Transfer pricing issues arising from the COVID-19 pandemic

By Gaurav Jain, Chartered Accountant, India, & Priya Mani Bhutani, Transfer pricing professional, New Delhi

The new decade is only three months old, but it has already witnessed an unprecedented phenomenon.

COVID-19 has made the world economy see one of its lowest times, and the worst may not yet be fully realized. However, the undercurrents of this universe are such that every challenge has an underlying solution and an emerging opportunity.

Quarantine requirements may have temporarily disintegrated the modus-operandi of multinational enterprises; however, with the eventual phaseout of the global lockdown, the inevitable need to realign and reframe intragroup policies from a tax standpoint cannot be side-lined.

In this article, we highlight ways that MNEs can cope with the current distressing situation.

Supply chain management

With most countries in full or partial lockdown, realigning value creation along an enterprise’s supply chain is crucial. While the practical execution of this realignment may be the need of the hour, it is imperative to consider implementation from a transfer pricing perspective.

Any change to the functional profile of a multinational group entity, such as the performance of additional value-adding functions due to value chain realignment, would have a bearing on the entity’s economic characterization in line with any additional risks assumed and assets owned by the entity. The remuneration attributable to or earned by the entity should be at par with this characterization.

As the statistics indicate, the pandemic’s effect varies between countries. Accordingly, decision-makers may consider relocating additional functions remotely to countries that experience low impact. The effect of such a transition may temporarily change the profit allocation between MNE group entities in line with their function, asset, and risk profile.

One of the most common supply chain transformations may be value shifting from physical to digital platforms to ensure business continuity. For example, for an IT service company, after-sales services may be automated using a bot that addresses first and second level queries/ concerns without requiring physical visits by technicians.

In doing so, the allocation of costs incurred developing the bot and its ownership, maintenance, upgrades, etc., among group entities and their taxability would need to be established.

Similarly, due to the lockdown, key decision-makers may be grounded in other tax jurisdictions and forced to conduct business through digital platforms. This could lead to the creation of a permanent establishment on foreign soil and taxability based on an arm’s length basis.

Because of the current pandemic, a pharmaceutical company could start producing more generic drugs to comply with the growing demand, in contrast to its earlier production rate of generic vis-à-vis patent drugs. However, the generic drug may not result in high profits for the company. This, at first sight, may change the taxability of the company in the given jurisdiction.

Accordingly, MNEs having obligations to file the country-by-country reporting and master file must be extremely cautious of the information furnished therein.

MNEs having obligations to file the country-by-country reporting and master file must be extremely cautious of the information furnished therein.

On the one hand, country-by-country reporting may exhibit skewed tax risk indicators as compared to earlier year disclosures, as suggested by OECD this year. On the other hand, some sections of the master file must be redrafted if the group’s policies change.

Therefore, the need to document the rationale and reason for any change in the supply chain needs to be robust in the group’s annual master file. Accordingly, adequate documentation justifying the changes made may safeguard potential assessments for the group.

Working capital management

The most tangible effect of the pandemic on business is its impact on cash flow. A common way to manage this is by providing leeway on credit terms. Relaxing payment terms and the credit period may ease the pressure on cash flow.

Given its universal effect, such relaxed payment terms might be equally applicable to third party market players. Accordingly, it may not be a significant challenge this year to justify the same from an intragroup transaction perspective.

Further, to ease the burden on taxpayers, tax authorities around the world provided prima facie relief measures, such as the extension of year-end dates, the extension of statutory timelines, deferral of tax payments, etc. These actions could serve as an instant source of liquidity for firms.

Advancing intragroup loans may also be vital to support group entities’ financial requirements. However, in doing so, decision-makers must be cautious when evaluating the interest rates for advancing such loans since the market is already indicating lower rates of borrowing due to the economic downfall.

Groups must also review the terms of existing related-party financial arrangements. Given the liquidity crunch, there needs to be an evaluation of whether the rate of interest and the repayment schedule must be renegotiated.

Groups must also review the terms of existing related-party financial arrangements. Given the liquidity crunch, there needs to be an evaluation of whether the rate of interest and the repayment schedule must be renegotiated.

The force majeure clause in agreements should be closely assessed as many companies are contemplating the emergence of COVID-19 as an act of God. This may lead to discontinuation of service agreements and pose a threat that existing business contracts will be held void.

Arm’s length price

Arm’s length price is measured as an index of profitability earned or price charged by independent market players. COVID-19 is a pandemic, and therefore, its impact is pervasive, i.e., there may be a delay in ascertaining the financial data of the comparable companies in the public domain. This is primarily because, at the time of undertaking transfer pricing compliance, there may not be adequate, financial data available for undertaking benchmarking analysis for the period impacted by COVID-19.

Once the lockdown phases out, many companies may not be working in their full capacity immediately. This may have an impact on the composition of their fixed and variable costs incurred during the year. While doing the comparability analysis, each company may have different capacity utilisation rates. However, the details of the same may not be publicly available.

To address this issue, MNEs may resort to economic adjustments suggested in OECD transfer pricing and those upheld in jurisdictional regulations.

Adjustments for differing working capital requirements or capacity under-utilisation (using the latest financial data to the extent possible) may be helpful in documenting and numerically exhibiting the need for adjustments required in the pricing policy for intragroup transactions.

 Such adjustments may also help MNE assess the extent of change they may consider viable.

Reconsidering operating costs

Another issue is whether operating costs warranting a mark-up should be recomputed this year.

Typically, captive service providers are remunerated on a fully loaded cost plus mark-up basis. However, at this time, the definition of operating costs is distorted, in substance over form. Many costs that are fixed in nature may have to be incurred; however, the recharge for the same with a mark-up from the service recipient may be contended.

Additional payments of royalty for technical know-how or fees for technical services may also be an area of dispute.

The benefit accrued from availing these intragroup services typically justify the payments. However, during these times, one needs to be wary of the fact that the actual benefits accrued for these services may be questioned. Accordingly, any exceptions made for such payments need to be adequately thought through and documented appropriately.

Changes in tax avoidance instruments

Companies that have tax avoidance agreements, such as advance pricing agreements, in place with tax authorities may need to revisit the assumptions upon which such arrangements were based. A change in critical assumption and important factors, such as functional characterisation, risks assumed, costs incurred for mark-ups, allowance of payments, etc. may require the renegotiation of the agreemen with the authorities.

Conclusion

Most of the changes to MNE intragroup policies will likely be justifiable in the short-term, given the present situation. However, the persuasive value of these changes may be contested once the tax authorities regain constancy.

Like MNEs facing cash flow problems, the mindset of tax authorities that scrutinize tax matters will be affected by the economy’s cash flow. Therefore, any change in intragroup policy will be subject to close monitoring for base erosion and profit shifting.

From a taxpayer perspective, what is required is laying down policies that are not only commercially and economically viable but also rationally substantiated. Robust documentation to validate any change from the existing policies is mandatory and a crucial defense from tax litigation hardships.

Robust policymaking, even at this time when the clear picture hasn’t emerged, is the only hope to contain the hard impacts of this pandemic.

Transfer pricing policies and the guiding principle for its assessment will not change; accordingly, stakeholders should not only consider the benefits of their decisionmaking on business but also its effect on the economy and people at large.