COVID-19 – Potential Transfer Pricing Impact and How to Prepare
Per the Organization for Economic Cooperation and Development (“OECD”), the COVID-19 virus outbreak presents the greatest danger to the world economy since the 2008 global financial crisis. In the midst of the COVID-19 pandemic and resulting market volatility and uncertainty, many businesses are experiencing unprecedented global disruption and concerned with the economic impact. Multinational enterprises (MNE) are faced with issues such as supply chain disruption and reductions in consumer demand, which corresponds with lower sales and limited ability to travel on business. The impact of COVID-19 may not only be devastating operationally and financially, it may also give rise to transfer pricing implications. This is further exasperated as the transfer pricing landscape has changed dramatically since 2008, and as a result of the OECD’s BEPS initiative transfer pricing it is under even greater scrutiny.
As mentioned in Transfer Pricing-Why It Matters, MNEs routinely engage in related party transactions such as the sale of tangible goods, provision of services, loans and advances, rentals of tangible property, and transfers of intangible property. In all cases, the price charged between the parties is the transfer price. As a result, transfer prices are used to calculate how profits should be allocated among the different parts of the MNE in different countries, and are used to determine how much tax the MNE pays and to which tax administration.
MNEs follow transfer pricing rules that require evaluation and documentation supporting adherence to the arm’s length standard. From a US perspective, the IRC Section 482 regulations require a detailed review of the functions performed, assets employed, and risks assumed by the respective parties (also known as the functional analysis) when determining appropriate transfer pricing outcomes. Ultimately, this is a facts and circumstances based analysis and includes reviewing the terms of intercompany contracts and the economic substance of the transaction(s).
As the world reacts to COVID-19, many MNEs are moving quickly to put in place contingency plans. Such plans may result in altering or shifting functions and risks across the organization to respond to the immediate needs of the business. However, it is important to note that a change to the functions and/or management of risks directly affects the transfer pricing analysis of the group. To ensure adherence with the arm’s length standard, a review of the allocation of risks is critical.
As reward typically follows risk, transfer pricing policies generally result in allocation of the majority of profits to the entity that incurs risks, performs key functions, makes investments and/or maintains and develops intellectual property. However, in an economic downturn MNEs may experience widespread operating losses or reduced profitability. Thus, MNEs may be faced with the following questions – Which entity bears the loss? Should losses be spread across the organization? If so, how? Will this be challenged by tax authorities?
It is clear this situation may call into question the appropriateness of existing intercompany arrangements and transfer pricing policies. This is particularly true for MNEs facing losses, when they have historically based their transfer pricing on an allocation of profits. As the arm’s length nature of the allocation of losses may give rise to challenge by tax authorities, it is important to take steps now to review and contemporaneously document the financial and operational impact of COVID-19 and revisit existing transfer pricing policies and intercompany agreements. Below are potential actions points for MNEs to consider for COVID-19 transfer pricing risk management:
- Model the impact of COVID-19, rework financial forecasts and consider the need for immediate or more frequent transfer pricing adjustments.
- Review transfer pricing models – Are they up to date, and do they reflect the current situation? If not, adjust as needed and document. For example, MNEs may consider the following:
- Evaluate any changes to the supply chain, and ensure they reflect any re-allocation of functions, assets and risks across the group.
- Consider whether restrictions on travel impede day-to-day activities related to management functions, or activities that support the DEMPE functions (Development, Enhancement, Maintenance, Protection and Exploitation of intangibles).
- Review limited risk entity structures, ensuring the appropriate functions and risks analyses are available should a structure be challenged by the tax authorities.
- Evaluate transfer pricing activity related to moving cash into or out of affected countries to pay for crisis-related expenses.
- Contemporaneously gather and maintain information to support transfer pricing to justify any changes made.
- Review the terms of intercompany agreements and Advance Pricing Agreements.
- Consider the impact of the global pandemic on worldwide operations. Does it give rise to the need to restructure or relocate some operations to diversify risk?
In conclusion, while transfer pricing is always subject to challenge, if proactively approached and documented, results generally stand up to audit. As COVID-19 continues to cause global uncertainty and economic disruption, it is important for affected MNEs to take action early. With the likelihood of enhanced transfer pricing scrutiny in an economic downturn, by taking steps now to consider the potential impact and review transfer pricing policies MNEs will be better positioned to mitigate transfer pricing risk related to COVID-19.
If you would like to discuss the above and how COVID-19 may impact your business and transfer pricing models, please contact Stuart Lyons, lead of BNN’s international tax practice, or Andrea Reilly at 1.800.244.7444.
Disclaimer of Liability: This publication is intended to provide general information to our clients and friends. It does not constitute accounting, tax, investment, or legal advice; nor is it intended to convey a thorough treatment of the subject matter.