases the tax deduction because a company is computing cost of sales based on more recent and inflated inventory cost values. The LIFO conformity rule requires that companies using LIFO for tax reporting must also use LIFO for financial reporting purposes. Thus, if a company wants to increase its tax deduction, it will have to switch to LIFO also for financial reporting. So we can expect an increase usage of LIFO reporting, at least for US companies. IFRS does not allow for LIFO reporting. But if you are doing a US transfer pricing analysis with a US tested party and comparable, be on the lookout for the need for LIFO/FIFO adjustments.

If transfer prices and financial results are impacted by increased exchange rate movement and volatility that will need to be addressed in documentation. Old IRS guidance may find new relevance.

In the US, many companies avail themselves of the safe-harbor in the 482 regulations to support the interest rates on their US-dollar denominated intercompany loans. As the Applicable Federal Rates (AFRs) are adjusted upwards rapidly, some taxpayers may find that they can no longer rely on the safe-harbor and will have to support the rates charged with an economic analysis.

Inflation is back, tell a friend.

This isn't an exhaustive discussion of all the impacts of inflation on transfer pricing. But it hopefully provides a good flavor that the implications are far-reaching. Some old, long-forgotten tools and practices may be discovered by younger practitioners that have learned transfer pricing in a low-inflation, low-interest rate environment.