TP controversy in the pharmaceutical and automotive industries: commonality or contrast?

Both pharmaceutical and automotive groups have long been subject to transfer pricing controversy of some sort, including tax authority enquiries but often also mutual agreement procedures (MAPs) to resolve double taxation arising from controversy, or in some cases entering into advance pricing agreements (APAs) to prevent controversy. It is easy to understand why both industries feature a relatively small number of significant groups with sizeable global footprints and considerable intracompany flows.

This article explores some of the aspects of these industries that have contributed to this controversy.

Superficially, the automotive and pharmaceutical industries seem hugely different. From a transfer pricing perspective, however, consideration of the functions, assets, and risks might well reach similar conclusions as to what the value drivers are in each industry. Both industries are reliant on R&D (for automotive, this is focused on technical and design; for pharmaceutical, this is focused on drug discovery and application) and both industries manufacture products ultimately for a consumer but distribute in the main through third parties rather than directly to those consumers.

Manufacturing supply chains are particularly complex in the automotive industry, with many third-party suppliers being utilised and frequent cross-border movement of components. Many would conclude the pharmaceutical industry is also subject to these complexities. Brands are important for both industries, but what drives the value of the brand may well be different. Both industries are regulated to a high degree but in a varying manner, which is discussed in more detail below.

There are significant barriers to entry in both industries and therefore disruption tends to come more from R&D-led developments. The electric vehicle changes that have greatly impacted the automotive sector have been technologically led but have allowed new entrants to the global market to emerge as competitors to the more established groups.

When we look at the business models deployed by businesses, we start to see divergences that would affect any transfer pricing analysis. Notably, a central ‘entrepreneur’ structure with a single entity owning key intangible assets and undertaking core entrepreneurial functions, and a web of entities undertaking more routine functions such as contract manufacturing or distribution, remains the dominant model in the automotive industry.

However, in the pharmaceutical industry there are more instances of joint entrepreneurs within a group, and cases where intangibles are owned by more than one entity, as well as, in particular, distinct types of intangibles being owned by separate entities. As a general guide, one can see more of a concentration of development, enhancement, maintenance, protection, and exploitation (DEMPE) functions, and particularly the DEMP elements, at the head office (home state) of a typical automotive group, whereas DEMPE functions in a pharmaceutical multinational enterprise (MNE) may take place in multiple entities.

It is interesting to consider what these similarities and differences mean for the controversy trends in these industries.

A significant volume of transfer pricing controversy continues to focus on matters at the supposedly simpler end of the scale, such as the application of the transactional net margin method to a distribution or manufacturing entity. This controversy may be related to fundamental issues such as the identification of comparables that underpin the arm’s-length range, points in the range targeted, and any adjustments required.

It is interesting that these seemingly simple transfer pricing issues have been the subject of much controversy due to the size of the underlying transactions and therefore the tax at stake. Ultimately, of course, these issues are a matter of price and therefore ideally subject to resolution in a MAP or, increasingly, an APA.

Many dispute resolution and prevention procedures concern the arm’s-length markup for manufacturing (a term that, in practice, can vary from simple assembly to a much more fully fledged and risky activity) or a distribution return. These issues, which seem deceptively simple, remain areas where both automotive and pharmaceutical groups need to consider transfer pricing policies.

Automotive groups have long had to grapple with the problem of limited third-party distributors comparable to the traditional automotive national sales company. This is an issue that perhaps does not exist to the same degree in the traditional pharmaceutical sector, but developments in bespoke patient therapies also raise comparability considerations for the distribution end of the supply chain.

Turning to manufacturing, we have long seen controversy in the relevant markup to be applied but also as to whether certain costs should be treated as pass-through or marked up. Lack of adequate information about comparables can make resolution time consuming.

At the more difficult end of the spectrum, issues concerning inadequate or excessive manufacturing capacity and low utilisation have often featured in controversy. It is important to establish why, how, and at whose behest capacity exists and is utilised. In any group where decisions can be taken for sensible commercial reasons on a global scale, it is not always easy to ‘draw down the corporate veil’ and ascribe capacity and its utilisation to individual entities, let alone factor in how this would affect the pricing between independent entities when manufacturing was undertaken. Factually – i.e., legally and economically – making sure an entity conducts a level of activity that can be benchmarked (that is to say, something that could be considered routine and relatively low risk) will lead the way to the correct transfer pricing policy.

Unfortunately, the transfer pricing treatment of business restructuring and the rationalisation of manufacturing capacity are issues that are likely to remain in the short to mid-term, particularly in the automotive sector.

In the automotive sector recently, some groups have adapted their historical models to bear more risk as a result of third-party distribution networks no longer having a buy-sell model but instead receiving a commission. In theory, this may well increase risks in the national sales company of the MNE, which would need to be factored into that company’s distribution return unless it could be established that the new activity was, in fact, being conducted elsewhere.

In the main, automotive groups continue to adopt a traditional transfer pricing model, reflecting that most of the important intangible property (IP) and value drivers tend to be located at head office. Overseas activity is mainly distribution and manufacturing, and can be rewarded with benchmarking; albeit benchmarking that needs to recognise any increased functionality and risk compared with supposedly comparable independent companies.

In this sector, it is mainly the case that DEMPE functions tend to be in a single jurisdiction, with residual profits or losses sitting by default within that jurisdiction. Irrespective of the level of integration within an overall business that is split between entities, profit split is typically not seen as the right answer within the automotive sector because of this concentration of DEMPE functions.

This is often not the case within the pharmaceutical sector. Tax authorities continue to scrutinise the substance of ownership of intangibles, particularly where groups have entities in traditionally lower-tax jurisdictions. A common challenge is whether it is appropriate for all residual profits to be earned by the legal owners of intangibles in complex value chains or whether other entities undertake DEMPE activity that should earn more than a routine return.

Such questions have long featured in controversy in the pharmaceutical sector. The funding and control of R&D and, as a consequence, the allocation of profits or losses arising from successes or failures are complex topics that, by their very nature, are difficult to resolve, requiring an analysis of arm’s-length behaviour as well as price.

In the pharmaceutical industry in particular, the lengthy timeframe that often exists between R&D spend and potential income associated with that spend can result in a tax authority challenging the degree to which an entity would bear costs in the short to medium term, notwithstanding that if successful, the entity may enjoy substantial taxable profits in the longer term.

Paragraph 1.130 of the OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations (the OECD Transfer Pricing Guidelines) recognises that the nature and extent of government regulation of the market is an economic circumstance relevant for determining comparability when assessing arm’s-length pricing.

Both industries are heavily regulated and the interplay between market forces and regulatory intervention necessitates a nuanced approach to transfer pricing and may lead to transfer pricing controversy.

Considering firstly the pharmaceutical industry, regulation spans many areas. Those with the most notable impact on transfer pricing relate to the following:

• Drug development and approval – the industry faces strict regulations governing clinical trials, data submission, and the approval process itself. Government agencies set rigorous standards for safety and efficacy before a drug can be marketed. These regulations cover aspects such as trial design, data integrity, and post-market surveillance. Inherently, this regulation creates costs and economically significant risks that the business must manage. How the intricacies of these regulations are reflected in transfer pricing policies is a matter that often arises in controversy and that must be addressed by determining which entities bear and manage the key risks associated with the regulation.

• Regulated pricing – many countries have regulations controlling the price of pharmaceuticals, often through government price setting or negotiation with manufacturers. In markets such as the US, reimbursement policies determine which drugs are covered by public health insurance, impacting market access and profitability. Price regulation has an impact on the overall profit available in a business’s value chain and can impact the returns of all entities. It also adds another key dimension when considering whether transactions with third parties may be considered to be comparable uncontrolled prices in a transfer pricing analysis.

The automotive industry is also heavily regulated (e.g., related to emissions, safety, and fuel efficiency) but is also subject to market incentives, such as subsidies for electrical vehicle production, which can vary significantly across geographies.

Perhaps the single largest development affecting the automotive sector has been the regulation around emissions. The need to avoid regulatory fines at a national or wider level is a clear and substantial risk. How this risk is managed in practice and which entities are involved must be taken into account in any transfer pricing policy. Technology, manufacturing, and distribution activities all play a role in managing emissions across the whole product range offered by an automotive company. Establishing which entities are involved in this complex activity is vital to establishing the correct underlying transfer pricing.

Due to some fundamental differences between the two industries, some themes arise in transfer pricing controversies in each sector that are not widely found in the other.

Firstly, the topic of hard-to-value intangibles, found in the OECD Transfer Pricing Guidelines, remains a more significant issue in the pharmaceuticals industry than the automotive industry. These rules focus on determining arm’s-length pricing in relation to intangible assets, which, by their nature, lack readily available comparable market data (e.g., complex patents, cutting-edge R&D, and brand names with uncertain future value).

Naturally, where hard-to-value intangibles exist, there is greater uncertainty in the transfer pricing analysis, which may lead to transfer pricing controversy. That may involve a business aiming to prevent controversy by seeking APAs or being subject to challenge through audits. In the pharmaceuticals industry, there is a prevalence of hard-to-value intangibles due to the high degree of uncertainty inherent in drug development. The long lead times, high failure rates, and regulatory hurdles mean that the value of a pharmaceutical intangible, such as a new drug candidate, is highly uncertain at the outset.

In the automotive industry, while there are comparability challenges, the identification of hard-to-value intangibles is not as widespread and therefore controversy on this topic is more limited. In particular, where component parts of IP – i.e., technology and a brand – are owned in one territory and the attached DEMPE functions take place there, it is rarely necessary to even consider the value of this IP for transfer pricing purposes. Any quantification of what component parts constituted the value of an automotive brand would be a difficult exercise. Many industry people would doubtless conclude that technology, design, and manufacturing quality matter more than brand advertising, but the area itself is not without controversy.

Cost-sharing arrangements and any associated controversy are prevalent in the pharmaceuticals industry but remain relatively rare in the automotive industry. Controversy issues related to cost-sharing arrangements cover a range of issues, including whether participants in a cost share are valid participants and whether the measurement of anticipated benefits is appropriate.

As the automotive industry increasingly invests in R&D for technologies such as electric vehicles and autonomous driving, the use of cost-sharing arrangements may increase, potentially leading to a rise in related transfer pricing controversy.

The pharmaceutical and automotive industries, despite their apparent differences, share a common thread: business models with widespread footprints and typically high levels of transfer pricing controversy. Both sectors face intense scrutiny regarding the allocation of residual profits, the appropriate consideration of DEMPE functions, and the arm’s-length return for supposedly benchmarkable/routine functions.

However, differences do exist in the specific areas of controversy. The pharmaceutical industry grapples more frequently with the complexities of hard-to-value intangibles and the intricacies of cost-sharing arrangements, while the automotive industry faces unique challenges related to fluctuating market incentives, emissions regulations, excess capacity, etc.

The ongoing evolution of both industries, driven by technological advancements and regulatory shifts, will undoubtedly continue to shape the transfer pricing landscape. And this is before we even consider the matter of tariffs…

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