Coronavirus: Managing Your Asia Supply Chain and Transfer Pricing Risks in a Global Pandemic

The world is currently witnessing the devastating impact of the novel coronavirus (COVID-19), with the World Health Organization (WHO) now declaring it a global pandemic. The COVID-19 crisis is causing substantial shifts in financial markets and the macroeconomy, with direct implications for global supply chains and profitability, across most industries and geographies. The impact will be exacerbated in the coming weeks and months, as governments have placed unprecedented restrictions on the movement of people as a measure to delay the spread of the virus.

This article sets out the impact of coronavirus on global supply chains of Multinational Enterprises (MNEs) and the likely transfer pricing challenges.

Impact on Global Supply Chains

Some of the measures taken in China to slow the spread of the virus have had and will continue to have enormous flow-on effects globally. These include:

• Closure of factories and quarantining of workers across the country, which has resulted in a ceasing or dramatic slowing of production and procurement activity
• Ports and other transport and logistics infrastructure have been fully or partially suspended
• Government departments and banks have been operating at limited capacity, preventing regulatory approvals, customs clearance, financing transactions, etc.
• On the demand side, China represents a huge market for the products of many global MNEs. This market has been decimated in the past two months.

The highly integrated and complex nature of global supply chains means that a slowing or ceasing of production in China has an immediate impact on the entire supply chain for many MNEs. For example, the limited availability of Chinese-made auto parts and components is directly impacting parts distributors globally and now directly impacting production capabilities of automakers in Japan, Korea and the U.S.

While companies take stock of the impact of these measures on their bottom line, one likely outcome in the medium to long-term may be a  further restructuring of business models and supply chains, to diversify procurement activity and to establish alternative manufacturing bases away from, or complementary to, mainland China in locations such as Vietnam, Bangladesh and Cambodia.

This will not address the economic impact of the coronavirus; indeed, at the time of writing, there are indications that the spread of the virus has been curtailed in China. However, it is intensifying in countries such as South Korea, Italy, Iran and the U.S. In recent years, labor cost pressures and the trade war with the U.S. have already led to some shift in focus away from China. However, the coronavirus has served as a blunt alarm bell for MNEs that long term prosperity depends on a reduced concentration of the supply chain in one or a limited number of countries and more focus on diversification of supply and demand markets.

What It Means from a Transfer Pricing Perspective

From a transfer pricing perspective, changes in the macroeconomy and expected supply chain realignment as a result of the coronavirus will impact in the following ways:

• Falls in operating profits or losses may come to the attention of applicable tax authorities. The taxpayer should be able to demonstrate that such outcomes are a result of commercial and economic factors rather than a non-arm’s length transfer pricing policy. This defense may be supported by economic modelling of the impact of COVID-19 on sales revenue, Cost of Goods Sold (COGS) and operating expenses. 
• In future fiscal years, comparable company analyses (such as in a transactional net margin method) would have to be considered closely, to determine if the comparable companies have reflected the financial impact of the COVID-19 crisis, above or below the line, and to align that presentation with the related party financials.
• Realignment of the transfer pricing model with changes to the supply chain will be necessary to ensure profitability reflects the allocation of functions, assets and risks across the group. Master file and local file documentation may need to be updated to capture such changes.
• The economic impact of the virus is likely to create cash flow issues for some MNE groups and necessitate either external funding (potentially based on parental guarantees) or funding within the group. Such internal funding transactions or guarantees need to be priced on an arm’s length basis and in line with the recent OECD Transfer Pricing Guidance on Financial Transactions.
• The virus may lead to M&A activity as MNEs seek to better manage the economic fallout. Such activity should be supported via integration and alignment from a transfer pricing perspective.
• As global supply chains change, MNEs may need additional tax valuations, which will require the calculation of discount rates. This will present a need to determine a country-adjusted risk factor which is dependent (among other things) on the impact of COVID-19 on the individual country’s economy.
• Transfer pricing will most likely be elevated even further in the priority list of governments and tax authorities, to secure revenue to support fiscal stimulus measures including tax concessions, incentives and rebates. For example, the Chinese government has already introduced VAT exemptions on some services. The German government is looking at tax deferral options while some Asian tax authorities have suspended audit activity in the short term. Taxpayers should ensure they understand these measures and the potential impact on their transfer pricing policies and intercompany structures.
• Despite the numerous challenges and adjustments that may be expected to supply chains and transfer pricing positions, ongoing compliance obligations will largely remain in place. As operating budgets are expected to be cut to deal with COVID-19 risk mitigation, in-house tax and finance managers may be faced with tighter budgets to manage transfer pricing compliance. They should therefore ensure they have a well-considered plan in place to manage their documentation and other obligations holistically and cost effectively.

It is becoming evident that the economic impact of COVID-19 will be felt long after the health risks have subsided. The disruption to China-centric procurement and manufacturing and its impact across the supply chain of MNEs will accelerate efforts to diversify the global footprint, to better manage and hedge such risks in the future. Supply chain adjustments and the broader economic impact of COVID-19 need to be fully aligned with the transfer pricing model. Additionally, the appropriate framework should be in place to manage compliance needs and the inevitable tax authority scrutiny going forward.

Read Transfer Pricing Times – First Quarter 2020