Recessions affect the economy in many ways, directly influencing consumer demand, global supply chains, and, notably, transfer pricing (TP) practices due to losses and changeable risk profiles, making it harder to apply standard pricing methods in cross-border transactions. When the market experiences a downturn, multinational enterprises (MNEs) often face challenges across their value chains, with many facing unexpected losses, challenging contractual obligations, and operational breakdowns. Since transfer pricing relies on compliance with the arm’s length principle, economic downturns require companies to review their current policies and adapt to new market conditions.
Why Recessions Matter in Transfer Pricing
Transfer pricing frameworks adopted worldwide, generally in alignment with the OECD Guidelines, require that businesses report profits over a multi-year period. However, financial losses incurred in a recession are often permanent, and not recoverable through future profits, and when an MNE reports consolidated losses, these must be allocated among the various legal entities within the group. The challenges in this regard have also been addressed by the OECD, arguing that during economic downturns, the arm’s length principle must be applied flexibly, considering the actual economic circumstances faced by businesses. This includes recognizing that losses may be appropriate and that transfer pricing analyses should reflect the real allocation of functions, assets, and risks among associated enterprises, even when traditional comparables are scarce or less reliable due to the recession’s impact.
In times of economic disruptions, including recessions or global crises, several key issues lead to challenges in transfer pricing. In this article we will focus on:
- Inappropriate or outdated comparables
- Applying the arm’s length principle through method selection
- Not One Size fits all: the documentation dilemma
Inappropriate or Outdated Comparables
Traditionally, the transfer pricing analysis has relied on the use of comparable data, which in times of economic hardships faces several limitations, including public financial data being unreflective of the current business environment. As well, the pool of comparable companies is affected, given that loss-making or failed firms are often excluded from databases. Finally, differences in financial strength between large MNEs and smaller local companies can affect results, as larger firms are generally better positioned to survive long periods of economic uncertainty.
While these issues seem to persist in times of hardship, efforts have been put into identifying coping mechanisms to mitigate risks. One approach is to look beyond financial data and examine the real-world behavior of third parties during recessions—how they renegotiate contracts, allocate losses, or adjust pricing strategies.
Perhaps most importantly, MNEs must revisit the foundational aspects grounding their existing transfer pricing models. Functional, asset, and risk (FAR) profiles it is possible that change significantly during a recession; for instance, supply chain changes, the reallocation of decision-making authority, or a transformation in customer behavior could mean that entities within the group are now performing different functions or controlling new risks. In such cases, sticking to traditional pricing models could result in misaligned allocations.
Applying the Arm’s Length Principle Through Method Selection
One major challenge in transfer pricing during economic downturns is determining whether the method used pre-crisis still reflects arm’s length conditions. The economic environment affects how transactions are carried out and which risks are borne by each party. This may make previously reliable transfer pricing methods unsuitable or distort the results they generate.
Traditional methods based on pricing (Comparable Uncontrolled Price, Cost Plus Method, and Resale Plus method) can become difficult to apply when market conditions have drastically changed. Meanwhile, profit-based methods, such as the Transactional Net Margin Method (TNMM), may better accommodate variability in costs and profits, due to their simplicity and data availability, and therefore can be better suited for periods of notable economic divergence. However, these too can lead to distorted results, especially if one-sided approaches fail to reflect the economic reality of both parties involved.
Strategies to address this challenge include:
- Reassessing the selected method: Evaluate whether a different method, such as a profit split, is more appropriate due to shared risks or losses.
- Updating comparables: Use more recent or broader industry data and include multiple-year data to reduce the impact of one-time shocks.
- Applying comparability adjustments: Modify financial data to reflect differences in capacity utilization, government aid, or cost structures.
- Considering the nature of exceptional costs or revenues: Identify whether these should be allocated based on actual risk-bearing entities.
- Ensuring consistency in risk assumptions: Especially when determining if limited-risk entities should share in losses.
Ultimately, flexibility and documentation are key. Taxpayers must justify their method choices with updated analysis that reflects the altered economic landscape.
Not One Size Fits All: The Documentation Dilemma
In a recessionary environment, documentation becomes a critical pillar of transfer pricing compliance. Tax authorities are likely to intensify scrutiny, expecting taxpayers to justify changes in pricing arrangements, functional profiles, and profitability across group entities. This expectation is further complicated by evolving local laws, shifting definitions of related parties, and differences in government interventions across jurisdictions. Another layer of complexity arises from the uneven global impact of a recession. Therefore, a one-size-fits-all transfer pricing response may be inadequate. Tailored approaches that reflect the specific economic conditions and regulatory landscapes of each jurisdiction are essential.
Multinational groups must actively track changes in supply chains, intercompany transactions, and economic circumstances. Documenting these changes in real-time—through board minutes, internal communications, revised contracts, and market analysis—is essential to explain how decisions align with the arm’s length principle. When available, internal and external comparables should be identified to support pricing decisions.
Moreover, when significant deviations from projected performance occur, taxpayers should consider using price adjustment mechanisms, where permitted by domestic law. These mechanisms must be fully documented, showing how and why price revisions were necessary, supported by evidence that independent parties might have done the same.
Given data constraints, tax administrations are encouraged to interpret documentation in light of the practical challenges businesses face in accessing contemporaneous information. Nonetheless, MNEs should aim to create a detailed, coherent narrative that captures both the ex-ante reasoning and ex-post results—ensuring that transfer pricing positions are transparent, reasonable, and defensible under audit.
Key takeaways
In conclusion, economic recessions necessitate a well-reasoned approach to transfer pricing. MNEs must avoid the mechanical application of pre-recession policies and instead adopt economically grounded and evidence-backed strategies. The goal remains to align intercompany outcomes with arm’s length standards, but the path to achieving this in a downturn requires more flexibility, transparency, and rigorous documentation than ever before.
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