Market fluctuations impact on Company taxation

What effect did Coronavirus have on markets?

The economic turmoil associated with the COVID-19 pandemic had wide-ranging and severe impact on financial markets, including stock, bond, and commodity (including crude oil and gold) markets. Since restrictions were lifted there was a huge increase in demand across the board in almost all sectors and during 2022. Businesses and consumers have been faced by a number of economic challenges, ranging from disruption to global supply chains, staff shortages and soaring energy prices.

Why is inflation so high?

Demand out stripping supply becomes one of the main factors contributing to the high inflation rates both in the UK and across the globe.  The Consumer Price Index (CPI) rose by 9.9 per cent in the year to August 2022.  With the wholesale energy prices falling and the government’s intervention on energy costs, many hope and believe that the rate of inflation may have peaked, but likely to remain high for a while to come.

This can leave businesses in difficulty when these increased costs cannot be passed onto customers, ultimately leading to a reduction in their margins.

What are the banks doing about it?

To ease the impact of inflation central banks are raising interest rates. In the UK, the Bank of England raised the UK base rate from 1.75% to 2.25% in September 2022, which is still less than half of the rates experienced pre 2008, but this can be a concern to heavily leveraged businesses and consumers.

All of these factors can influence the real-world pricing of transactions between unrelated entities and, in turn transfer pricing arrangements for transactions between related entities.

In addition to impacting the taxable profits of related entities, transfer pricing arrangements have repercussions for VAT and customs duties. Therefore, it may be appropriate to consider a re-review of transfer pricing policies and in particular the benchmarking analysis.  

What is transfer pricing?

Transfer Pricing is based on an arm’s length principle and tries to establish a price or amount to be paid in commercial transactions between related parties that must be agreed upon when taking into consideration the prices or compensations set between independent third-party entities in similar business circumstances.

In the UK, a company is required to comply with the Transfer Pricing regulations when an entity exceeds the following limits:

• More than 250 employees; and
• Either annual turnover of more than €50million or a balance sheet total of more than €43million.

Where the UK entity is part of a group, the limits above apply to the whole group.

Transfer pricing policy

A robust transfer pricing policy should ensure that every group entity is paid a market rate based on the functions they perform, assets they hold, and risks they are exposed to. The economic fluctuation we have experienced recently may result in costs rising and sales falling, therefore, from a transfer pricing standpoint it is vital that the impact of each factor is considered.

Existing transfer pricing policies should be robust enough to operate effectively despite economic changes to a certain degree. However, this might not always be the case, and groups should consider whether their transfer pricing policies reflect the business’s operating model appropriately and whether the intra-group charges are producing the appropriate results in the current economic environment.

Consequences of inflation 

A rapid increase in inflation can have a massive impact on a company’s ability to function, not only from a transfer pricing perspective but also for the wider business.

An intra-group agreement may include provisions which address inflation or respond to inflation automatically, but in the last decade inflation has been very low and therefore in many cases largely ignored. 

In its simplest form where an entity providing services is rewarded using a margin on cost, then the increased cost base will ultimately be passed on to the purchaser. However, this can become more complicated in situations where a charge is made based on budgets at the start of the year, which party is exposed to the risk of higher costs than initially forecast? Would a purchaser acting at arm’s length automatically accept inflationary price increases. One might ask would it have any choice? Furthermore, is there a level where the service provider becomes uncompetitive, and the entities would need to renegotiate? This will depend on the circumstances and the risks for each entity.

What do I do now?

Businesses have a lot to consider currently, but transfer pricing should not be ignored. Robust transfer pricing policies and processes are essential for large groups and entity profitability. We recommend companies review their transfer pricing policies and their operations to ensure they are still appropriate in the current climate.

For more information and guidance on this, find out more about our International Services Team here and how they can help you get ready, or call them on 01293 227670.