COVID-19 and Transfer Pricing: Adjust, Document, and Implement Now!

The global COVID-19 pandemic has disrupted the world and the economic impact will be felt for a while.  A quick economic recovery is on everybody’s mind and governments have made record-breaking stimulus packages available to help avoid a prolonged recession.  Nevertheless, many multinational enterprises (“MNEs”) have experienced an abrupt departure from “business as usual” and will face challenges around liquidity; their supply chain; their employees; and existing legal obligations entered into pre-COVID 19. 

This article focuses on a number of actions MNEs can take to adjust their existing transfer pricing, thereby better positioning themselves in 2020 and helping them defend their transfer pricing position for COVID-19 affected years.  As always, a good rule in transfer pricing is to adjust, then document contemporaneously, before real-time implementation.

Improving Liquidity

With respect to liquidity needs, MNEs can free up liquidity by a) reviewing their intercompany financial transactions and b) even amending the terms and conditions of existing intercompany agreements to allow for the temporary suspension of intercompany payments.  

Higher utilization of cash pools can be a very effective tool to improve liquidity.  MNEs can improve liquidity by implementing cash-pooling arrangements or simply temporarily suspending payment of certain intercompany services or royalty charges.  This is even more defensible if it can be documented that such payments to third parties would also be delayed or suspended. 

MNEs should review the credit limits of participating entities; consider a remuneration for liquidity buffers; and allow for “defaults” in the event of losses being attributed to cash pool participants.

Other avenues to manage liquidity include:

• Utilizing inventory purchases as a pledge for securitization to lower the cost of funding.
• Changing payments terms, buying back excess inventory, and possibly adopting intra-group factoring arrangements.

Again, it is of importance to document any changes contemporaneously and prior to implementation.  The documentation should explain how the transfer pricing policy changes compare to what is currently being observed in the market. 

Managing Supply Chain Disruption Impact on TP

COVID-19 has impacted contracts, financial transactions and long established supply chains.

Supply chain disruptions are occurring on both the supply side and demand side, as shown in the table below:

Changes in demand and supply patterns can include runs on markets and suppliers being unable to deliver on purchase orders.  Both demand and supply disruptions will influence the decision making of an MNE’s crisis management. 

Review Value Chain Analysis

Immediate responses by an MNE should include a careful assessment of the company’s value chain analysis.  Obvious questions to address during the assessment are:

• Changes in significant people functions or locations. Consideration should be given to reviewing TP policy or assessing other risks (e.g., “permanent establishment”)
• Changes in relevance of intangible property (“IP”)
• Changes in responsibilities relating to the development, enhancement, maintenance, protection, and exploitation (“DEMPE”) of IP
• Identifying available incentives and credits that local governments are providing for idle workforce and work-sharing. And, assessing whether transfer pricing policies are conflicting with the incentive requirements.

Related Parties Considerations

As a result of these sudden changes taking place in market-based transactions, related party arrangements need to be reviewed and adjusted where necessary.  MNEs should review routine and entrepreneurial remuneration of related parties.  Routine entities typically do not incur non-routine risks and losses resulting from normal market risk are often assigned to the entrepreneur within the MNE. 

In a COVID-19 world, one may ask whether the costs associated with the virus should be included in the cost base and compensated by the entrepreneurial parent. The answer could be that MNEs may be able to take the position that the costs of the virus should be borne among all related parties due to its global nature.  This position could drive down the profitability of routine entities to break-even or potentially loss-making levels, thereby reducing the tax burden in some jurisdictions which were traditionally guaranteed a positive fixed return.

With respect to the economic analysis, it is important to note that traditional benchmarking will not reflect the sudden dramatic changes in the marketplace. Internal comparables and other market data provide much stronger evidence to support the arm’s length nature of a COVID-19 adjusted transfer pricing regime.

When developing an economic analysis for a COVID-19 adjusted transfer pricing regime, MNEs should look at historical division of profits across the supply chain and mirror the pattern on 2020 data.  Also, an analysis that reflects the downturn in 2008-2009 data and applies reasonable adjustments to the latest comparable data can be helpful.

Review Existing Contracts

In combination with a solid economic analysis, a review of existing intercompany and third-party contracts should be urgently taken.  The review of agreements should cover any recent changes to the terms and conditions currently observed in the market place due to COVID-19.  Contemporaneous amendments to agreements prove to tax authorities that the terms were agreed by the parties before entering into the transaction, i.e., ex-ante, and not later, i.e., ex-post.  Amendments that are retroactive in nature and try to support a transaction that occurred in the past are typically rejected in audit settings.

Advanced Pricing Agreements

Lastly, in case of existing advanced pricing agreements (“APAs”), MNEs should review both on-going and concluded APAs.  For concluded APAs and rulings, critical assumptions will need to be reviewed as potential changes to value chain drivers and forecast profitability may impact such agreed assumptions. Discussions will need to be held with tax authorities to determine if critical assumptions can be revised; or if they will accept a one-year variance; or if the APA will no longer be valid.

APAs and rulings in progress should be also revisited to determine the current relevance of data and information already presented to a tax authority.  Furthermore, the parties should reconfirm the ability of both the taxpayer and tax authority to proceed with agreed timetables and the validity of the data already submitted, and address any unforeseen changes during the negotiation period.

Summary

MNEs are urged to identify the key business impacts of COVID-19 on their transfer pricing policies. They should strategically consider how proposed crisis responses can be supported by the transfer pricing function.  They can then proceed to make the necessary adjustments to the existing transfer pricing policy and follow-up by preparing contemporaneous documentation. 

This process should include amending legal agreements, and developing robust and contemporaneous audit files to support the new transfer pricing policy.  Lastly, implementing the new policy timely results in reaping benefits from increased liquidity, better aligned DEMPE functions and the ability to defend lower or higher than normal returns in 2020. In short: adjust, document, and implement.