Five Transfer Pricing Actions Multinational Enterprises Should Focus on During COVID-19
The COVID-19 pandemic has led to supply chain disruptions and declining demand, exposing multinational enterprises to the risk of ineffective transfer pricing policies. Based on insights from experts at Crowe LLP, this article proposes five action recommendations: reviewing existing transfer pricing policies, re-evaluating intercompany agreements, assessing debt positions, proactively addressing tax audits, and considering the tax implications of supply chain adjustments, to reduce tax efficiency losses and ensure compliance.
This article is a guest contribution by Barry Freeman, Principal, and Selena Schneider, Managing Director, at Crowe LLP, a public accounting and consulting firm. The views expressed are solely those of the authors.
The COVID-19 pandemic has disrupted supply chains, caused production issues, and led to a decline in global demand, resulting in operating losses across various segments of the value chains of some multinational enterprises. As a result, many executives are under pressure to adjust their supply chains to ensure future sustainability.
Tax departments are under dual pressure to address issues exposed by transfer pricing policies based on assumptions of normal market functioning. If supply is constrained or demand is interrupted, even temporarily, companies may be unable to perform their functions, and such functional gaps can lead to significant tax inefficiencies and distort profit allocation or loss sharing within the group.
Actions to take
Given the high stakes, executives should consider the following five transfer pricing actions when responding to economic turmoil and mitigating intercompany transaction vulnerabilities.
1. Review existing transfer pricing policies
Assess whether target profit levels for limited-risk distributors, contract manufacturers, and sales agents should be adjusted. Observe market transactions within the company and make appropriate adjustments to intercompany transactions. Ultimately, returns must be aligned with what independent enterprises would do in similar circumstances.
Companies can make immediate adjustments to intercompany transactions by setting profit margins within the existing range based on available comparable data. The OECD Transfer Pricing Guidelines state that any point within the interquartile range is consistent with the arm's length principle. However, comparable data may not fully reflect the impact of the economic downturn. Additionally, relying solely on three years of data may not capture the downward impact on comparable companies' sales and profitability. Therefore, further adjustments may be necessary.
2. Review intercompany agreements
Determine whether action is needed under existing terms. Many intercompany agreements include force majeure clauses to address economic disruptions. Legal counsel should assess whether these clauses allow the company to be relieved of obligations to compensate foreign parties under limited-risk contract manufacturing or distribution arrangements. Other agreements may need to be amended or terminated to allow changes to intercompany terms.
3. Assess the company's overall debt position
Evaluate whether it is possible to renegotiate existing loans. If terms are successfully changed, the company may also benefit from revisiting its intercompany financing arrangements.
According to the OECD Transfer Pricing Guidance on Financial Transactions published in February 2020, it may be reasonable to renegotiate more favorable terms on intercompany loans, defer payments, or even recharacterize portions of existing loans to support the cash flow of related parties severely affected by the pandemic.
4. Tax audit response
Proactively discuss current economic conditions with auditors and, where possible, reach agreement on the pandemic's impact on the company and how to mitigate the situation. If the company faces audit issues and potential adjustments, consider initiating an advance pricing agreement to engage in discussions with tax authorities. Proactive pricing negotiations with tax authorities in key jurisdictions, especially during this uncertain period, can reduce audit risk.
5. Consider tax and transfer pricing implications
These implications relate to supply chain restructuring and adjustments to functions and risks based on current and future conditions. Decisions to exit markets due to the pandemic should be documented, including termination clauses and exit-related payments, to demonstrate that no compensable value, such as intangibles, has been transferred. Develop well-supported economic analyses demonstrating that losses are related to the exceptional circumstances of the pandemic and that restructuring is essential for business continuity.
Looking ahead
Given the rapidly changing environment, tax departments must remain focused and implement adjustments to their intercompany structures to ensure compliance and risk issues are addressed.
Tax authorities will encounter various issues when auditing businesses affected by the pandemic. Tax departments must continue to emphasize the importance of documenting intercompany transactions and ensuring their transfer pricing positions are well-supported by documentation.