COVID-19 has made force majeure a hot topic in transfer pricing. The idea is that the pandemic was an unexpected development of such power, like a natural disaster, that transfer pricing agreements can be changed to reflect the changed economics of a changed world.
But is there any case authority to support this approach? In fact there is, from one of the largest US transfer pricing cases of the 1990s.
The case is National Semiconductor Corp. v. Commissioner, T.C. Memo. 1994-195, 1994 WL 159797. National Semiconductor was a company with a long history of competing in the less-sophisticated, lower-margin segment of the semiconductor market. In the 1970s, the company became convinced that its future lay in the manufacture of more complex and higher-margin devices like microprocessors and memory devices. It began investing heavily in the R&D to develop these products.
Under National Semiconductor’s supply chain, the US parent carried out R&D and fabricated the silicon die containing the miniature electronic circuitry that performs the essential functions of a semiconductor device. The fabricated die were sold to Asian affiliates, which performed the lower-value-added, back-end manufacturing processes required to make the devices usable in electronic products. Once back-end manufacturing was completed, the Asian manufacturers sold the finished goods to the US parent and affiliates in other countries for eventual sale to third parties.
Under the company’s transfer pricing structure, the US parent exclusively bore the risks of the R&D—and would have reaped the benefits if the new products had been successful. But they weren’t, and the US parent suffered enormous losses from its R&D investments. The IRS insisted that transfer pricing was to blame and invoked section 482 to allocate income from the Asian affiliates to the US parent for a six-year period.
The Tax Court rejected the company’s arguments that the US parent, as the risk-taker, should exclusively bear the losses arising from the unsuccessful products. In doing so, the court observed that the US parent and the Asian manufacturers were mutually dependent:
The Asian subsidiaries were very profitable during the years in issue. They relied on petitioner for their success. In an uncontrolled situation, the Asian subsidiaries would not have allowed petitioner to go out of business, because that would mean economic death to the Asian subsidiaries as well. Dealing at arm’s length, the Asian subsidiaries would have at least allowed petitioner to break even.
Id. at *29 (emphasis added). The Court reasoned that, under these circumstances, arm’s length parties would renegotiate: “The prices for the sale of wafers and/or the purchase of assembled circuits, if negotiated at arm’s length, would have been adjusted to allow both entities to earn a profit sufficient to continue to attract the capital required to maintain, expand, and modernize their respective operations.” Id. at *24.
To be sure, National Semiconductor did not address the sort of extreme events that justify invocation of force majeure. But its reasoning might be even more powerful. After all, if a low-value-added manufacturer would agree to renegotiate prices to address losses incurred by an R&D risk-taker because products were unsuccessful, might not a limited-risk distributor or contract manufacturer agree to renegotiate prices to address a principal’s losses arising from the economic disruption caused by a pandemic?
Looming large here is the court’s emphasis on the “mutual dependence” between the low-value-added manufacturers and the R&D risk-taker—and its conclusion that failure of the R&D risk-taker would cause the “economic death” of the low-value-added manufacturers. See id. at *29.
While the proper result in any transfer pricing case depends on the specific facts and circumstances and a careful analysis of what unrelated parties would do in arm’s length dealing, National Semiconductor is an essential authority to consider in analyzing whether a renegotiation of transfer prices is merited.