While the world’s attention is focused on the human impact of COVID-19, the economic impact has been catastrophic for many companies globally. Some have retooled, converting their operations to produce essential medical supplies, whereas others are struggling and dependent on economic stimulus packages and goodwill for survival. Another group, unfortunately, will not survive. Currently, companies (both domestic and multinational) are reviewing their businesses and what improvements they can make–both short- and long-term–to survive this pandemic and come away with a sustainable and profitable business model. For multinationals, adjustments to business models will likely necessitate a review of their transfer pricing structure.
There are several key considerations for multinationals:
- The review and revision of business and transfer pricing models can be arm’s length behavior in a time of crisis like this;
- All decisions taken and changes made should be commercially driven;
- All decisions taken, and the rationale for those decisions–including any assumptions about future events–should be documented contemporaneously as this material will be an important part of demonstrating that the decisions taken today were commercially appropriate; and
- Although audit activity may have been suspended, revenue authorities will come at taxpayers very aggressively after the crisis is over to replenish their treasuries and as part of that, will scrutinize in detail the decisions made (and not made) by multinationals.
In the short-term, it is imperative that companies survive. From a transfer pricing perspective, multinationals should continue to abide by the arm’s length principle and take into account how independent parties would deal with similar circumstances in making their decisions. They need to assess the commercially realistic options that are available to them; and look to what independent companies are doing to adapt and survive. Each multinationals’ situation will depend on its specific facts and circumstances, so that decision-making process must be documented contemporaneously.
Contemporaneous documentation is a term often associated with preparing transfer pricing documentation to support a company’s tax return. However, in this context, contemporaneous documentation refers to maintaining a file in which evidence of third-party behavior is captured to support decisions taken to change or adjust transfer pricing models in light of the pandemic. This file can be maintained internally by company personnel. Ideally, this should include at least some high-level consideration of the options realistically available to each party. This data or evidence can be drawn on in the future to support actions taken if challenged by revenue authorities and can also be included in normal transfer pricing compliance documentation.
For a multinational, there may be several different issues in the short term that can be addressed, including:
- Where related parties are paying royalties for the use of intellectual property and/or brand intangibles and they face the prospect of incurring operating losses (or substantially reduced operating profits) during this period, it may raise questions as to whether royalty rates and/or payment terms should be adjusted. A consideration of the options realistically available to the licensee and licensor would be useful here. In addition, there may be a basis for market support payments;
- With existing related party funding, one question is whether interest rates should be revised or payments deferred by lenders or central treasuries to provide additional liquidity to related party borrowers. It is relevant to look at how independent banks are dealing with their borrowers in similar circumstances;
- Additional emergency funds may be required by group entities to ensure that their supply chain remains intact and they are able to recover once the economic situation improves. Banks may require parental guarantees or other credit support as a condition of lending to group entities. The terms of such support should be consistent with evidence of what is happening in the marketplace in similar circumstances;
- Where service charges are made between group entities, consideration could be given to charging on a cost recovery basis only for a limited period of time or perhaps deferring charges in order to provide financial support to the service recipients; and/or
- With inventory flows, there are several points to consider:
- Related party manufacturers and distributors that operate on a reduced risk basis may seek short-term discounts, rebates, extensions to payment terms or support for excess inventories from related party suppliers or principal entities to alleviate losses that would otherwise be incurred locally to ensure that the entities remain solvent. These actions may be taken in order to preserve the supply chain;
- On the flip side, should fully-fledged distributors share in channel losses? Support for this would lie in a consideration of the options realistically available;
- Consideration also needs to be given to whether the arm’s length returns in current transfer pricing models should be adjusted (and how to support that). At a basic level, this could involve a consideration of the appropriate point in the range of existing sets or more global adjustments to those ranges, for example by reflecting movements seen during other economic crises;
- It is important to note that any adjustment to prices post-importation can have customs implications. Also, price discounts made prior to importation need to be considered in the context of relevant anti-dumping regulation; and
- Is there a potential force majeure event between the related parties and if so, what are the procedures and consequences provided for in such a situation in the parties’ legal agreement?
Transfer pricing is a multi-faceted issue and any change to a transfer pricing model needs to be considered from the perspective of each of the jurisdictions in which the parties to the transactions are resident. One-sided analysis will only create risk for multinational groups. Additionally, a decision to make changes to a transfer pricing model to respond to today’s crisis needs to consider whether the change will create any historical or future risk.
While some of these actions may be seen as non-arm’s length during “normal” times, they are arguably commercially necessary in the current unprecedented economic times. It is critical that taxpayers capture market related data contemporaneously that evidences the transactions being reviewed or contemplated and the commercial reasons for the decisions taken and the pricing implemented. It is also important that the parties agree to revisit any temporary arrangements within a commercially realistic timeframe and that the agreements contain terms and contingencies that reflect how arm’s length parties might impose sunset clauses.
While most of the attention at the moment is on ensuring the survival of the business and keeping the supply chain intact, there may also be opportunities for multinationals to reap some longer-term commercial benefits from the current situation:
- The severity of this crisis will have a significant impact on the valuation of various components of the multinational supply chain. This may necessitate business restructuring, which may have longer-term commercial benefits. Diminished entity and/or intellectual property values may reduce any capital gains tax or other exit charges that would be applicable on the restructure/transfer of those assets if required. This means that not only might a business restructure be commercially necessary, it could be undertaken with a reduced overall tax impact, provided that the transfers are carried out at an arm’s length price and that the business restructuring decision is commercially sustainable and appropriately documented;
- Should the economic impact of the pandemic be prolonged, it may challenge the viability of centralized structures, creating long-term structural losses for certain entities;
- The pricing of related party funding transactions may be renegotiated as the creditworthiness of borrower entities in the group may be adversely impacted by the pandemic. While this might otherwise justify an increase in the interest rate margin, any amendments to the terms and conditions of related party financing transactions must reflect changes seen in the market between independent parties;
- Companies may reconsider reliance on safe harbours and decide to implement arm’s length pricing of related party transactions supported by comparability analyses and benchmarking, including relying on arm’s length debt tests for thin capitalization purposes to support a higher level of gearing and interest deductibility where balance sheets have been weakened; and/or
- Critical assumptions in existing advance pricing arrangements should be reviewed as the current economic crisis may cause them to be triggered. In certain circumstances, this may enable multinationals to explore more favorable terms with the relevant tax authorities based on the current economic situation.
Critical assumptions in existing advance pricing arrangements should be reviewed as the current economic crisis may cause them to be triggered. In certain circumstances, this may enable multinationals to explore more favorable terms with the relevant tax authorities based on the current economic situation.
These are volatile and uncertain times. Multinationals must proactively review their transfer pricing arrangements and take whatever commercial actions are necessary to survive this crisis. Some commercial decisions may improve multinationals’ business models and may also provide tax opportunities. All decisions undertaken by multinationals need to be considered carefully and must be supported by market-based data where possible, and be captured and retained in a transfer pricing file for future reference.