Economic turmoil also affecting transfer prices
Inflation is one of the main economic issues for 2022. The impact of high input prices and disrupted supply chains are other factors businesses must cope with. But there are also other adverse factors. The slowing economy has also revealed new issues in the area of transfer pricing.
Many companies operating within the Czech economy are part of multinational groups. These companies trade with other companies within the corporate group, using a certain agreed transfer price for mutual supplies and deliveries. Transfer prices are very often set in a simplified manner, applying a price equalling costs and profit markup or a market price reduced by a certain margin.
Late 2021 and early 2022 saw several market events that continue to put intragroup contractual relationships to a significant test. These events include electricity price increases of more than 100% year-on-year and the rise in the REPO rate from 0.75% in August to 3.75% in December, resulting in an increase in market interest rates. Another important factor is a rise in inflation to 6%, while according to the CNB expected inflation may reach 10% in January 2022. This inflation then puts pressure on wage increases, all this amid a persistent structural labour shortage on the market. Problems continue to prevail in supply chains, particularly in the automotive industry. This sector will face further challenges this year, not least in the context of the transition to electro-mobility and the need to prepare for the Green Deal. Finally, the appreciation of the Czech crown against the euro must not be left out of this list.
This market turmoil gives rise to questions CFOs must ask: "Can the price increase in the Czech market be passed on to group customers? Would independent businesses make price adjustments? Retrospectively or prospectively? Does the current transfer price setting still allow for the generation of sufficient cash flows? Which group company can end up holding the short end of the stick when considering the distribution of functions and risks?
In our practice, we are increasingly witnessing situations that require attention and strategic consideration for the future. As an example, consider a company that expanded its production and financed this investment with debt in the past. If the interest on this loan was, e.g., set as a floating rate linked to PRIBOR, then this was a design that worked perfectly in an environment with low reference rates. But will the operating profit generated be sufficient to meet the debt service requirements under the current circumstances? And we should not only think about debt; export-oriented companies in the position of contract manufacturers, e.g., will have to consider which of the contracting parties will bear the effect of the appreciation of the Czech crown. And rest assured, the tax authority has a clear view on this question, especially when the inspection takes place after a gap of two to three years. Discussions with the tax authority in this respect are usually quite vigorous and based on the tax authority’s assumption that the development of the exchange rate had been clear. Simply, you should have had a very good crystal ball!
The above also materialises during the preparation of the financial statements and when deciding what to write in the notes to the financial statements or in the annual report. With the passage of time the tax administrators will want to replenish the state treasury and businesses should be well prepared for discussions with them. Do you keep meeting minutes, emails and other supporting information that documents the considerations you made (usually with limited information regarding future developments)? Do you have justifications for the conclusions reached and details of who made the relevant decisions at your disposal? Is such documentation sufficiently robust?
If you're asking yourself these questions, we will be happy to offer our independent view on your specific situation and assess how strong your hand is in this matter.