The world as we know has and continued to rapidly change because of COVID-19 and the ongoing political developments such as the upcoming elections in the United States (US), the United Kingdom’s (UK) impending exit from the European Union (BREXIT), trade wars between economic superpowers, and climate change, among other global emergencies.
COVID-19 being the most recent health crisis was categorized as a pandemic by the World Health Organization (WHO). This pandemic has not just impacted individual health and stretched health care systems worldwide, it has substantially impacted the world’s financial markets and economies, affecting global supply chains and profitability for years to come.
China had to initiate factory lockdowns early on, which impacted global production output and caused delays in distribution to end markets. Factory closures in China and lockdowns in key economic centers worldwide, had a domino effect on other industries such as oil and gas, airlines and hospitality and retail, among others. Governments worldwide have announced emergency fiscal measures including Central Banks slashing interest rates on borrowings to insulate their economies from the effects of recession.
While the macro economic impact of COVID-19 crisis continues to be evaluated, it is critical that multinational corporations that are operating cross-border and entering into inter-company transactions, manage their response to this development. This would include assessing the impact the crisis has had on their profitability as well as a potential overhaul of their global supply chains. Some considerations to note from a transfer pricing perspective are:
Revisit transfer pricing models and policies: In instances where a multinational group has had a significant impact on its performance and chooses to restructure its operations by reallocating functions, assets and risks (FAR) to better manage its supply chain it will be important that the transfer pricing model / policy be revisited and updated accordingly. Where this results in a change to the transaction profile as well as the terms and conditions that govern inter-company contracts (examples include, an increase in inter-company financing and related guarantees, increase/decrease in sale/purchase prices, interactions due to inter-company services, negotiation of customer contracts, change to credit terms, impact on inventory flows due to supply disruptions among others), it could result in changes to inter-company pricing basis and the arm’s length returns attributable to each entity involved. It should not be assumed in the current environment, where the parent entity that traditionally performed key Functions, owned high-value Assets (including intellectual property) and assumed significant Risks (FAR), would be the only entity to centralize Group wide losses while the other entities remain profitable.
Perform Function, Asset and Risk and Value Chain analysis: While updating transfer pricing policies and inter-company pricing models, it is critical that the multinational group perform a thorough value chain analysis to reflect changes that may have occurred in each of the entity’s key functions, asset ownership and assumption of risks.
Economic analysis: One of the key principles when performing an economic analysis to determine the arm’s length range of returns to substantiate a taxpayer’s position is that significant events be factored in and such analysis be revisited. The traditional practice of updating or a roll-forward of comparable company benchmarks / prices using the comparable uncontrolled price (CUP) method, are unlikely to reflect the most up to date economic realities faced by the multinational group. As such, taxpayers may have to consider the following options:
Reallocation of the FAR and use of the Profit Split Method (PSM) – taxpayers may potentially consider adoption of the profit split approach and allocate profits/losses, if suitable. Although when adopting the PSM, it is crucial that several (stringent) conditions are met and there is a clear identification of value generated by each entity involved, resulting in the allocation of profits/losses. A simplistic approach to adopting the PSM is not only likely to attract scrutiny, it will be challenging to document the rationale and support the arm’s length nature of such an allocation.
Consistent loss-making comparable benchmarks – when performing a benchmarking study to identify a comparable set, the approach of outright rejecting consistent loss-making companies may have to be revisited.
Use of the CUP and price comparisons – where a taxpayer relies on price benchmarks using the CUP method, it will be important that the 5 factors of comparability be evaluated in context of any changes and determine if the price comparison continues to remain appropriate.
Employees and secondment arrangements: cross-border arrangements include key personnel (employees) and it is therefore critical that multinational groups assess the impact of ongoing changes to immigration law considering a crisis like COVID-19. These changes will have a direct impact on employees on secondments to other countries as well as the inter-company arrangement(s) in question. Additionally, if employees that travel for business to other locations and are unable to return to their home country due to travel restrictions and advisories, therefore, warranting remote working arrangements, such arrangements could create permanent establishment (PE) implications for the multinational group. While the Canada Revenue Agency (CRA) has issued pronouncements that there will not be a PE if the employees are in Canada because of travel restrictions, this position might differ country to country.
Governance and implementation of changes: Where multinational groups make changes to the transfer pricing model/policy, these changes should be immediately reflected in the inter-company agreements, inter-company accounting systems, invoices as well as ensure any year-end adjustments required are put through prior to the close of the financial year or filing the annual tax return, to reflect the up to date facts and circumstances.
Document impact on business: where multinational groups have made changes to their transfer pricing model/policy or adversely impacted by the COVID-19 crisis, it will be imperative that taxpayers be able to articulate such changes and/or the reasons for changes to the profitability, in their annual transfer pricing documentation. While this could vary depending on the industry, it will be crucial to document any variances to performance as a first instance to defending the taxpayer’s transfer pricing position to tax authorities, going forward. Alternatively, if a taxpayer is pursuing an Advance Pricing Arrangement (APA), the taxpayer should model and document the impact on the business as this will qualify as a change to the crucial, underlying assumptions on which the APA is/will be based.
Manage transfer pricing obligations – where a multinational group is required to prepare and file a Country-by-Country Report (CbCR) and/or CbCR notifications, local transfer pricing disclosures as well as prepare or file a Group Master File, multinational groups should monitor any changes to filing deadlines (where these might be extended in the short term). Such filings should incorporate both quantitative (information on accounting adjustments, write-off’s, disposal of assets etc.,) and qualitative information on the impact on the multinational group’s business. If one or more entities is faced with a local transfer pricing audit, it is important that deadlines be managed with the tax authority accordingly and any delays to submission of information requested are agreed upon.
Other taxes – if a multinational group, restructures its operations due to the impact of COVID-19 and the inter-company transactions are subject to withholding taxes, Customs or Goods and Services Tax (GST) / Harmonized Sales Tax (HST) / Value Added Tax (VAT) etc., it will be critical that the effect of these taxes be assessed when making changes. Alternatively, if a multinational group exits a certain market, it might need to meet exit tax and compliance obligations, prior to such closure or disposal.
Managing transfer pricing risks is going to be critical as businesses and Governments navigate uncertain times. Multinational Groups until most recently have been witness to the renewed focus being placed on transfer pricing and tax transparency by the Organisation for Economic Cooperation and Development (OECD) by way of the BEPS 2.0 project. With this continuing to be a key focus for the OECD and tax authorities worldwide, along with a global crisis such as COVID-19, transfer pricing arrangements are likely to see increased scrutiny by tax authorities and viewed as a key driver for tax revenue to balance fiscal deficits and manage tax collection targets.
Contact our Transfer Pricing Principal & Practice Leader, Avinash S. Tukrel, if you have any questions or would like to discuss how this might affect your European business operations.