Businesses are struggling to survive during the COVID-19 global pandemic and are considering many different options, especially around cash management. Transfer pricing should not be overlooked, and this is not only for compliance reasons. Transfer pricing can assist with alleviating some of the pressures that businesses are currently dealing with. Below is a summary of transfer pricing matters that should be on every multinationals (MNEs’) radar:
Business models, transfer pricing methods and benchmarking:
Many business models consist of a single entrepreneur with low risk operating companies throughout the world. These include, toll manufacturers, limited risk distributors and/or limited risk service providers. These subsidiaries with routine functions are normally considered the least complex entities and therefore are the tested party for the transfer pricing analysis. Usually, these routine functions are expected to earn a relatively small but stable profit margin on a TNMM basis (sometimes also a guaranteed return). Allocating losses to these routine functions is in normal circumstances highly unusual. However, this applies to regular business circumstances and nothing is normal right now. Although risks are limited, arguably, they still bear local market risks and are not “risk-free” entities (unless there is a guaranteed return).
Owing to the fact that the arm’s length range is based on a comparison with historic independent party transactions, with potentially different market conditions than the current economic conditions, it may be a reasonable approach to consider that the standard range does not reflect the current economic conditions. Therefore, a lower point in the interquartile range could be applied. Additionally, this range is a three year weighted average of the comparable profit margins. It may be necessary to rely on a single or multi-year range to adjust to the economic downturn where possible. Lastly, working capital adjustments may assist with reducing the range slightly, especially looking at the accounts receivables element, as companies are being paid less frequently during this time.
Some websites and blogs mention that perhaps a negative mark-up should be applied to services to assist with the current crisis. I am not sure I agree with this. There is probably more merit in saying that certain cost elements within a service are not beneficial if, for example, they did not provide a beneficial service during this time rather than applying a negative mark-up? However, bear in mind that even if no service is provided, there may still be value in having a service provider on standby.
The effect of government assistance:
The OECD Transfer Pricing Guidelines stipulate that there are some circumstances in which a taxpayer could consider that an arm’s length price should be adjusted to account for government interventions such as quarantines and travel bans. As a general rule, these government interventions should be treated as conditions of the market and in the ordinary course they should be taken into account in evaluating the MNEs’ transfer price in that market.
Transfer pricing documentation:
In these difficult times, having a robust and contemporaneous documentation in place ensures that you have considered the local transfer pricing requirements. This provides the tax authorities with the necessary information to conduct an audit and mitigates the tax risk of MNE’s. The group should prepare corresponding transfer pricing documentation to explain which party should bear the losses or quantify the losses caused by the pandemic. I believe there is merit in having a COVID-19 chapter in FY2020 documentation that talks to this and aligns to the industry analysis and government interventions. Furthermore, this chapter should look at some sort of budgets (tested to prior years) vs actuals and explain the difference. Ultimately, it should be made clear that there was no mispricing that resulted in the losses but rather it was the economy, and therefore this could still be supported by the arm’s length principle. From experience, documenting this shortly after the pandemic is best in order to avoid any confusion as to what happened a few months or a year ago.
Reconsider financing structure:
As a result of the pandemic, MNE’s may be in more need of funds for the continuity of the business. The drastic changes in the market could trigger clauses in financing arrangements for collateral or the maximum level of debt to equity of the borrower. Companies may avail themselves to meet their financial obligations through (implicit) guarantees by the parent company. Under the new guidance on financial transactions, it may be reasonable to renegotiate financial arrangements to more favourable terms, delay interest payments on a temporary basis, or re-characterize short-term loans as long-term loans, similar to what third parties would do.