Tariffs and Possible Risk Mitigation Through Transfer Pricing

Tariffs have taken center stage in U.S. trade policy, with the current administration implementing measures to address trade imbalances, protect domestic industries, and respond to global economic shifts. These policies have created opportunities and challenges for businesses engaged in cross-border trade, particularly those with supply chains spanning multiple countries.

Some observers argue that foreign trade partners will bear the costs, while others believe consumers will ultimately pay, and some predict that both parties will share the burden. Regardless of how the situation develops, multinational enterprises are already exploring strategies to mitigate the risks posed by tariffs and adjust their operations accordingly. One such approach involves transfer pricing.

Transfer pricing rules outlined in IRC Section 482 and Section 6662 mandate that pricing for intercompany transactions between a U.S. company and its foreign affiliate be based on the “arm’s length” principle. This means the price should be consistent with what would be charged in a similar transaction with an unrelated third party. This process helps establish appropriate profit margins for these transactions by considering factors such as location, nature of the business, firm size, and number of employees. With the implementation of tariffs, adjustments to the valuations of intercompany transactions and benchmarking will become necessary. The added burden of tariffs will impact internal calculation methods, so it is essential to explore these changes in more detail.

A transfer pricing study establishes benchmarks by identifying comparable third-party transactions. Once these benchmarks are established, an appropriate profit level indicator is used to determine the profit that the service provider, manufacturer, or licensor—referred to as the “tested party” should recognize. Transfer pricing documentation ensures that related-party transactions are priced fairly, allowing tax authorities worldwide to tax entities based on accurate profit declarations.

To illustrate how tariffs can influence the cost allocation process, consider the Comparable Profit Method (CPM). This method relies on two key elements: analyzing costs and determining the appropriate profit margins for the tested party. Naturally, the party incurring the tariff cost assumes a higher level of risk due to the additional expense. In transfer pricing, “cost” encompasses any operational expense directly related to a transaction. For intercompany transactions, tariffs are treated similarly to sales tax, being added to the cost of executing the transaction. Such adjustments can be substantiated with proper documentation and detailed explanations.

Another critical aspect of transfer pricing documentation is identifying suitable comparable third-party entities, a process that may change as conditions evolve. The selection of these comparables depends on various factors, as mentioned earlier, and the introduction of additional tariffs is likely to alter the pool of appropriate comparables due to the shifting economic environment in the U.S.

These uncertainties are expected to persist until more information becomes available. In an unpredictable landscape, adopting a cautious approach is essential to avoid future pitfalls. As a result, comprehensive transfer pricing documentation is more important than ever and is expected to grow significantly over time.

If you have any questions about how the anticipated tariffs could impact your client’s business, please reach out to our Global Business Services team.