Immediate transfer pricing effects of the Covid-19 pandemic
At the beginning of 2020, the new virus SARS-CoV-2 (Covid-19) that originated in the city of Wuhan, China surprised the world causing an unprecedented disruption to our modern world. By the middle of this year the virus has become a global pandemic evolving at a rapid and uncontrollable pace resulting in great loss of life and very significant reduction of global economic activity. This new landscape brings new business challenges, and will test the adequacy of transfer pricing policies throughout the world.
The moment requires taking timely decisions
An important aspect that companies must consider during this pandemic is taxation. It is of vital importance for taxpayers that are part of a business group, and who have operations with related parties, to evaluate whether their transfer pricing documentation is consistent with their economic reality. An incorrect assessment could trigger an overestimation of the taxable base possibly at great detriment to the company’s financial situation. Some of the items that should be considered are the following:
My business is losing money, are the comparables as well?
The main purpose of the global transfer pricing regime is to demonstrate that transactions carried out among related parties are consistent with the arm’s length principle. The complicated current economic outlook where a decrease of demand meets supply chain disruptions could lead to smaller or even negative margins from intercompany operations, and likely to the business overall. In this situation, and given the frequent use of transfer price methods based on profitability ratios, it is necessary to confirm the reasonability of the reference parameters (interquartile ranges) used in the analysis to avoid a bloated taxable income due to the selection of comparables that are not affected by the same economic circumstances of the taxpayer. There could be greater complications for companies that previously experienced a restructure, have migrating functions or risks, or lease their excess capacity and now operate through contract manufacturing or limited risk distributor business models, models which are supposed to impede the assumption of risks unrelated to those activities. Any transfer pricing analysis must observe the performance of the real comparables to determine the possible impact of the current economic reality and make necessary adjustments to derive reference parameters that accurately reflect the circumstances brought about by the Covid-19 pandemic.
Additionally, and because of the reduction of activities, one must be alert for the impact in the provision of intercompany services. Their interruption or changes in the terms in which they are provided must be correctly documented to comply with the benefit test required by the OECD Transfer Pricing Guidelines. Another relevant question relates to intangibles, in regards of the application of the commensurate with income rules, and in cases of hard to value intangibles, the effect of the current and future economic conditions in its valuation.
How can I renegotiate with my related parties?
The current circumstances are triggering the renegotiation of contractual terms -when possible-. The extension of deadlines, modifications of payment terms, and even adjustments to previously agreed considerations is frequent. Because the intercompany agreements must replicate the negotiation dynamic observed with independent third parties, under the current circumstances it is necessary to identify the contractual terms to be adjusted taking into consideration the negotiation trends observed by the taxpayer and its industry.
What if I receive financing from related parties?
An immediate need for many companies will be to obtain additional resources to remedy the current situation. In this case, taxpayers must consider the new regulatory framework introduced by the OECD’s Transfer Pricing Guidelines for Financial Operations published in February of this year. The new provisions for intercompany financing in these guidelines will complement the already established anti-abuse rules that limit interest deductions in cases that exceed pre-established proportions of debt/capital or of adjusted earnings (EBITDA). In any case, it imperative to identify how the pandemic affects the structuring of capital and financing requirements of the group, the correct financing mechanisms and eventually, in the existence of intercompany debt, derive the intercompany interest rates attributable to each entity as a function of credit risk. One should also take notice of possible benefits from group synergies due to cash-pooling schemes and the effects these may have on guarantee rates from the HQ or some other entity.
Business will not be the same
The pandemic will have a lasting effect on many sectors of the economy. Many organizations will have to evaluate a possible restructuring of their value chains that would imply a movement of functions to jurisdictions that offers a greater competitive advantage or a reduction of risks. Automation and the appearance of disruptive business models are and will continue to be a tendency. In this sense, the evaluation of transfer pricing risk as it relates to future business restructuring is of primary concern to avoid a tax contingency, potentially claiming a return for the business units or functions that were deployed elsewhere. In the case of the digitalization of the economy, there is an expectation for the OECD to release its conclusions on this matter through its “unified approach”, which will propose to tax digital companies through two mechanisms or pillars. At the moment they are understood as i) market value renumeration of “routine” business activities carried out by the group in the jurisdiction where it takes place, and ii) impose a global tax rate (GloBe) on the remainder of the group’s profits, assigning each tax jurisdiction a return as a function of what the entities in it contribute to the multinational’s income.
The immediate future is uncertain and will require a careful navigation in order to avoid ever more aggressive controversies with tax authorities as well as avoiding the potential materialization of transfer pricing risks due to erroneous planning. We invite you to reach out to us to discuss these pressing issues and define a plan of action that would allow you to take decisions in the short, medium and long term that benefit of your firm.
