In the context of the macro economic turbulence and geopolitical tension, the prices of energy and resources (“E&R”) supplies have been under substantial fluctuation. This also give rise to challenges to the relevant multinational companies ("MNCs") in their transfer pricing (“TP”) management.
Very commonly, the E&R giants have made significant tax payment contributions to the communities; at the same time they have also contributed quite some landmark TP controversy court cases (to name a few: in Canada and Australia) that give rise to profound impacts to the global TP practice.
While the E&R businesses normally have multiple steps in the value chain (e.g., location and feasibility assessment, exploration, exploitation/mining, processing/refining, logistics, sales, and sometimes also with waste management), the most significant intercompany transactions in term of transaction values often take place when the mining/processing entity in one jurisdiction selling to the trading entity (or marketing hub) in another, or the group’s off-shore procurement/trading center reselling to its affiliates. This article would focus on the E&R intercompany buy-sell transactions based on our observations in the market, including both China in-bound (e.g., with MNC's Mainland China trading entity for import and local sales) and out-bound (e.g., with China headquartered group's Hong Kong entity as trading and financing platform) arrangements.
Industry features
We would start with examining a few special features of the E&R industry, which could help set the stage for further elaborating how these features leading to TP challenges for MNCs.
Price volatility: It is almost like a gambling if someone tries to predict a precise price of E&R supplies, and not surprisingly there are stories about players having suffered fatal losses due to the wrong judgment on the price trend (and lack of internal control). The large customers with strong bargaining power often prefer to enter into long term contracts with the suppliers, in order to smooth out the price fluctuation impact over time. On the other hand, the customers with smaller volume/weaker financial capability, or those with unexpected short-term demand, would have to purchase at the spot contract price. These are two quite fragmented markets, and sometimes the prices could be very different.
Use of hedging: As a natural solution to manage the price volatility, E&R suppliers often collaborate with the financial institutes to hedge against the risk via the use of derivatives in the commodity exchanges. Needless to say, the hedging strategy, decision and work protocol could be critical to the group’s business sustainability; those are often managed and supervised by the group’s centralized specialist team, rather than discretion of the local subsidiaries.
Inventory risk management: Given the nature and volume of E&R supplies, there is not many alternatives of the logistics arrangement and inventory management. If any default on a large transaction after shipping, the supplier may not immediately find another customer, and basically it is not feasible to return the goods. Therefore in a third party arrangement the supplier would often require protective clauses in the offtake agreements (e.g., by imposing stiff financial penalty in the event of default), limiting the buyer’s ability to cancel the contract; the supplier would also require down-payment/deposit before shipping. MNCs would often mimic such industry practice in the intercompany contracts.
Environmental, Social, and Governance (“ESG”) sustainability: As a top priority, large E&R companies must fully comply with the highly regulated requirements by acting as responsible social citizens. This could be witnessed in their comprehensive annual ESG reports, with attention to labour safety, environment protection, and collaborations with stakeholders in the community, etc. There is increasing awareness and demand for ESG disclosures to serve the public interest, and E&R players must commit more resources to evaluate and manage the ESG risks of their operations. As part of it, carbon neutrality has become the key topic when setting up the future business strategy, in particular for those suppliers of “traditional” energy and resources.
Potential mismatches of people functions, risks and assets
It is not unusual to see a few mismatches within the same MNC group in the industry: one entity with key headcounts manage the physical goods trade, but the legal title of goods and the large transaction revenue is held in another entity. The latter entity, though with fewer headcounts, is exposed to inventory risk and market risk. To make it more complex, the group may have different entities dealing with goods trade and hedging/paper trade respectively, and the profit and loss would sit in different entities.
As a common TP method, one might tend to decide which entity(ies) could be viewed as the least complex for the application of transactional net margin method (“TNMM”). This may not necessarily work well given the mismatches in the industry. Different TP policies would need to be considered, including the profit split, in order to decide the proper approach for alignment amongst jurisdictions.
In practice, the buy-sell entities (i.e., Mainland China entities import from overseas affiliates for resales, or Hong Kong entities acting as the buy-sell platform for the China based groups) could apply different TP policies. We would further discuss the risk-taker model and the limited risk model, not because they are the only two available, but they could well illustrate some typical issues in the industry.
Risk-taking buy-sell entity
For the risk-taking entities, normally they would set the intercompany prices following the market prices. The first step is to define whether the controlled transactions are regulated by long term supply contracts or spot contracts, since the third party pricing of these two markets could be quite different. In case one entity has both long term supply contract and spot contract with its affiliate, two separate economic tests would likely be required.
While there are public market price indices for common E&R commodities and could usually be taken as reference to set the prices in third parties contracts, the pricing formula may not be very straightforward. Instead, there could be multiple invoicing arrangements, and the final invoice price could be a function of various parameters such as price index in a certain period, weight, quality (after verification), freight, insurance premium, and interest, etc., even not taking into account blending or processing fee charges. As a result, the application of comparable uncontrolled price (“CUP”) method would require a detailed comparison between the intercompany pricing and the third party pricing.
There are also cases that no public available market price index for supplies of certain specifics, or no available third party transactions with equivalent volume in the relevant time period. And for spot price transactions, sometimes the price fluctuated even on the same day. In this regard, the intercompany pricing would have to make adjustment on top of the reference price based on reasonable working assumptions, and more difficult to illustrate the arm’s length compliance.
Given the large and frequent changes of market price, a risk-taking entity may have very unstable profit and loss results year over year (or even huge differences within the same fiscal year), which would be a challenge if the entity intends to finance its operation from local bank loans. As a result, parent guarantee may need to be in place to enhance the repayment ability; alternatively the entity may also use internal shareholder loans, but need to take into account the China foreign exchange borrowing limit of overseas loans and also the thin capitalization regulation.
Limited risk buy-sell entity
The TP policy of rewarding a limited risk entity a stable return may generally work better if the market price is relatively stable, but this is not the case for the E&R business. So the very practical issue is how to implement such model in reality.
If the buy-sell entity is incorporated in Hong Kong without foreign exchange control and indirect tax (e.g., customs duty), MNCs could easily implement an adjustment on the prices of prior transactions in order to align the buy-sell entity margin with the intended range. In Mainland China, however, such one-off TP adjustment would need to detour a series of road blocks including foreign exchange, customs, and VAT implications. Given the practical difficulties, some China entities in the industry had to create new transactions such as intercompany service fee payment/income to adjust the local margins; even this is for the good purpose of TP compliance, without business substance it may give rise to other unfavourable consequence.
Over the recent years, China government authorities have heard about the taxpayers’ comments, and we do see a few new initiatives that aim to facilitate the compliance and implementation of cross-border intercompany transactions.
In 2020, State Administration of Foreign Exchange (“SAFE”) published the bulletin of the guidelines for the administration of foreign exchange accounts for the current items, with an update in 2021 to provide instruction on how the banks proceed with the profit compensation under TP adjustment for MNCs. In particular, the banks shall review relevant documents from tax or customs authorities, profitability adjustment agreement, and invoices, etc.
In 2021, State Taxation Administration (“STA”) announced the program of the simplified procedure to apply for unilateral Advance Pricing Arrangements (“UAPA”), aiming to shorten the timeline of UAPA negotiation for taxpayers qualifying the pre-conditions.
In 2022, a pilot program in Shenzhen would allow taxpayers to reach agreements with both local customs and tax authorities at the same time in relation to the pricing of future goods imports from overseas affiliates, which may effectively help the taxpayers to address the different concerns on the related party import price from customs and tax authorities. It is expected that similar programs would be rolled out to other cities in future.
While it is always a big decision for MNCs to step into an APA/advanced ruling application, E&R companies could carefully review if the above programs may be useful to address the current TP challenges and achieve more certainty.
Considerations on hedging arrangements
E&R companies often use the hedging transactions to manage the market price risk. In a TP context, we have two common questions: 1) Which legal entity would enter into the hedging contract? 2) Which legal entity(ies) would benefit from such hedging (or what is the scope of hedging)?
To start with a simple scenario, a Hong Kong buy-sell entity holds the title of inventory, and it enters into a hedging contract for its own assets with its own funding to limit the market price exposure; it also receives guidance from its HQ on the hedging strategy. Given the hedging is for Hong Kong entity’s own position, the only TP consideration in this case may be whether it should pay a service fee for the HQ guidance, depending on the functional and risk profiles.
As a more complex situation, the Hong Kong entity has a cash surplus, and it receives instruction from HQ to enter into hedging contract against the overall position of the other group affiliates (not just for Hong Kong entity). Understandably, the OECD TP Guideline (2022) could only provide general comments on the hedging in the chapter of Transfer pricing aspects of financial transactions. In this regard, the group would need to delineate the transactions and assess whether the Hong Kong entity should pass through the hedging gain/loss to the affiliates, and if needed, how to implement such in practice.
Considerations on ESG
In the past ESG was often viewed as a back-office function (rather than a key business driver), and part of it maybe as shareholder activity. Nowadays obviously ESG is not just compiling an annual report at the group level, but all the operating entities would need to follow the ESG requirements. In particular, more and more E&R companies now have developed new ESG oriented organizational and governance structure, setting up ESG goals as corporate vision, and linking the management performance with ESG KPIs. From a TP perspective, it is worth reviewing if the ESG could become a more important value driver in the E&R business, as opposed to a cost center.
On the other hand, it is expected E&R companies would substantially increase the functions and activities on carbon neutrality, such as internal carbon pricing, internal campaigns/management measures of reviewing and promoting the reduction of carbon emission, external trading of carbon credits and derivatives. Accordingly, the companies and the TP practitioners would need to revisit the existing group TP policies and address the relevant TP challenges in this cutting-edge area, with considerations including: how to remunerate the new functions, who should ultimately bear the expenditure, and allocation of benefits arising from deliberate concerted group actions, etc.