In the era of globalisation, when multinational enterprises (MNEs) have branches, divisions, subsidiaries and offices operating across the globe; it is common for them to transact goods and services from one jurisdiction to an associated enterprise in another tax jurisdiction.[1]
- The story so far
The topic that is dominating conversations worldwide is the COVID-19 pandemic. In addition to the serious health impact of the virus, it is also affecting vital components of the global economy, such as production, the supply chain, consumption and financial markets.
The restrictions on economic activity have led to the disruption of supply chains. Businesses are facing a drop in demand as income levels are declining. Manufacturing and distribution functions that require transportation, physical labour, logistics and movement of people have been hit the hardest. Industrial sectors such as airlines, hospitality and tourism, and luxury retail have seen deeper declines compared to others. Many companies have moved towards digital means of delivering products and services and implemented work-from-home measures as they adapt to operate in a COVID world. Some operating costs, such as travel costs within organisations, are declining and could help preserve margins in the face of reduced revenue. Companies are focused on conserving cash and ensuring liquidity in their operations.
At a time like this, the transfer pricing policies (price paid by the parent company or foreign arm to a local subsidiary for transactions between them[2]) that guarantee the entities within the group — contract manufacturers, limited risk distributors, suppliers captive services — a guaranteed minimum profit, are becoming very difficult to implement. At the same time, risk-taking entities, such as licensed manufacturers and regional distributors, do not make enough profit from local operations to pay committed intra-group royalties or distribution rights payments. As a result, the financial results of the group and, in particular, of the parent company are under pressure.
- Covid-19’s business impact
The impact of the coronavirus (COVID-19) is being felt by all companies in the world. It has changed the way the world functioned, just like the Great Depression and the 2008 financial crisis, did in the past.[3] But everyone’s main concern is “will things get back to normal?” The reality is that many companies are struggling and some have even ended. But seeing the economic adversities of the past, there is renewed hope for recovery with the emergence of new industries. Consequently, things will return to normal, but the “new normal”!
Various businesses have been impacted due to COVID-19. The impacts include:
- Reduction of profits or losses due to significant reductions in third-party income.
- Interruptions in the supply chain that cause difficulties in the delivery of goods and services to group companies.
- Increase in the cost of debt, due to the increase in the credit quality of an individual group or group entities.
- Guarantees for third-party financing at the request of external funders, in response to breaches of debt agreements or requests for additional debt.
- impact on Transfer Pricing
COVID-19 has radically changed the businesses on an unprecedented scale, with an impact that varies between different businesses. This triggers the need to review and potentially amend transfer pricing policies to reflect new economic conditions and ensure appropriate allocation of gains or losses, as transfer pricing is often designed assuming the overall earnings of the group and thus therefore, the impact of these economic changes can result in distortions, in the allocation of profits and losses between group companies.[4]
Some common transfer pricing issues that businesses are addressing during this outage period are: financial transactions, business-to-business contracts, disruption management, intangibles, remote work, operational transfer pricing, fees, dispute resolution, and APAs. Other issues include:
Pressure on Existing Transfer Pricing Policies
Existing transfer pricing policies are already under pressure with the ongoing economic downturn. One element of this is that negatively affected companies will be asked in the future to explain low operating profit or loss to tax authorities for both the current and upcoming years. It may be prudent to model the impact of COVID-19 on operating results, to help demonstrate in the future the business justification for changes in transfer pricing and other planning decisions, and ultimately show that low profits or losses were not the result of non-arm’s length transfer pricing policies.
Need to Adjust Transfer Pricing Models
There may be a need to adjust transfer pricing models so that they are in line with any commercially driven changes made to the global supply chain,[5] and to ensure they reflect any reallocation of roles, assets and risks across the group. Businesses will have to review whether actual conditions experienced are synonymous with past transfer pricing policies, and as a result legal arrangements become critical (and may need to change) to show the actual versus economic allocation of functions, assets, and risks.
Potential Breach of Advance Pricing Agreements (APA)
- What is APA?
APAs made with the tax authorities are an effective risk management tool to minimise disputes over the transfer pricing agreements adopted. The taxpayer’s proposed arm’s length price/range uses past transactions to forecast future business earnings and make so-called “critical assumptions.” These critical assumptions generally do not consider a change in the economic conditions or the FAR of the counterparty involved in the transactions, or fundamental changes in the conditions of a particular industry. Taxpayers who have agreed to an APA with the Department of Revenue should review critical assumptions and assess whether the COVID-19 pandemic could trigger the need to consult with tax authorities, renegotiate the agreed approach, or review or cancel the APA.
- Potential Breach
All existing APAs should be re-examined and new ones should be reconsidered due to the impact of COVID-19 on the group. Certainty is provided by APA about the agreed transfer price or profit margin over several years, provided they are met with critical assumptions. Taxpayers and tax administrations agree on critical assumptions that, if not met, allow them to reconsider the APA. The APA would be cancelled if, due to COVID-19 or otherwise, the agreed critical assumptions are no longer met. As an alternative, there might be renegotiation of APA by the taxpayers and tax administrations.
Non-compliance with the APA could include: proceeding with business as usual, renegotiating the APA during the time period of demonstrable impact, and suspending the APA modification for a specified period.[6]
- Suggested Transfer Pricing Method
Profit/Loss Splits
Current transfer pricing analyses primarily focus on an operating profit-based comparison between a tested party and comparable companies using the transactional net margin method[7] (TNMM). However, in a world under recession, the transactions between companies and the behaviour of the companies of a multinational group may change, requiring a change in the most appropriate transfer pricing method to be applied to test compliance with the principle of arm’s length. For example, some group companies may begin to perform greater functions and take greater risks in a recessionary phase. Practical limitations on the availability of adequate and reliable data for comparable companies could be another factor driving change when examining the most appropriate transfer pricing method to administer during an economic downturn.
Applying a profit and loss split method to determine arm’s length considerations in such cases may be more appropriate than using historically administered TNMM-based methodologies. In all of these instances, the search must carefully consider the new data and apply a transfer pricing methodology that autonomous third parties would have agreed to under similar facts and circumstances.
- Industry Outlook and Analysis
Although it is an incipient situation, the global epidemic of COVID-19 is already, possibly the most socially disruptive global event of our lives. As the pandemic persists, it is clear that the economic impact of the crisis will worsen. Businesses will suffer and industries can transform in unforeseen ways. From a transfer pricing perspective, it is crucial to understand the implications of this pandemic. Through careful consideration of transfer pricing and economic theory, evaluation of heuristic approaches, and collaboration with tax advisers and operational staff, businesses can chart a course as the world comes up from this unprecedented event.
Moreover, this challenging situation has brought with it a series of uncertainties that could lay the foundation for innovative solutions from multinational companies and business consultants to address the critical situation at hand. Governments are promoting different ways to reduce the economic situation in various countries, by introducing tax relief and risk mitigation measures to help multinational companies support their business positions. MNEs need to map their way to align the transfer pricing considerations that arise from this exceptional situation.
A correct saying during these challenging times –
‘It is not the strongest or the most intelligent who will survive from the crisis, but those who can take actions to best manage the change.’[8]
Hence, action should be taken to best manage the transfer pricing policies in order to mitigate loss.
*4th year student, BA LLB (Hons.), National University of Study and Research in Law, Ranchi. Author can be reached at singhalankrita2@gmail.com
[1] Transfer Pricing, The Institute of Companies Secretaries of India, May 2018
[2] Sachin Dave, COVID-19 impact: Transfer pricing issues may crop up at MNCs, The Economic Times (April 13, 2020)
[3]Gita Gopinath, The Great Lockdown: Worst Economic Downturn Since the Great Depression, IMFBlog (April 14, 2020)
[4] Steve D. Felgran & Steven C. Wrappe, INSIGHT: It’s Different This Time – Pandemic- Induced Recession Drives Transfer Pricing Changes, Bloomberg Tax, June 26, 2020.
[5] Patrick van Leeuwen, Potential impact of COVID-19 on your current transfer pricing model: Is action required?, Bakertilly (May 8, 2020)
[6] Tax impact of COVID-19 on intragroup arrangements, Allens-Linklaters (April 17, 2020)
[7] Jose Rafael Monsalve, Application of the Transactional Net Margin Method in transfer pricing analysis, CIAT (July, 15, 2019)
[8] Leon C. Meggison
