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Oil and gas industry downturn and transfer pricing considerations

Randy Price, Sam Fletcher and Mayank Gautam explain how a downturn in production for the oil and gas industry and a reduction in the price of oil will impact an energy company’s transfer pricing arrangements.

After a four-year period of relative price stability, oil prices fell sharply in the second half of 2014. While volatility has been a common theme for oil prices in the last several decades, last year's fall in oil prices differs from those of the past, stemming from changes in supply conditions, expansion of oil output in the US, receding supply disruptions and OPEC's switch to a policy to defend its existing market share. With supply conditions and price not expected to substantially change in the near term, the oil & gas (O&G) industry will be required to adapt to new market dynamics.

Often, the impact of the decline in oil price is heavily dependent on the segment in which the companies operate in the O&G industry value chain. The upstream segment, dominated by oil majors and large integrated O&G companies, tends to reduce capital investment in this environment. Depressed prices often decrease a project's expected returns from future production, which results in lowering the project's potential rate of return and thus diminishes incentives for investment spending.

Decisions made by the upstream segment to decrease capital spending have put downward pressure on other sectors of the O&G industry, with the most acute impact on the oil field services (OFS) sector. As oil prices and upstream investment spending fall, reduced demand for rigs and other oil field services may be severe. In a March 2015 report, Forbes calculated that the worldwide O&G industry, including OFS companies, parts manufacturers, and steel pipe makers, have laid off at least 75,000 personnel during the current downturn. The service companies have borne the brunt of these dismissals, with nearly 59,000 layoffs, because their activity and revenue streams are directly related to drilling activity. According to a Moody's report, OFS companies may experience deep, protracted, cyclical downturn conditions for the foreseeable future, given that even with a moderate oil price increase, integrated oil majors will likely remain cautious about capital and investments.

A topic that has attracted considerable attention in recent months as the O&G industry continues to experience downturn has been how tax departments within O&G companies should address the serious challenges posed to related-party transaction policies and results dictated by the current economic crisis. The challenge may exceed the limits of what can be managed within the transfer pricing systems currently applied by many O&G companies, and may require a changed approach to transfer pricing systems currently adopted. The following sections discuss transfer pricing challenges and practical ways to overcome such challenges, and highlight long-term tax planning opportunities that may be available based on the current environment.

Challenges and practical solutions

Transfer pricing methods assume stable conditions for variables such as revenue, costs, and overall profitability. However, during an economic downturn, these steady conditions may be severely tested. During normal economic times, transfer pricing policies often lead to operating profits for transacting parties that are consistent with profits at comparable companies, and thus acceptable to tax authorities.

The current O&G contraction is idiosyncratic and countercyclical to the trend in the broader economy. That is, while the O&G industry is in a downturn, the broader economy may be improving or on a longer-term trend-line. Because transfer pricing benchmarking for O&G companies often relies on functional comparables from other industries, the benchmarking that was reliable in normal economic times may not be realistic in the downturn, because these comparables may not experience the severity of the specific downturn to the O&G industry. Thus, companies may find it appropriate to adjust transfer pricing approaches developed during normal economic times to approaches that are more appropriate for these downturn conditions.

Such adjustments for recessionary periods in a specific industry are consistent with the guidance in the US transfer pricing regulations. This section aims at providing a framework for addressing transfer pricing issues that O&G companies may potentially encounter during the current downturn.

Adjusting for economic conditions

To ensure the potential comparable data are indeed comparable and do reflect the economic reality for controlled parties, an adjustment for transfer pricing methods, such as the comparable profits method or the transactional net margin method, may be considered appropriate.

Revise existing comparable sets

To account for the current industry-specific economic conditions and improve the reliability of the CPM analysis, the existing comparables set can be screened based on quantitative criteria to identify comparables whose growth rates differed significantly from the tested party. Additional screening criteria such as SG&A to sales and amounts of fixed costs relative to total costs might also be explored. While there is a sound theoretical basis for applying quantitative screening, actual implementation may lead to the selection of only a few comparables. As a practical matter, certain restrictive screening criteria can be relaxed to obtain enough comparables to which additional qualitative or quantitative adjustments can be applied.

Revise comparable companies' financial data

Adjusting profit ranges of comparable companies to mimic the reality in the O&G industry can also be explored. Depending on the particular facts and circumstances of the tested party, the financials may be adjusted for differences related to volume, cost structure, inventory, and excess capacity. Further, adjustments can be made using established statistical and econometric techniques, such as regression analysis, to establish an underlying relationship between sales and profitability. Additionally, for certain categories such as cost structure or excess capacity, when comparable companies may not have enough publicly available data, an economic indicator or industry statistic specific to the O&G industry could be used as a guideline to quantify the relative magnitude of such adjustments. For instance, a correlation can be computed for average comparable company profitability against the economic indicator specific to the O&G industry, which may be used as a basis to make adjustments.

Revise tested parties' financial data

Another set of adjustments that can be performed to tested-party financial results relate to specific variables that lag during the economic downturn. For example, short-term profitability may be impacted by a significant sales decline as reductions in the cost of goods sold or SG&A cannot be accomplished as quickly. During this intermediate time period, it may be reasonable to use benchmarks derived from the company's operations in periods during which it experienced normal growth conditions to perform comparability adjustments.

Revise time period for averaging

Using average profit ratios over multiple years is also a common practice based on the rationale of smoothing the effect of business cycles. However, in the case of a severe downturn, relying on a three-year average including data from two preceding years may not be appropriate. Taxpayers have the ability to use a longer period for comparable company profitability, including financial data from a previous downturn (for example, extending the multiple-year period to include the last O&G recession during 2008 and 2009). Such an approach would increase the likelihood of finding observations on comparable companies that are similar to the current downturn in the O&G industry and may provide a better estimate of the time period used for calculating an average.

Pooling comparable results

Because different comparable companies may have experienced downturns in different years, pooling, rather than averaging the comparable data may provide another approach to the analysis. Pooling the results takes each available year of comparable data as a separate observation to establish a range of benchmarking. Under this approach, an appropriate range might be created from a relatively small number of comparable companies. Additionally, because it treats each comparable data set as a separate observation, pooling tends to yield a wider interquartile range, which might appeal to tested parties impacted by the O&G industry downturn.

Preempting challenges

During a downturn, taxpayers in the O&G industry may face losses unrelated to transfer pricing, and the transfer pricing method suggested for normal operating years may no longer be a reliable or supportable method. For example, the CPM may no longer be the best method when all related parties participating in certain transactions generate losses. In that case, a transactional method or profit or loss split method may be more appropriate.

Further, the current downturn in the O&G industry is an economic event felt comprehensively across geographies, lowering profit margins of multinational O&G companies. In such circumstances, tax authorities are likely to scrutinise closely the deductibility of outbound payments when local entities incur losses, presenting practical challenges in defending such deductions. Therefore, certain outbound costs related to recharge of headquarters and back-office support, payment for trademark or tradenames, franchise fees and other payments related to the use of intangibles (centralised costs) should be carefully analysed and a strong defence position should be prepared contemporaneously to anticipate future audits and potential denials of deductibility of such costs.

A more favourable development in recent years has been the increased willingness of tax authorities to accept some inbound centralised costs as deductible business expenses. However, the economic downturn poses a threat to their continued deductibility, because it may be difficult to substantiate that the centralised costs were of benefit to the recipient when the local entity suffers losses. In these cases, businesses could face an increased risk of double taxation when centralised costs are partially or fully denied as deductible business expenses in the local country.

Furthermore, tax authorities may invoke, commensurate with income standards, to put pressure on local loss-making affiliates' ability to pay for centralised costs. In addition to the nature of payment, risk with respect to such transactions may be increased depending on the identity and likely tax attributes of the recipient of the payment. Accordingly, such payments may be scrutinised closely if they are paid to intermediate affiliates in low-tax jurisdictions.

Given the prevailing economic environment and potential transfer pricing risk, the defence of transfer pricing arrangements for O&G companies is clearly important. The transfer pricing approach undertaken will need to be supported through appropriate documentation, including relevant intercompany agreements and economic analyses. The need for such documentation is critical, because tax audits may occur several years after the events at issue; therefore, it is important to memorialise the relevant facts on a contemporaneous basis.

Finally, the transfer pricing documentation report can be used to tell the company's story of economic hardship as it relates to intercompany pricing for the past fiscal year. It may be informative to provide a narrative that leads up to, and helps explain, the results of the economic analysis. Ideally, taxpayers should support and explain any low, or negative, operating results by explaining the broader economic conditions in a contemporaneous manner, rather than being reactive to alternate narratives put forth by the tax authorities. Once the tax authorities have put forward their position, rebuttal may be a difficult task, which reaffirms the need for appropriate documentation.


While the current downturn creates challenges for the O&G industry, it also presents opportunities for tax departments to revisit assumptions and estimates of asset values and supply chains that may need to be enhanced or rationalised to create more value in the future should an O&G industry recovery take hold.

For example, the current downturn may enable the better alignment of intellectual property (IP) within the supply chain where local geographic management and exploitation is occurring (for instance, an Asia Pacific manufacturing facility) because it is no longer cost prohibitive from a tax perspective to transfer the IP out of the developer's tax jurisdiction. Specifically, economic downturns provide a rationale to reevaluate assumptions such as growth rates, profitability, and discount/hurdle rates that are critical to assessing the true value of IP that may be transferred in a related-party context.

Another potential opportunity presented by the economic downturn is for O&G companies to reduce their transfer pricing risk by entering into an advance pricing agreement (APA) with tax authorities. APAs offer certainty that the tax authorities will accept the selected transfer pricing method to be used for related-party transactions over a fixed period of time. APAs can be beneficial in a downturn because they can provide an O&G company an opportunity to discuss the impact of the current downturn on its transfer pricing policy with the tax authorities as it unfolds, and to propose a mechanism to seek relief. If the taxpayer is taking advantage of certain non-traditional adjustments for the tested party/comparable companies (as discussed earlier in this article), APAs may be the right vehicle to discuss the need for and application of such adjustments.

Just as the current downturn is disrupting traditional business models for struggling O&G companies, the current wave of international tax reform is creating uncertainty over the ongoing effectiveness of tax outcomes under existing business structures. As the G20-OECD Action Plan on base erosion and profit shifting (BEPS) unfolds, O&G companies are expected to enter the BEPS era with unique economic circumstances in light of depressed oil prices. BEPS particularly targets situations in which risks, and the resulting rewards, are not aligned with value-creating functions, such as location of key employees. Profits that previously would have flowed contractually to entities providing access to at-risk capital may be repositioned to key people functions and, to some extent, asset-holding locations post-BEPS. This change is significant for O&G companies, especially OFS companies where much of the substance that creates value lies in its people and assets. O&G companies considering short-term operational changes to mitigate the impact of a downturn should look ahead and assess whether such changes – either in the supply chain or the company structure – would be appropriate in the post-BEPS time period.


The current downturn in the O&G industry has significantly affected companies, especially those that continue to operate in the OFS sector, potentially rendering existing transfer pricing methods vulnerable. This, coupled with increased compliance requirements and enforcement activities, has heightened the transfer pricing risk for O&G companies. As a practical matter, taxpayers dealing with transfer pricing challenges can take advantage of specific provisions within regulations and make valid adjustments. It is important to prepare appropriate transfer pricing documentation to memorialise which approach the taxpayer takes to modify existing transfer pricing to address downturn-driven challenges.

The current downturn is also an opportune time to consider whether the overall transfer pricing policy meets the needs of the company in the long run. The current downturn is forcing O&G companies to reassess operations and quickly adapt their tax policies. It is likely that companies may engage in a number of business-driven changes that may impact their transfer pricing. If companies execute changes at this time, the changes can be explained as a reaction to the downturn, and the profit impact of those changes will have the proper context of the overall economic downturn.



Randy G Price

Director, Transfer Pricing

Deloitte Tax LLP

1111 Bagby Street, Suite 4500

Houston, TX 77002

Tel: +1 713 982

Randy Price is the leader of Deloitte Tax's transfer pricing practice in the Houston, Texas office. His transfer pricing experience includes client engagements spanning the entire energy value chain. Randy's primary area of focus is assisting energy-related clients in the management of global transfer pricing planning, documentation and tax controversy matters. In addition to his core energy related experience, he has significant experience with transfer pricing issues involving the cost sharing of intangibles and related buy-in payments for technology focused industries.

Before joining Deloitte, Randy spent more than 10 years as an international tax/transfer pricing executive for a Fortune 500 multinational company where he developed, implemented and ultimately defended multiple transfer pricing transactions from the IRS exam phase through appeals. In addition, he has experience with transfer pricing planning and controversy matters in multiple jurisdictions outside of the US. Given Randy's experiences both within the industry and at Deloitte Tax, he provides the practical and technical transfer pricing skill set that clients desire in today's complex transfer pricing environment.



Samuel Fletcher

Senior Manager, Transfer Pricing

Deloitte Tax LLP

1111 Bagby Street, Suite 4500

Houston, TX 77002

Tel: +1 713 982

Sam is a manager in Deloitte Tax's Houston, Texas transfer pricing practice. He has over 8 years of experience in transfer pricing, specialising in the oil and gas industry, both in Houston and Calgary, Alberta.

Sam has been actively involved in a variety of outbound and inbound projects providing services to large multinational clients. His recent engagements within the oil and gas industry include tax and transfer pricing value chain planning related to the export and marketing of natural gas from North America into Asia, transfer pricing planning analysis to determine long-term pricing of LNG cargo transactions, and transfer pricing assistance and successful IRS defense for a marketing and distribution company of crude oil products.

Sam has also consulted on cross-border supply chain transfer pricing for clients in the recreational vehicle and software industries.



Mayank Gautam

Manager, Transfer Pricing

Deloitte Tax LLP

1111 Bagby Street, Suite 4500

Houston, TX 77002

Tel: +1 713 982

Mayank Gautam is a Manager in Deloitte Tax's Houston, Texas office. He has over 7 years of transfer pricing experience advising clients and providing specialist advice on diverse transfer pricing matters such as global and local documentation, planning, multi-jurisdictional cost sharing and licensing on intangible property. Mayank has significant experience assisting clients with transfer pricing controversies, dispute resolution and litigation and has provided assistance with authority negotiations and advance pricing agreements. His transfer pricing experience also includes identification, analysis, and documentation of tax provision implications of transfer pricing issues. Additionally, Mayank has provided transfer pricing advice for several due diligence studies, mergers and acquisitions, corporate relocations, and restructurings.

Before joining Deloitte, Mayank worked for another major accounting firm in their Mumbai and Houston offices. He is an economist by training and has taught university level economics courses in the US and in India. Mayank has also conducted research in international macroeconomics and finance.

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