As a transfer pricing practitioner with many years' experience across many industries and transactions, I’ve heard many reasons for making working capital adjustments (WCA). I’ve seen it described as ‘standard’ or ‘automatic’, as well as ‘unreliable’ and ‘rarely to be performed’. I’ve also heard some describe it as an adjustment they ‘believe in’, or an economic factor that an arm’s length party would ‘always’ take into account in their pricing. To untangle this knot, I’ve set out below some of the issues that I would consider before undertaking a WCA.
Working Capital in Business
First, let's recap what working capital adjustments are meant to achieve. Working capital represents the funds companies use to finance their accounts payable, receipts and inventory purchases. As short-term finance comes at a cost to the business, more or less working capital can lead to more or less interest costs, so managing working capital is a means of managing the firm’s costs and managing its margins. More working capital can impact revenues as some companies set beneficial payment terms and have high stock levels to encourage sales. When customers are given more time to pay (say 60 days instead of cash on delivery), sellers need to borrow more to fund this credit. Buyers may similarly benefit from lower borrowings where they have more time to pay; higher inventories may also need higher borrowings to support their purchase.
Some transfer pricing approaches emphasizes the time value of money as a cost and a cost that would be taken into account by independent parties in a competitive environment. This can make it seem that working capital adjustments are standard, automatic or obligatory. It's common to hear observations in a transfer pricing dispute that a third party “would” charge a higher price for longer payment terms and in a competitive environment “should” include an amount to reflect payment terms and compensate for the time value of money.
Whether or not the firm is advantaged or disadvantaged by its working capital strategies can therefore depend on whether suppliers or customers respond to different payment terms, whether price premiums or discounts are actually available from customers or suppliers in practice, and also the extent to which the firm has control over their receivables, payables and inventory levels. We also need to bear in mind that some customers may not be willing to pay a higher price even if they are given extended additional time to pay. It follows then that different levels of working capital employed in a business may or may not explain differences in prices or profit margins.
Working Capital in Transfer Pricing
Differences in working capital may suggest differences in comparability and so WCA could neutralize the effects of different trade terms and inventory levels. In a transfer pricing context, the tested party and comparables can have different working capital strategies and use different prices or generate different profits accordingly. Working capital adjustments are an attempt to arrive at adjusted comparables as the basis of determining their profit level indicators or comparable uncontrolled prices.
The mechanism to calculate the working capital adjustment itself is based on calculating an adjustment to the cost of sales and sales revenues. The adjustment itself is based on amending the reported sales revenues or cost of goods sold of a comparable to account for the differences in payables, receivables and inventory using an imputed cost of finance for the differences identified.
OECD Guidance on WCA
The OECD’s standard of comparability means that if there are material differences between the controlled and uncontrolled transactions, adjustments should be made if the effect of such differences on prices or profits can be ascertained with sufficient accuracy to improve the reliability of the results. The OECD re-iterates that working capital adjustments should only be considered when the reliability of the comparables will be improved and reasonably accurate adjustments can be made. (See OECD 2017 Annex to Chapter III para 1)
For instance, in the OECD’s 2017 Transfer Pricing Guidelines (TPG), its states at ¶ 2.87 that "in those cases where there is a correlation between credit terms and sales prices, it could be appropriate to reflect interest income in respect of short-term working capital within the calculation of the net profit indicator and/or to proceed with a working capital adjustment." Similarly, in the case of the comparable uncontrolled price method, differences in contractual terms e.g., sales or purchase volumes and credit terms, may require working capital adjustments to the comparable prices.
This guidance reinforces the notion that adjustments for comparability need to be seen in the commercial arm’s length context of the tested party and the comparables. One approach is suggested by the notion that the time value of money may be an element of pricing “in a competitive environment”. This suggests that an analysis of how companies actually operate in those markets, or more precisely the tested parties or comparables selling and purchasing behaviors in those markets, demonstrates that prices recognize this time value of money. But even that would be subject to caveats, as a party implementing a market penetration strategy may mean that the cost of the time value of money are dealt with in some other way e.g., not passed onto its buyers or passed on only in part. WCA in some situations may not improve comparability.
Relevant market evidence of third-party behavior that supports adjusting prices or returns for the differences in working capital seems vital, as does an analysis of the payment terms and practices used by the tested party and comparables. The basis for a WCA – I would suggest – has to be more than a straight comparison of the financial accounts of the tested party and the comparable.
Reliability of WCA in Transfer Pricing
The reliability of a WCA should be considered in other ways as well. For instance, a WCA involves adding or removing a notional cost of funds (which could be represented as the cost of debt or equity) to/from a comparable’s prices or financial results, but that notional cost could in fact be constrained by commercial factors impacting the level and cost of debt that a company is able to carry. In some cases, a comparable or tested party however may not be able to access the level of funds that a WCA may imply. Further, the arm’s length level and cost of debt, or equity if a firm would need to use that source of funds, will need to be calculated as well, possibly impacting interest expenses claimed if the tested party is being adjusted (say, to an arm’s length level of working capital).
There may also be questions about whether the tested party or the comparables are the entities whose prices or margins need to be adjusted. For instance, it may be a concern that the tested party has adopted working capital policies that aren’t arm’s length, due to the control of the parent over the tested party in more ways than just pricing. Before adjusting the comparables to meet the level of working capital reported by the tested party, additional review would be necessary to understand the reasons for the tested party’s working capital. It may be appropriate, where non-arm's length payable terms have been adopted, to adjust the tested party for that feature and then consider anew the need for a WCA. A review of comparables from the tested party’s industry and dealing in similar products might provide insight both into arm’s length capital structures as well as insights into pricing behavior and the nature of competition in the tested party’s industry.
There are other issues that might impact on the reliability of working capital adjustments including:
- Differences in seasonal vs non-seasonal capital needs of the tested party and comparables, based on different economic circumstances, markets, product or service offerings that impact prices reported;
- Differences in reported working capital balances due to different reporting dates, which can be relevant when tested party and comparables reporting periods don’t align; and
- Merger and acquisition or other events that suddenly shift tested party’s or comparables’ working capital levels.
As noted above, an appropriate interest rate to apply to a difference in working capital must be chosen. A relevant interest rate could be chosen from several options. For instance, the cost of debt used in a capital asset pricing model, interest rates from relevant commercial loans, the tested party’s internal debt cost, or perhaps the Applicable Federal Rate (AFR) in the US.
The merits of a working capital adjustment also have to be considered in light of their interaction with other adjustments as well. For example, a comparable uncontrolled price in one currency may need to be converted to the currency of the tested party before applying a WCA. Other adjustments that could interact with a WCA include those for differences in inventory value reporting (first-in-first-out, last-in-first-out or inventory-replacement value operating profit); adjustments to sales or cost of goods value that may impact calculations of the Berry ratio; debt cost and debt levels if the debts are related party and so effect interest deductions and thin capitalization; and functional differences that imply different levels of working capital all need to be considered.
One approach to a working capital adjustment is the ‘one step’ method explained in the TPG (annex to Chapter III) resulting in an adjusted operating margin. There may be advantages, however, in making separate adjustments to cost of goods and sales, or to the comparable uncontrolled prices themselves. This analysis could examine each of the adjusted prices, gross and net margins and Berry ratios, and consider more directly whether the implied prices are consistent with commercial pricing behavior and uncontrolled prices.
Tax Authority Expectations
The attitudes of tax authorities may be relevant to consider as well. For instance, a country’s rules or fiscal authorities' expectations may insist on applying the adjustment or at least showing the impact of a working capital calculation. A court may have certain expectations of an expert if the WCA is to be included in testimony in litigation.
Other circumstances may allow for WCA’s to assist in resolving disputes. Competent authorities working to resolve double tax in a mutual agreement procedure, or as part of a unilateral or bilateral advance pricing arrangement (APA), may seek to explore the calculation as a way of achieving broader agreement on, say, an arm’s length range of operating margins. Negotiators may also review levels of working capital, the potential impacts of WCAs, and then agree limits on the taxpayer’s levels of working capital as a critical assumption in an APA.
Hopefully, this note demonstrates why working capital adjustments shouldn’t be standard or automatic, nor something to be believed in or not believed in. Instead, the adjustment should have a sound commercial basis that demonstrates that it’s consistent with arm’s length behavior and materially improves comparability.
Geoff Morris is an independent transfer pricing advisor with more than 20 years' experience analyzing, negotiating and resolving transfer pricing disputes. As Senior Director with the Australian Taxation Office’s Economist Practice from 2010-2020, he helped develop the ATO’s economic position on transfer pricing risk reviews, audits, advance pricing arrangements and supporting competent authority negotiations.
He can be contacted at: firstname.lastname@example.org
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