The COVID-19 pandemic has created a public health crisis of international scale and severely disrupted countries around the globe. On top of unprecedented operational challenges related to supply chain disruptions and the transition to a remote workforce, businesses must grapple with the demands of tax compliance. Amidst the broader landscape of business and tax concerns, transfer pricing (TP) presents issues that are particularly pressing during these uncertain times.
Transfer pricing takes into account market place activities based on arm’s length principals which are recurring and part of normal operations and excludes extraordinary activities caused by, for example, the current COVID-19 situation. Many multinational enterprises (MNEs) base their TP policies, which often involve subsidiaries around the globe, on patterns of global economic growth that have generally prevailed over the past decade, particularly profit-sharing. Today these same policies may be insufficient for the allocation of losses driven by the COVID-19 outbreak.
To address concerns, companies should revisit their existing transfer pricing models to streamline and identify cost-effective solutions to manage their transfer pricing risks and compliance. During this global pandemic, some transfer pricing areas to address include:
- Reevaluating transfer pricing policies for so-called routine return entities that receive “guaranteed profits;”
- Applying economic adjustments in calculating the 2020 inter-company amounts;
- Ensuring robust transfer pricing documentation is in place to support deviations in policies.
Revisiting transfer pricing approaches
The global health crisis calls for a reassessment of the existing transfer pricing approaches adopted by taxpayers in terms of functional analyses, econometric theories and methods, industry analyses, and comparability analyses. The frequently debated aspects in a comparability analysis during global turmoil involves reviewing the selected comparables, revisiting screening techniques, and performing economic adjustments to factor in the impact of the global pandemic.
Some examples include:
- Accepting loss-making companies in the comparable sets to determine true arm’s length pricing;
- Applying financial ratios to the results of the comparable companies to align with the tested party’s increased expense ratios (e.g., fixed costs/general and administrative costs to total costs);
- Potentially adopting a loss-split approach, bearing in mind potential challenges by taxing authorities;
- Adjusting tested-party financial results to identify certain extraordinary expenses incurred due to the coronavirus outbreak;
- Choosing an appropriate time period. Often we apply a time period of three years before the tax year under review. However, this may not be appropriate during periods of downturn.
- Selecting your reference markets to carefully assess the choice of the country in which the comparables operate;
- Using regression analysis to make adjustments to the financials of the comparables to estimate the effect of change in sales on change in return on total costs for manufacturing comparables, and the effect of change in sales on the change in return on sales for distribution comparables. Other comparability adjustments can be made for differences related to inventory, working capital and excess capacity as a result of the impact to business operations caused by COVID-19.
The United States and Organization for Economic Cooperation and Development (OECD) transfer pricing guidelines emphasize the importance of making reliable economic adjustments to account for differences in economic circumstances so that a comparability analysis can adhere more closely to the arm’s length principle. The U.S. and OECD guidelines allow the use of established statistical and econometric techniques to make appropriate economic adjustments. Crucial evaluation points prior to implementing such adjustments are: determining the nature of adjustments; in-depth search for reliable comparable data to determine the crisis impact; determining the adjustment amount; and documenting the rationale that supports such economic adjustments.
Arm’s length principle
Keep in mind that changing TP policies raises the question: how do we define arm’s length under these circumstances? While comparable data demonstrating the impact of COVID-19 on independent companies will not be available until sometime next year, Treas. Reg. § 1.482-1(a)(3) provides flexibility for U.S. taxpayers reporting transfer prices. Taxpayers may affirmatively use Section 482 to report prices other than those charged on a timely, original tax return if necessary to arrive at an arm’s length result. Taxpayers may also use amended or untimely returns to report corrected arm’s length prices, but only if this increases U.S. taxable income. However, it is important to consider that counterparty countries may not respect such adjustments.
Businesses should revisit their inter-company agreements. Some may find that they have the flexibility to adjust pricing policies to respond to unforeseen circumstances, or that a force majeure clause provides an exit. Others may realize they have locked themselves into a result that no longer makes economic and/or business sense.
Companies in the latter camp may be able to amend their agreements but should prepare to address potential challenges by tax authorities. Moreover, if a change in TP policy is not accompanied by a change in functions, assets, and risks, tax authorities might not respect the change, or might challenge prior-year results on the basis of the new policy.
Advance pricing agreements (APAs)
Taxpayers who currently have advance pricing agreements (APAs) also need to take into account COVID-19’s impact to the APA. The continuing viability of an APA is premised on the satisfaction of critical assumptions, which are APA-specific but usually include an assumption that the business activities, functions, risks, and assets of the taxpayer remain materially the same as those described in its APA request. Whether or not a critical assumption is breached, taxpayers may consider seeking the consent of the Internal Revenue Service (IRS) and any applicable foreign tax authorities to revise their APAs in response to this pandemic.
Where a critical assumption is not met and the parties cannot agree on revision, the IRS may cancel the APA. While there is a risk for some taxpayers, it may be an opportunity for others who discover that their APAs are not suited to their new business reality.
Transfer pricing documentation
During a downturn in the economy, it is almost necessary to provide more-than-enough documentation to support the potential losses and additional expense in the tax structure of an MNE. Tax authorities will scrutinize intercompany payments more aggressively since local governments want to recover as much tax revenue as they can.
In addition, waiting for tax authorities to present their position could result in an unfavorable adjustment, steep penalties, or time-consuming litigation. Thus, taking a proactive approach to documentation is extremely important. Not only will it demonstrate the severity the taxpayer has taken to support the losses/expenses in the tax structure, but it will also better position the taxpayer if an audit should arise, even years later.
Having robust and contemporaneous documentation in place ensures that taxpayers have considered the local transfer pricing requirements, provides tax administrations with information necessary to conduct an informed transfer pricing risk assessment and provides tax authorities with useful information while conducting an appropriate, thorough audit.
Particularly during challenging economic times, taxpayers need to explain why the losses in the tax structure reflect arm’s length transactions based on the functions, assets, and risks assumed by each related party. The documentation requirements may be different between jurisdictions, and more explanation is recommended to describe the “before, during and after” of an economic downturn.
Why is it important to take these steps now?
It is well understood that transfer pricing is a top priority, as well as a risk area, for multinational companies in any economic environment. It is less understood why it should be an even higher priority in the current economic environment brought on by the COVID-19 pandemic. In fact, transfer pricing requires even more attention now, as the economic shift impacts the overall business more than ever.
Most obviously, global taxing authorities will try to obtain as much global tax revenue as possible in the post-pandemic environment. When this occurs, and it will, the most obvious targets will be those companies which are not locally based, as well as those based in high-tax jurisdictions. For companies that fit this profile, the time is now to initiate procedures to mitigate risk in both the subsidiary and parent company countries, but also to optimize transfer pricing positions to reduce current and future tax exposures at the same time.
Cash flow is tremendously important as well. Right now cash is a precious commodity and transfer pricing is often the most effective tool to match cash reserves or generation with cash needs. Non-strategic transfer pricing policies can lead to imbalanced global cash pools in difficult times. Proactive transfer pricing changes can make dramatic and immediate positive cash flow changes, while simultaneously lessening the taxpayer’s reliance on expensive and condition-laden third-party financing.
How can Squar Milner help?
The transfer pricing issues raised by the COVID-19 pandemic are wide-ranging and vary between industries and even between taxpayers.
But we are here to help. Our Transfer Pricing specialty tax practice and International Tax Services department is comprised of leaders and experts to help you navigate these unprecedented waters and ensure your transfer pricing policies are sufficiently capable of handling this economic landscape.
We can work with you to understand the nuances of the COVID-19 impact on your transfer pricing policies and develop thorough documentation. For any questions on how our Transfer Pricing team can help you or any general questions regarding the coronavirus implications on your business practices, please reach out to us.
Disclaimer: This material has been prepared for informational purposes only, and is not intended to substitute for obtaining accounting, tax, or financial advice from a professional tax planner or financial planner. All information is provided “as is,” with no guarantee of completeness, accuracy, timeliness or of the results obtained from the use of this information.