The pharmaceutical and automotive industries represent two segments that operate significantly worldwide with complex value chains and extensive intra-group operations. In this context, Transfer Pricing disputes have been comprising constant audits, Mutual Agreement Procedures (MAP), and Advance Pricing Agreements (APAs) that exemplify this level of attention from tax authorities. These controversies mainly revolve around the allocation of functions, risks, and assets-especially intangible ones-and the determination of appropriate margins for entities with routine functions.
This article addresses the most common conflict points in both industries, identifies similarities and differences, and offers insights into how companies can address these challenges in their Transfer Pricing policies.
Value Chain and Operational Organization: Functional Similarities
At first glance, the automotive and pharmaceutical sectors may appear very different. Conversely, from the perspective of function, asset, and risk (FAR) analysis, there are several parallels:
- Both engage in research and development (R&D)-intensive activities. In the automotive industry, for technological design, improvements, and new models; in the pharmaceutical industry, for molecule development, clinical trials, and complex regulatory compliance.
- Companies in both sectors manufacture products for sale in multiple jurisdictions, with most of their distribution handled by third parties (distributors, pharmacy chains, concessionaires).
- Supply chains involve the cross-border transport of components or raw materials, which requires consideration of logistics costs, customs duties, and intermediary margins.
- Brands or product reputation are relevant value factors in both industries. However, the origin of brand value may differ (technology/innovation in automotive vs. scientific reputation, clinical efficacy, and trademark in pharmaceuticals).
These functional similarities mean that particular Transfer Pricing challenges (e.g., finding suitable comparables, adjusting for functional differences, supporting ranges) arise in both industries.
Critical Controversial Areas in Both Industries
1. Manufacturing and distribution margins
One of the usual points of contention is the remuneration of entities performing routine functions, such as assembly, distribution, storage, and logistics. Although these roles may seem simple, the controversy focuses on:
- The choice of the appropriate comparable to set the margin (net profit margin, sales margin, etc.).
- Functional adjustments for differences in volume, risk, market conditions, and regulatory environment.
- The inclusion or exclusion of certain pass-through costs (unmarked costs) versus costs that should be subject to markup.
- In the automotive sector, the limitation of independent comparables for car distributors in certain countries can make benchmarking difficult.
2. Hard-to-value intangibles
In the pharmaceutical sector, the controversy surrounding intangibles is more pronounced:
- Assets such as molecules in development, emerging patents, or evolving technologies have uncertain value and little comparability, creating an inherent risk of disputes.
- The long time period between investment in R&D and actual income may lead authorities to question whether a local or intermediary entity contributed sufficient value or whether it should receive a portion of the residual profits.
- In the automotive industry, although there are technological and brand intangibles, these are often more concentrated in the parent company or a single jurisdiction, which simplifies the allocation of residual benefits.
3. Cost-sharing arrangements
The use of cost-sharing arrangements-where several entities within the group share development costs in exchange for future profit sharing-is more common in the pharmaceutical industry:
- There is an ongoing debate regarding whether all participating entities possess the necessary substance to assess cost-sharing accurately.
- In addition to reasonably estimating expected benefits, including formulas used, market assumptions, risk adjustments, etc.
- In the automotive sector, the use of cost-sharing is even less common but may increase with the evolution toward electric vehicles, autonomy, and automotive software.
4. Regulation and market distortions
Both sectors are heavily regulated, which complicates comparative analysis:
- In pharmaceuticals, regulation affects clinical trials, drug approval, and regulated prices (state reimbursement, price control mechanisms).
- Regulatory requirements impose costs, risks, and time frames that must be accurately accounted for in the functional analysis to determine which entity assumes those risks.
- In the automotive industry, regulations on emissions, safety, fuel efficiency, technical standards, and incentives for electric vehicles may alter the competitive landscape and return expectations.
- In addition, government incentives, subsidies, or local regulations may favor one country over another, introducing biases to be considered when evaluating comparables.
Key Differences Among Industries
- Complexity of Intangibles: The pharmaceutical industry faces a greater degree of uncertainty and difficulty in valuing emerging intangibles, which complicates it than the automotive industry, where intangibles may be more definable (brands, designs, technological know-how).
- DEMPE distribution: In the automotive industry, DEMPE (development, enhancement, maintenance, protection, exploitation) functions are commonly concentrated in a central entity within the group. In the pharmaceutical industry, these functions may be more distributed among entities within the group, which increases controversy over who deserves residual profitability.
- Frequency and magnitude of cost-sharing: Pharmaceuticals tend to use more cost-sharing due to the nature of their research-based business. In contrast, the automotive industry has been more traditional in central development and distribution structures.
- Capacity issues or infrastructure surplus: In the automotive industry, there may be capacity constraints or underutilization of plants, and discussions about whether it is reasonable to consider additional margin for these facilities.
Practical Implications for Transfer Pricing Policies
Transfer Pricing management in regulated sectors requires a comprehensive approach. The DEMPE model must support entities that will assume functions related to intangibles, applying a rigorous comparable analysis, avoiding superficial references, and utilizing specialized methodologies for the complicated valuation of intangibles.
In the case of cost-sharing agreements, real economic substance, solid grounds for profit distribution, and reasonable assumptions must be demonstrated. Likewise, the quickly evolving nature of regulations and competition requires periodic review of TP policies to adjust them to new risks and incentives. Finally, tools such as APAs and MAPs become essential mechanisms for ensuring certainty and reducing the likelihood of disputes.
Conclusion
The pharmaceutical and automotive industries share robust global structures and are naturally exposed to Transfer Pricing scrutiny. Conversely, how this scrutiny manifests itself differs considerably. The pharmaceutical sector handles complex intangibles, lengthy development periods, and intricate cost-sharing agreements; the automotive field faces comparability challenges related to routine operations, emissions regulations, and adjustments for idle capacity.
For companies operating in these sectors, the path to a defensible Transfer Pricing policy requires:
- Clarity in the allocation of functions and risks
- Robust and structured documentation
- Constant monitoring of the regulatory and market environment
- Proactive dispute prevention strategies
Ensure Compliance and Reduce Tax Risks
Transfer Pricing disputes can be costly for multinational companies, both financially and in terms of reputation. Specialized advice enables the structure to solid policies, properly document intra-group transactions, and anticipate the requirements of tax authorities.
TPC Group provides strategic support for the design and defense of Transfer Pricing policies tailored to each sector and jurisdiction, providing security and efficiency in an increasingly demanding tax environment.
Source: ITR