Lockdown has disrupted transfer pricing (TP) within multinational enterprises (MNEs). Even as restrictions are gradually eased, there continues to be considerable uncertainty over the risks, circumstances and comparables used to determine arm’s length transfer prices.
The potential for tax authority audit and dispute is heightened by the extent to which what you do now differs from past designations on risk and return. In common instances, limited risk distributors or ‘cost plus’ entities could face challenges from tax authorities if they start to record losses, while higher risk/high profit operations appear to have been insulated. In the long-term, you could also face retrospective challenge as tax authorities come under pressure from cash-strapped governments to recoup some of today’s state aid and lost tax revenues.
Drawing on the TP issues raised by our clients from around the world, our TP experts highlight the dilemmas your business could face in determining arm’s length transfer prices, the ramifications and potential risks. We conclude by setting out six practical ways to navigate through the TP minefield.
Of the many challenges your business faces right now, TP might not seem like the most pressing. Yet, it impinges on many of the issues in most urgent need of addressing, from cost management and stabilising income streams to how to use government grants effectively. Moreover, the TP decisions taken during 2020 could come back to haunt you in the coming years as tax authorities look retrospectively for opportunities to boost the tax take from MNEs.
“The transfer pricing implications should be considered up front as part of key business decisions. If functions, risks or assets are transferred overseas to consolidate business positions, for example, how will this affect transfer pricing? How might changes in inter-company financing impact the risks and other factors influencing the transfer pricing model?”
Leslie Van den Branden, Partner, Grant Thornton Belgium
What then are the developments that could affect your TP policies and their management?
One of the basic principles of TP is that it should conform, at least indirectly, to some form of observable transaction or reflect what two unrelated parties would reasonably pay in an arm’s length transaction. 2020 offers little observable precedent for either approach.
“Today’s sharp falls in turnover and disruption to supply chains are taking transfer pricing into new and uncharted territory. There is also little or no precedent to help determine what an unrelated party would expect in an arm’s length transaction. Transfer pricing policies are therefore likely to need thorough review, possible revision and clear substantiation to support any new determinations.”
Wendy Nicholls, Joint global head of transfer pricing, Grant Thornton
So, what does this all mean in practice?
Issue 1: TP policies opened up to challenge
Many businesses saw revenues grind to a halt as lockdowns were imposed, but staff and other costs didn’t go away. From a TP perspective, one of the dilemmas has been that operations typically identified as low risk such as assembly or warehousing may now be running at a significant loss.
While many third party operators may also be suffering losses, and intra-group pricing should reflect the extraordinary economic realities as far as possible, you would still need to justify why the risks have changed and why they might not have been fully reflected in pre-crisis determinations.
“Transfer pricing isn’t an exact science. Business strategies are subject to change, especially in a crisis situation. If you decide that revisions to your transfer pricing policies are needed in line with the arm’s length principle, the decision should be documented and substantiated properly.”
Charles Marais, Partner, Grant Thornton Netherlands
The danger is twofold. First, tax authorities may now question whether some of the limited risk operations were such a low risk within ‘cost plus’ evaluations in the past, or whether they should have made more profit in the ’good years’. Second, how much of the losses you are now incurring can be allocated to those low-risk activities, or will the loss claims be rejected?
The reverse is also true for ‘super profit drivers’ such as entities engaged in innovation or owning other intellectual property, which paradoxically may not see as much immediate operational loss as trading entities. Have the risks borne and rewards allocated to the high risk/profit IP sources been justified from a TP perspective? And if losses are now being borne by the low-risk operations, which may have paid little tax in the past, are you at risk of hemorrhaging tax because you are unable to relieve the losses?
A big danger is that the perceived TP anomalies highlighted by the COVID-19 emergency in areas such as whether the risk designation is justified could lead to tax authority investigations. These could involve multiple authorities, with different incentives: the head office country may be very keen not ‘share the pain’ but the subsidiary jurisdiction may want to preserve its positive returns.
As tax authorities look to increase revenues in the coming years, the anomalies in TP designations could come under intense scrutiny. What you do now therefore has to be fully justifiable, with a close eye on the potential for retrospective challenge. The scrutiny could range from the production of goods and provision of services to IP and financing – in other words, virtually any type of transaction.
While the situation is extraordinary, the risks vary according to function and where they are located. Failure to re-evaluate could have a significant impact on the country where the risks are borne.
Equally, where risk designations are changed, this will have repercussions later on. For example, an operation in which the downside risks are increased would generally be expected to earn a higher reward going forward.
“Although tax authorities should make accommodations given the nature of the crisis, some may not. Faced with this possibility, you should review each tax authority’s policy and prior history with your company.”
Pascal Luquet, Partner, Grant Thornton France
Issue 2: When does normal begin again?
From a TP perspective, the period during lockdown has clearly been exceptional. But what about the rest of 2020? As reopening gathers pace, some businesses are already seeing a significant uptick in revenues. But for most it may be months and even years before they get back to anything approaching normal.
“Profit-based transfer pricing approaches assume that profits are made and that there are reliable cost and sales forecasts. They are not realistic. Sudden changes in sales or production capacity utilisation will lead to unexpected losses that need to be reported properly.”
Brad Rolph, Joint global head of transfer pricing, Grant Thornton
The challenge is determining the duration of the exceptional period for TP purposes and when it could be deemed to have ended. It’s also important to assess whether benchmarks conducted in the past remain applicable or whether new benchmarks should be undertaken for the period during and after COVID-19.
While many businesses are now opening up, they are still feeling the impact of restrictions such as social distancing. It’s therefore difficult to know how the results for the rest of this and the next financial years will play out. Scenario modelling could be applied, but it may be well beyond the year-end before impacts and durations can be determined with any certainty. It may therefore be necessary to divide periods of account from a TP perspective into before, during and after the emergency.
Groups should look to adopt reasonable arrangements to align transfer pricing policies with the changing realities within the business. Examples include working out how to reflect the different distribution of profit and loss within the supply chain. Further priorities include working out to what extent a temporarily paused or scaled back operation should be remunerated differently to when it was fully up and running.
Issue 3: Questions about the allocation of state support
TP management is complicated by state aid such as government subsidies for staff costs. Governments naturally want their money to be used to support local jobs.
As an MNE, you also face the challenge of how revenues and subsidies are allocated from one state to another. If one state makes good your losses through furlough schemes or business loans, is it reasonable that another less generous state should benefit when (post-support) profits and losses are allocated across the whole supply chain?
As many operations deemed low risk from a TP perspective such as warehousing are also relatively labour intensive, determining who takes the benefits of the subsidies and who bears the losses opens up significant risk of challenge.
It’s important to ensure that TP and other tax decisions, calculations and payments are aligned.
“Current transfer pricing policies may not reflect the commercial realities of disrupted supply chains. As a result, profits and expenses might not be allocated in the appropriate jurisdiction. Revisions will be needed to correct this misalignment.”
Paolo Besio, Partner, Bernoni Grant Thornton
The way forward
Although nothing in the past really compares to the full lockdown seen in 2020, the 2008 financial crisis provides some precedent for the kind of revenue disruption seen at present. One of the most important lessons from the financial crisis is that audits may well take place years after the event and therefore TP decisions need to be documented promptly so as to stand up to scrutiny.
Industries are coming together to determine the foundations for best practice. However, their endeavours are hampered by the lack of contemporaneous benchmarks and comparables upon which to base their recommendations.
The OECD is also looking at the transfer pricing issues raised by the COVID-19 emergency. Whilst consensus is difficult and the guidance is likely to be fairly generic, there is acknowledgement that countries will face ‘increased revenue needs’ and the OECD has said that ‘in a post-crisis environment, it is likely that addressing the tax challenges of the digitalisation of the economy and ensuring that MNEs pay a minimum level of tax will be of even higher importance’.[i]
Your business is therefore being forced to make prompt decisions based on imperfect information that will later be scrutinised with hindsight. How can you address these difficult questions?
As the squeeze on revenues and available cash increases, we’re seeing a significant increase in the risk appetite regarding TP within many businesses. When survival is at stake, this may be one way to hold onto and/or release funds. At the same time, the risks of challenge from surrounding TP have been increased by the current situation. This is a difficult balance.
“Companies appetite for transfer pricing risk may change as they look to conserve cash. Where these companies may have conservatively targeted the median operating margin previously, they may now designate a significantly lower, or zero returns in some jurisdictions due to cash constraints. While this may be a risk they are prepared to take now, the tax authorities will be looking for ways to recoup lost revenues. Their prime targets are likely to include businesses that have significantly changed their transfer price risk appetite and approach.”
Jason Casas, Partner, Grant Thornton Australia
Continuing uncertainty over the duration and impact of COVID-19 on your business mean that many decisions will need to be provisional at this stage. They would then be subject to change and finalisation at year-end and beyond.
“As ex-post testing may not provide sufficiently substantiated results, it’s important to prepare and document ex-ante forecasts to defend the arm’s length character of crisis adjustments made.”
Jean-Nicolas Bourtembourg, Partner, Grant Thornton Luxembourg
Ensure that subsidies for staff and other overheads and operating costs are fully factored into TP decisions.
“A big question for MNEs is who takes the loss and who benefits from any subsidies. Country-by-country reporting will allow governments to see whether or not the subsidies they provide are supporting jobs and operations within their jurisdictions.”
Juan Martínez, Partner, Grant Thornton Spain
Judge whether the benchmarks used to determine TP treatment are still valid and, if not, how they can be updated. The exceptional nature of the current situation inevitably increases the subjectivity of your decisions. For this reason, it’s important to ensure that clear justifications and documentation are in place. You might also consider adjusting benchmarks to include loss makers and make comparability adjustments based on the reduction in business being reported by similar companies in your industry. It may even be necessary to look at alternative approaches to determining ranges of arm’s length prices, such as economic game theory to model the behaviour of unrelated parties in this unprecedented situation.
“Although taxpayers can expect heightened scrutiny from tax authorities, it’s better to alter and document transfer prices to align with new arm’s-length realities than to continue legacy transfer pricing approaches that rely on pre-pandemic expectations.”
Steven Wrappe, National technical leader, transfer pricing, Grant Thornton US
Although finalised decisions on TP treatment may not be possible until year-end, it’s still important to record data, document decisions/justifications in real-time and include these in your monthly management reporting pack. This will help to ensure that the risks are clear and being considered. You can then make a better case if you come under investigation in the years to come.
Make sure decisions over TP are consistent with, and take account of, the knock-on impacts on other key tax and business management priorities including financing, VAT and government relations.
Conclusion: A stitch in time saves nine
As supply and demand are disrupted, so too is the basis for TP. Clearly TP designations will change as operations are scaled back and revenues dip. But simply saying that these are exceptional times and adjusting accordingly aren’t enough as TP approaches used now could invite tax authority challenge of both pre-pandemic and post-pandemic designations. Determining and defending approaches will be much easier if TP is forecasted, managed and documented as a real-time exercise rather than retrospectively.