Effects of current crises on TP approaches in the automotive industry

Automotive industry participants continuously face various disruptions and challenges. From the COVID-19 pandemic to interrupted supply chains, geopolitical instabilities, the energy crisis and increasing inflation, automotive companies have been in a permanent state of emergency for years.

The supply bottlenecks in semiconductors, which began in 2021 and continued through 2022, were a determining factor for supply chain disruptions for automotive companies. Material shortages as well as a production downtime of wire harnesses in Ukraine in spring 2022 further exacerbated this issue, leading to an increase in order backlogs and long waiting times for new cars. Political instability and related price increases for energy supplies came into focus during the year, with both gas and electricity becoming dramatically more expensive. This mix of challenges was also reflected in increasing producer and consumer prices - producer prices in Germany for industrial products recorded the highest year-on-year rise since 1949.

Those challenges, however, have had a diverse impact on economies globally. While Europe and the US recorded declining sales in 2022, sales in China grew by double digits. Even broken down to sales regions, car registrations ranged widely. In Europe, this ranged from an increase of 1% in Germany to a decrease of 10% in Italy. Thus, automotive companies had to cope with overutilisation and underutilisation at the same time across plants in different countries and regions.

In addition, the automotive industry is in the process of its largest transformation ever. The technological transformation is driven by increasing demand for electrified vehicles and legislative requirements pushing the industry towards sustainability. On a global level, hybrids, plug-in hybrids and pure electric vehicles are expected to catch up with vehicles run by classic combustion engines soon in terms of sales volume. Certain parts of the automotive supplier industry, especially those companies heavily involved in developing and manufacturing parts of the classic combustion engine, will need to counter the falling demand in their current products with new business segments through investments and innovations. In addition, the ongoing digitalisation and high customer expectations for advanced connected technical solutions are further challenges in automotive markets.

One of the key challenges in mastering the technological transformation is maintaining an adequate workforce. Shortages of skilled labour amplifies the competition among companies to attract and sustain talent. COVID-19 has also left its mark and solidified employees’ wish for flexibility in their workplace. For example, a survey by Deloitte on the “future of workplace” indicates that 83% of participants desire the possibility to work outside the office, whereas the majority (51 %) would even like to work between one and three days on average remotely. Increased bargaining power on the employees’ side indicates that employers are having a hard time refusing the wishes of staff.

The above disruptions and challenges provide a number of organisational and operational difficulties from the perspective of TP:

From a group perspective, strategic functions along the value chain need to be identified and remunerated accordingly. Strategic functions are those having a global impact on the overall value chain and having an important control aspect over strategic risks, which may not only affect operations but the long-term direction of a business model. The current and future function and risk profile of legal entities within a group of automotive entities needs to be re-evaluated with respect to the latest impact from macroeconomic and geopolitical shocks. During the current crises, the strategic role of the procurement function gains higher importance and remuneration schemes might have to be revisited to account for this increase in value.

The question is whether a cost-based remuneration is still appropriate or if the strategic procurement function is entitled to a share of the residual profit. The higher costs for routine entities may also be due to measures introduced on group level to ensure the functionality and efficiency of the group during a disrupted environment. Consequently, companies in the automotive industry increasingly centralise their business operating model by, for example, implementing principal models to properly remunerate the strategy leader function.

Another important strategic aspect to be considered from a TP perspective is the group’s risk management function. The organisation of risk management includes defining processes, documenting risk control measures, implementing systems/tools as well as continuously monitoring and mitigating potential risk factors to ensure quick reactions and a flexible set-up to avoid severe impacts on the value chain. Such functions can gain enormous importance in times of crisis and be decisive for whether a group of companies makes profits or losses, and who will be entitled to profits or must bear losses resulting from a deviation of expected financial figures. Particularly multinational groups who have implemented a strong price setting mechanism will now face the question of who and how to implement price adjustments in case of major deviations from forecasted financial figures. Risk management departments can be helpful in making this decision and might gain importance in the overall risk control management of their organisation.

As another example, the impact of higher cost bases for routine service providers and their profit elements should be in line with the risk control possibilities and a revision of their strategic importance. Then it must be concluded whether any adjustment to the remuneration is necessary from an arm’s length perspective, be that an adjustment of the underlying cost base, the profit mark-up or even an entitlement to a share of the residual profit or loss.

First, it is important to ensure that intercompany agreements are properly reflecting the actual behaviour of the contractual parties and also ensure agility to a certain extent. License agreements between related parties need to be revised and checked for appropriateness given the challenges and changes in the automotive markets. For instance, increasing inflation may result in increasing revenues which may only reflect higher prices but not higher profitability. As a result, past intercompany agreements and prior remuneration schemes may be deemed inappropriate. In case the responsibilities or the value added by certain intercompany services have changed, or if material deviations from original terms and conditions are necessary, it might also be important to amend remuneration schemes or the like. Thus, remuneration schemes and TP guidelines need to be updated in line with any changes in these challenging times.

From a compliance perspective the above-mentioned aspects leading to changes in the TP system or remuneration scheme will need to be well documented in TP reports. This is especially true when major changes of a group’s operations are planned, like a relocation of manufacturing capacity, new service provisions, the provision of financial guarantees or funds. It is important to implement policies and procedures to identify the transactions which may be seen as reportable arrangements as penalties can be very significant.

Steering margins from intercompany transactions of entities which are routine in nature using the results from benchmarking studies is another challenge in disrupted times. The financial results from benchmark companies may not reflect the disruptions from current market threats as their financial KPIs are usually time lagged and might have to be considered incomparable to a current intercompany business relationship. Another issue of the time lag arises in the opposite case: recent disruptions are already considered in KPIs of comparable companies, those disruptions however no longer impact the KPI of the controlled party and hence, current intercompany business relationships are incomparable. Therefore, either neglecting or considering disruptive effects and steering a routine entity into a range of potentially incomparable benchmark companies may result in the entity earning understated or overstated margins, inconsistent with the values added by controlled parties within a group of companies.

Following the differences in demand and the disruptions along the supply chain, the utilisation of manufacturing functions within the automotive industry varied. This has led to reorganisations of production plants, resulting in expansions of cost-efficient plants versus closures of plants with underutilisation. From a TP perspective, this may lead to a centralisation of production functions, potentially requiring changes in the business model and the TP implications along such restructurings.

After the COVID-19 pandemic, the number of employees working remotely has increased, which requires clear guidelines defined by the employer. This considers which function can work from which location, and moreover make decisions on behalf of the company. It is to be expected that future tax audits will put a higher focus on potential permanent establishments resulting from flexible workplaces in different jurisdictions. It can be questioned whether flexible workplaces are of higher importance in the automotive industry than in other industries. With respect to any manufacturing function, flexible workplaces are as such not possible. For other activities not requiring any material, tools, machines, etc., this can be considered similar to other industries. Nowadays, the attractiveness of employers very much depends on options for flexible workplaces and increases the employee’s satisfaction.

All these difficulties and the ways in which multinational corporations adjust to them may modify the functional and risk profiles of various legal entities, result in business restructurings, or temporarily alter how they conduct their operations. Regarding a potential transfer of functions, such changes need to be carefully examined from a TP perspective. The steps for reviewing such incidents and considering any potential compensation claims are outlined in full in Chapter IX of the OECD Guidelines. Moving forward, an adaptable and flexible business model may involve more frequent IP transfers, production transfers, and restructurings, thus it is important to consider if the multinational's internal policies and operational procedures are appropriate.

As a result, the TP issues raised above, such as analysing and compensating strategic functions, ensuring compliance, properly applying benchmarking studies, and the impact of business restructurings, need to be considered.

The management of intercompany agreements, the economic pricing and valuation of functions and IP, as well as the implementation of such changes from an operational perspective, could be expected to require increased flexibility. 

The issues facing the automotive sector are likely to persist for some time, thus it is critical to carefully examine the current market environment.