How Will Tariffs Affect Intercompany Transactions and Transfer Pricing Strategies?
With Donald Trump back in the White House, trade tariffs are back at the top of the agenda as part of his America-first trade policy. Multinational companies must be prepared; especially those operating in Canada, China, and Mexico, for which significant changes are under way.
What are the implications for intercompany transactions and transfer pricing? What about intangibles? Read on to find out what we know so far.
Which Markets Are Affected by Tariff Increases?
This article makes no attempt to keep pace with the stream of announcements from the U.S. and counter-announcements from affected markets; that’s better served by news organizations. We know so far that certain countries such as Canada, Mexico, and China have come in for specific treatment — as well as individual product areas such as steel and aluminium. As we discuss later in the article, the key takeaway is preparedness and flexibility, regardless of the market in which you operate.
What Might be Next?
Alongside the headline announcements of tariffs for selected countries and on steel and aluminium, one of the first executive orders signed by the new administration was for the secretaries of Commerce and Treasury and the U.S. Trade Representative to launch an investigation into the causes of America’s international trade deficits. These are due for completion by the end of April with three reports to be delivered on the 1st and another on the 30th.
Issues for review include counterfeit products, anti-dumping duties, discriminatory taxes, and the impact of duty-free exemption on tariff revenues. The trade agreement with China will be reviewed for compliance and unreasonable practices, and U.S. intellectual property rights in China will be assessed.
The administration may potentially establish an External Revenue Service (ERS) that will not only collect tariffs but will also review existing agreements, look for areas for improvement, and identify any unfair trade practices. The feasibility of an ERS will be part of the review.
The Impact on Intercompany Activity and Compliance
Tariff increases will lead to substantial changes in already complex intercompany accounting processes — specifically regarding transfer pricing.
Tariffs are initially the importer’s responsibility and form part of their Cost of Goods Sold (COGS). Companies will need to decide whether legal entities in the U.S. will absorb the costs or update their policies so that costs are passed back to the exporter. In turn, this will affect the allocation of profit among entities, complicating matters in respect of Pillar II reporting.
How Tariffs May Affect Benchmarking
Tax authorities require evidence to show that pricing is in accordance with the arm’s length principle. However, the process of determining arm’s length pricing may be disrupted.
Arm’s length pricing is established based on market prices, yet tariffs often disrupt supply-and-demand dynamics. As such, previous pricing data will not reflect the changed markets.
Benchmarking could also be affected in other ways. Companies that bring production back to the U.S. or source locally will face lower costs than those that keep importing, despite tariffs making it difficult to establish comparable prices. Things become even more complex when peers change their pricing strategies to adapt.
Preventing Double Taxation
If costs are passed to an overseas subsidiary and their profits are adjusted downwards as a result, the overseas tax authority must still agree to the change.
If there is a dispute, the mutual agreement procedure can help. This procedure is a resolution mechanism within the U.S. tax treaty network that helps eliminate double taxation arising from transfer pricing disputes.
In the long-term, negotiations may take place between tax authorities within the treaty network due to the potentially unfavorable implications on exporters.
What About Intangibles?
Establishing the transfer price of intangibles, such as Intellectual Property, is notoriously complex. While tariffs typically apply only to physical goods, intangibles have an indirect impact if they affect the customs value of physical goods. On their own, they are exempt from tariffs.
Multinationals should review their royalty structures and IP licensing agreements and establish how the associated fees may affect the customs value of related imports. They should also assemble documentation to justify any valuation methods.
Strategies for Mitigating Tariff Impact
Companies are considering the following approaches to reduce the impact of tariffs.
Reassessing Customs Codes
In some cases, companies were historically able to reduce tariff exposure by reclassifying goods. This approach may now be unsuccessful due to the broad scope of impending tariffs, but perhaps there will be some exceptions.
Increasing Inventory Volumes
As a short-term solution, some companies are increasing their purchase volumes in advance of expected tariff changes.
Passing on Costs to Consumers
If competitors in the same industry are subject to the same level of tariffs, this tactic may be effective.
Supply Chain Restructuring
Organizations should evaluate their global supply chains to identify opportunities for optimization — whether that involves relocating production facilities or diversifying supplier relationships across different jurisdictions.
Exploring Customs Valuation Methods
Some approaches may bring more favorable results than others. Consider computed value, deductive value, or fallback methods — and the impact of making adjustments for intangibles.
Sharing Tariff Allocation
In certain cases, distributing tariff allocation among subsidiaries could improve overall profitability without compromising compliance.
Tips for Staying Compliant
Here are some suggestions to minimize compliance risks:
- Prepare now: With events moving at pace, companies have little time available to understand the implications for their financial processes. Even if some of the implementation delays persist, prepare as early as possible to allow enough time to implement changes and consult with tax advisors as needed.
- Maintain comprehensive documentation: Keep detailed records of IC financial transactions, including the rationale for pricing adjustments due to tariffs.
- Monitor changes in real-time: Continually track tariff updates and assess their impact on intercompany pricing strategies.
- Conduct periodic risk assessments: Identify potential exposure to customs audits and implement corrective measures.
The Role of IC Accounting Software in Managing Tariff Impact
As an intercompany accounting software solution, Virtual Trader automates the management of IC transactions, making accurate recording, reconciliation, and settlement much easier.
It provides real-time visibility into transactions and consolidates financial data across multiple ERP systems. It maintains comprehensive documentation trails, making it easier to demonstrate compliance under increased scrutiny. Automation also standardizes intercompany processes and ensures consistency across the organization.
Implementing transfer pricing strategies is laborious, so these capabilities become increasingly valuable while organizations deal with frequent changes in tariff rates — which may be the case here.
Conclusion
Changes to global tariffs are creating new challenges for multinationals. Even if you don’t operate within any of the markets that will be affected first, now is the time to prepare.
Success in this environment requires robust processes that are supported by advanced intercompany software. The optimal solution helps organizations maintain efficiency and accuracy, ensuring compliance as regulations change.
Virtual Trader does precisely that by automating intercompany reconciliations and settlement and by speeding up your financial close process. To learn more or request a demo, contact us today.
