INSIGHT: Covid-19 and the Impact on Transfer Pricing Policies

Heads of tax of multinational groups (MNGs) are under great pressure due to Covid-19 lockdowns in different countries and the consequent recession that will impact on year-end profit and loss (P&L) results of local subsidiaries. They will have to see whether the existing group transfer pricing policy is still valid and whether it can be applied automatically or if it is possible/necessary to make some modifications, thus permitting to better offset profit margins and losses at group level.

In the presence of centralized entrepreneur structures, where most of the relevant functions and entrepreneurial risks are concentrated at the level of the group entrepreneur, and other group companies are performing mainly routine manufacturing or distribution functions, the solution is not straightforward.

Covid-19 v. Economic Crisis

We have experienced a financial and/or economic crisis in the past but not a pandemic one. The main difference here is that a pandemic crisis implies a shutdown period that can trigger a financial crisis and an economic recession in certain sectors due to the fact that during the shutdown period most people have consumed economic resources without the generation of new resources.

Furthermore, each country is adopting different temporary measures in periods temporally not aligned which may cause a bottleneck in the group supply chain.

This means that this pandemic crisis adds a new dimension to the standards crises—financial and economic—and potential interconnected negative consequences that have to be handled in a different way from a transfer pricing (TP) perspective.

A Suggested TP Approach

Functional Analysis

MNGs are facing different situations depending on sector. Some MNGs may continue to function as normal during the lockdown but there are many that will be functioning quite differently.

Significant attention must be given to this latter group as the decline in revenue not always followed by a decline in costs may mean that companies suffer losses. This situation may trigger significant pressure at group level from the stakeholders on the internal tax department to change the TP policy and minimize the tax burden at group level.

Heads of tax have the dilemma that any change in the TP policy to spread losses throughout group subsidiaries might cause significant local tax assessments in future, as local tax authorities do not expect a company performing a routine activity, either in the manufacturing or distribution side, to incur significant losses. Furthermore, a change in current TP policy might also have adverse consequences on indirect tax and custom duties.

This complex situation requires a deep functional analysis to verify the conformity of the entrepreneurial (i.e. functions played, assets used and risks borne) profile given to each company in the group TP policy and the contractual arrangements in place to the actual economic behavior of the parties involved.

With regard to the first point, it is important to define to what extent each subsidiary/permanent establishment is a limited risk entrepreneur and whether its activity (manufacturing, service or distribution) is limited only to group businesses or is also open to third-party businesses.

Then the review of the inter-company contracts is needed to understand the given allocation of risks between the parties and the existence of force majeure clauses (such as flood, riot, fire, explosion, war, strikes) by means of which if any such event occurs the non-performing party will make reasonable efforts to notify the other party of the nature of such condition and the extent of the delay. The non-performing party will make reasonable, good faith efforts to resume operating as soon as possible.

Sometimes, the protracted force majeure situation may also cause the early termination of the agreement and/or indemnification requests. In most of these circumstances, provided that the functional analysis does not raise any contradictory responses, all the negative effects derived from this extraordinary situation shall be borne by the party directly experiencing the adverse event.

In carrying out the TP analysis, it becomes necessary to keep separate each phase of this pandemic crisis in order to see what TP principles can be adopted, inspired by the approach suggested in Chapter IX (business reorganizations) of the OECD TP Guidelines.

For a group taxpayer (either legal entity or permanent establishment), there are at least three different business phases:

• shutdown;
• reopening; and
• standard

In principle, we can say it is possible to manage each phase by adopting a specific TP approach to satisfy the arms’ length principle.

Shutdown

At present more than 90 countries have enacted shutdown periods in different ways for several manufacturing and retail activities.

This mandatory closure program is an extraordinary event provided by each domestic legislator, not manageable by MNGs, which falls into force majeure clauses typically included in most of the written contracts signed between unrelated as well as related parties. Consequently, all effects related to the shutdown might reasonably be borne by the local targeted taxpayer.

The P&L account related to this specific limited period shall include all revenues and costs sustained during the shutdown, net of the effect of any economic fund or contribution recognized by each government to the local targeted taxpayer.

Particular attention should be given to the clauses of the existing contractual inter-company arrangement to verify their respect of the arms’-length principle, the case law or the commercial practice and to understand whether a party might ask for an indemnification from the other party or not.

Reopening

This is the period of time needed for local business to return to normality. It starts from the end of the shutdown period and ends when the local company can carry on the business as usual, irrespective of the profitability level obtained.

Here the analysis is more complex, as it is necessary to look at the shutdown mismatches of the parties involved in the group supply chain and to define who has the responsibility for any eventual business bottleneck (i.e. the contract manufacturer, the principal or the limited risk wholesale or retail distributor).

Let us assume, for example, that no bottleneck arises and the local retailer has all the products available for sale. The group retailer is not able to perform as usual due to social distancing and freedom limitations imposed on local buyers and/or to their expected lower spending capacity.

In this situation it is advisable to apply the methodologies already applied in past economic downturns. This means, for instance, to carry out a “variance analysis” to compare the results obtained in the previous pre-Covid period to those obtained during this phase and verify the reasonableness of a possible neutralization of the negative economic effects not caused by TP policies.

Once these adverse economic effects are neutralized, the profitability margin of the targeted company should respect the arm’s-length conditions already defined through the interquartile range profitability of the benchmarking analysis prepared based on the previous three-year period.

Standard

This phase starts when the targeted company carries on business activities in a normal situation and the local business environment does not suffer from any Covid-19 restriction.

In this period, absent any justified economic reason, the profitability margin of the routine targeted company should respect the arm’s length conditions already defined through the benchmarking analysis prepared, based on the previous three-year period.

Depending on the specific circumstances, it might be possible to consider the entire range instead of the interquartile one or to include in the set of the comparable companies, entities that in the previous three-year period originated a loss.

The reconsideration of multi-year averaging benchmarking results is not advisable as, in general, it comes from a long period of economic growth; the alternative to only focus on 2020 financial results is not practically feasible as this data will be uploaded in the third quarter of 2021 and made available in the fourth quarter.

Financial Transactions

As a result of the above combined approach, some entities might suffer a loss and their capital structure might change accordingly. MNGs should verify whether existing and/or new loans can be regarded as indebtedness or should be regarded as some other kind of payment; in particular a contribution to equity capital, as suggested by the Organization for Economic Co-operation and Development (OECD) in its report Transfer Pricing Guidance on Financial Transactions issued in February 2020.

Transfer Pricing Documentation

• It is crucial to prepare detailed TP documentation to demonstrate the existence of the above-mentioned phases during the financial period under analysis and that the MNG has applied the correct transfer pricing policy. The TP documentation will prove that:
• negative results obtained by the targeted party during the shutdown phase is due only to force majeure causes and it has been managed by the parties fully in line as unrelated parties would have done. It is advisable to collect information and data in real time as requested in case of contemporaneous documentation;
• adverse results obtained by the targeted party during the reopening phase might be caused by external circumstances and, therefore, to non-transfer pricing factors;
• positive results obtained by the targeted party, spontaneously or as a result of a TP adjustment, during the standard phase will fall within the arms'-length range remuneration obtained through an appropriate benchmarking analysis.

Signed Advance Pricing Agreements (APAs) and Bilateral APAs

Many MNGs have decided to minimize uncertainties by signing unilateral or bilateral APAs; in these circumstances a lower level of flexibility is permitted as any decision must be communicated to the competent tax authorities.

Unilateral APA in Progress

As unilateral APAs bind only a competent tax authority and provided that this analysis complies with OECD Guidelines, there should be (at least from the Italian side) more availability to discuss the effects of the analysis even if any change in the APA written agreement would mean additional procedural work and the consequent notification to other OECD competent tax authorities involved.

Bilateral APA in Progress

Many competent tax authorities are reluctant to modify a bilateral APA as they see it as a binding contractual agreement.

A mere change in macroeconomic conditions is generally not considered a reason to amend a bilateral APA as tax authorities agree not to expect for the routine targeted company a higher level of income in a growing economy and a lower level in case of an economic recession.

The Covid-19 shutdown could be treated as a special adjustment to the existing agreement if it could not be managed within the critical assumptions provided in the agreement: in both cases the two competent tax authorities should formally agree to that.

Renewal of a Bilateral APA

It is certainly easier for competent tax authorities to consider the Covid-19 effects during the renegotiation of a subsequent five-year bilateral APA and agree a lower targeted range taking into account the shutdown and economic downturn effects, as a result of Covid-19.

Planning Points

MNGs must not underestimate the impact of Covid-19 from a TP perspective and they should start an in-depth analysis of their business as soon as possible, taking care that the actual TP solution might be different not only in each country but also in each role within the same country.

Paolo Tognolo is Senior Tax Partner and Founder of Studio Tributario Tognolo, Italy

This column does not necessarily reflect the opinion of The Bureau of National Affairs, Inc. or its owners.