When oil prices explode, is your Transfer Pricing still arm’s length?

Global oil prices have once again surged, driven by escalating conflict in the Middle East, attacks on critical energy infrastructure, and disruptions to key shipping routes such as the Strait of Hormuz. Rising fuel and power costs quickly translate into higher manufacturing expenses, increased logistics and freight charges, and mounting operational costs across supply chains. For Philippine entities that are part of multinational groups, this commercial reality inevitably raises a critical tax question: when external shocks fundamentally change the cost structures and profitability, can existing intercompany pricing arrangements still be considered arm’s length?

This question is not unfamiliar to businesses. Only a few years ago, the COVID-19 pandemic forced businesses and tax authorities alike to confront similar issues. Pricing models designed for stable economic conditions suddenly failed to reflect reality. Lockdowns disrupted supply chains, demand patterns shifted overnight, and many entities, particularly those characterized as “routine” or “limited risk” experienced losses or severe margin erosion. The pandemic served as a stress test for transfer pricing frameworks, revealing how vulnerable static policies can be when markets become anything but normal.

During the pandemic, Philippine taxpayers learned that contractual labels alone offered little protection. Entities described as limited risk were nonetheless questioned when they incurred losses, while benchmarking analyses based on pre-pandemic data were challenged for lacking relevance. Tax authorities focused less on how transactions were described on paper and more on how businesses actually operated during the crisis. Perhaps the most important lesson from that period was the growing importance of narrative. Taxpayers who could clearly explain why their results deviated from historical norms, grounded in commercial reality, were far better positioned to defend their outcomes than those who relied solely on numbers.

Today’s oil price shock revives many of the same issues, although under a different set of circumstances. Unlike the pandemic, which constrained economic activity, rising oil prices exert upward pressure on costs across almost every industry. Manufacturing entities must pay more for energy, distributors contend with fuel surcharges and transport volatility, and shared service centers must absorb increased power consumption expenses. These cost increases often occur suddenly, while intercompany pricing arrangements are typically set on an annual basis, creating a timing mismatch that strains existing transfer pricing models.

A key question, therefore, is whether the current environment can be considered an extraordinary market condition. While transfer pricing guidelines do not define such circumstances precisely, they do recognize that economic conditions affecting comparability must be taken into account. War-driven energy price spikes share many characteristics with the COVID-19 crisis: they are external, systemic, unpredictable, and largely beyond the control of individual operating entities. Treating these conditions as if they were part of normal market fluctuations risks applying the arm’s length principle in a purely mechanical manner, separated from commercial reality.

One of the most immediate transfer pricing issues arising from oil price volatility is whether existing intercompany prices remain arm’s length. Many Philippine subsidiaries operate under cost-plus or fixed markup arrangements that assume relatively stable cost bases. When fuel, power, and logistics costs surge, maintaining the same markup may result in sharply reduced margins or even losses. While the arm’s length principle does not guarantee profitability, persistent deviations from expected returns inevitably draw scrutiny, particularly when comparable companies appear to remain profitable.

This leads to a second issue: can routine or limited risk entities absorb oil-related cost increases without adjusting prices? From a tax authority’s perspective, there is an inherent tension. On one hand, absorbing significant cost increases may suggest that the entity is bearing risks inconsistent with its characterization. On the other hand, passing through costs without contractual support or functional justification may appear artificial. The issue is not whether costs have increased but rather who, under arm’s length conditions, should bear the economic burden of those increases.

Benchmarking analyses further complicate matters. Oil price volatility tends to widen profit dispersion among comparable companies, resulting in broader interquartile ranges and a higher incidence of loss-making comparables. Businesses are once again faced with difficult judgement calls: whether to include loss-making companies, whether multiyear averages remain meaningful, and whether current-year data better reflect economic reality. These are precisely the debates that emerged during COVID-19 audits, underscoring the cyclical nature of transfer pricing challenges during periods of crisis.

At the heart of many disputes lies the issue of risk allocation. Modern transfer pricing principles emphasize that risks should be allocated to entities that exercise control over those risks and have the financial capacity to bear them. In practice, oil price risk is often influenced by strategic decisions relating to sourcing, logistics, hedging, and pricing, decisions typically made at the group or regional level rather than by a Philippine subsidiary. When a local entity absorbs losses arising from oil price shocks despite lacking control over these decisions, questions inevitably arise as to whether the pricing outcome aligns with economic reality.

From the perspective of the Bureau of Internal Revenue, these developments are likely to translate into familiar audit questions. Why did profitability decline despite a routine characterization? Why were markups not adjusted in response to rising costs? Why do comparable companies remain profitable while the taxpayer does not? Experience from COVID-19 audits suggests that weak documentation often aggravates these issues. Generic references to “higher costs,” unsupported assertions of extraordinary circumstances, and benchmarking studies carried over unchanged from prior years all undermine a taxpayer’s position.

Practical defense strategies, therefore, must go beyond numerical adjustments. Pricing outcomes must be aligned with actual conduct, and transfer pricing documentation must clearly explain how oil price volatility affected operations, costs, and margins. Taxpayers should document not only the existence of higher costs but also their inability to control or mitigate those costs and the commercial rationale for any temporary deviation from target returns. The experience gained during the pandemic can serve as a useful template, but it must be adapted to reflect the distinct nature of energy-driven shocks rather than health-related disruptions.

Ultimately, the current oil price explosion does not suspend the arm’s length principle. Instead, it tests how faithfully that principle is applied under pressure. The lesson from COVID-19 remains relevant: arm’s length outcomes are not defined by stable margins or rigid adherence to historical benchmarks but by economically rational behavior supported by credible, well-articulated documentation. For Philippine taxpayers, oil price volatility is not merely an operational challenge. It is a transfer pricing risk that demands proactive management, thoughtful analysis, and a narrative firmly grounded in commercial reality.

Let’s Talk TP is a weekly newspaper column of P&A Grant Thornton that aims to keep the public informed of various developments in taxation. This article is not intended to be a substitute for competent professional advice.

Nikkolai F. Canceran is a partner from the Tax Advisory & Compliance division of P&A Grant Thornton, the Philippine member firm of Grant Thornton International Ltd.