INSIGHT: (In)direct Tax Considerations in Light of Covid-19 and Brexit

Covid-19 has led to unprecedented circumstances for business. While every tax director’s initial focus was on cash flow management and on navigating the available (tax) stimulus measures to determine whether their company qualifies for any of them, currently it is the cash tax impact of the consequences of Covid-19 on business that may be leading to unforeseen issues, threatening to challenge some of the cash flow management steps taken earlier.

A company’s transfer pricing structure inevitably allocates responsibilities, risks, and resulting levels of remuneration to group entities. The pandemic’s impact forced people to operate for an extended period of time from locations where they happened to be when lockdowns were imposed, required creativity in sourcing supplies when delivery of raw materials or other inputs dried up, and required investments and ad hoc changes to operating procedures, services, and production to meet obligations to existing customers, to cater to changed demand, and to contribute to help fight the pandemic.

With calendar year-end six months out it makes good sense to now consider if there will be any adjustments required to either (1) re-align with the original transfer pricing structure, or to (2) decide to implement changed operating procedures according to changed responsibilities and risks more definitely. Pricing for the ad hoc transactions and changed supply chains—particularly if those were intercompany transactions—may very well have been structured without a comparability analysis to ascertain what an arm’s-length price should have been. Although public data on comparables subject to the economic circumstances of today will not be available for a while, since database information lags behind reality for at least a year or so, this does expose corporate taxpayers to transfer pricing scrutiny. Furthermore, cash tax concerns may tempt associated enterprises to share the risk and reduce centralized headquarters losses while related service entities report profit margins that don’t seem right in a Covid-19 environment.

Tinkering with transfer pricing models this way will be a real balancing act that is not without risk. Short term gains in this respect may undoubtedly lead to longer term challenges. It should be considered that public data on comparables should at some point—albeit with delay—reflect the Covid-19 impact and lower margins. If a company chooses to assert lower returns up front, this may very well pre-empt it from doing so later.

While for corporate tax purposes there may still seem to be some time to consider what to do since corporate income tax returns are prepared post-year-end, for indirect tax purposes, the need for decisions may be more urgent. Any price adjustment decided and implemented for corporate tax purposes will need to be considered from an indirect tax perspective as well. Will price adjustments be sufficiently related to prior supplies of goods so that they can be considered a discount or additional payment related to that earlier supply? Or will the adjustment be considered a separate supply of services, and as such vatable, once there is no connection with a prior supply of goods? And importantly, can any VAT charged in a previous transaction that is adjusted be reclaimed?

For one, the timing and decision-making on this should be robust and supported with rationale, evidence, and all relevant other information, because once the corporate tax return is filed reflecting price adjustments, it is more likey than not, that a corporate tax audit will be initiated. The tax authorities in countries where associated enterprises used to have a risk-free profile and reported stable cost plus margin returns will likely question and challenge tax returns disclosing break-even results. After all the stimulus measures, tax authorities will need to bring in tax revenue, in whatever way or form, to allow their governments to continue governing. Also, VAT tax audit requests relating to transfer pricing adjustments, together with internal employee secondments or changed intercompany (distribution) agreements, are commonly observed and may be even more so, in light of Covid-19.

The now unavoidable Brexit presents similar concerns, in that any corporate restructuring of business between the U.K. and the EU mainland will trigger careful consideration of future pricing (and may trigger adjustments resulting from buy-out challenges). In addition, it will result in customs duties to apply between the U.K. and the EU Member States on goods imported/exported.

So what are the key rules and issues to consider related to adjustments? Below is a brief overview of the more relevant considerations.

Transfer Pricing Considerations

Example1: Brexit restructuring

If and to the extent certain activities performed in the U.K. are to be (partially) terminated post Brexit, and continued on the EU mainland in an EU Member State, for transfer pricing purposes, that may be considered a transfer of the business and related income stream from the U.K. to the EU Member State where those activities will now be performed and generate (taxable) revenue going forward. HM Revenue and Customs may very well require a buy-out for the U.K. entity having “given up” that income stream. To counter this, it may need to be substantiated that continuing the business from the U.K. post-Brexit would not have been viable, and therefore, the net present value of that supposedly forsaken future income stream is de minimis. If such argument cannot be successfully maintained and HMRC would assume a buy-out is due and makes a transfer pricing adjustment, there will be a(n arm’s-length) payment required (or imputed) from the entity in the EU Member State to the U.K.-based associated enterprise.

Also, an EU-based headquarters company may—going forward—wish to outsource some or all its non-EU business to a U.K.-based subsidiary for a myriad of reasons including reducing the cost resulting from application of EU-specific compliance and regulator rules. In that case, the EU-based company may be assumed to have sold (part of) its business intercompany and be required to report the receipt of a deemed buy-out payment. Ongoing services between the respective parties will need to be compensated at arm’s-length as well, and are highly likely to be scrutinized, in particular by the tax authorithy of the country where business activity ends up being reduced or terminated.

Example 2: Covid-19 restructuring

If and to the extent certain activities, like manufacturing, or services performed in the U.K. were halted due to Covid-19 lockdown rules or shutdowns due to health concerns, yet were taken over by a subsidiary in the EU that could step in and assume responsibilities (or vice versa), determining the arm’s-length remuneration for the services or manufactured goods will be a relevant consideration. If for cash management purposes another EU MS-based subsidiary handled payments (for example for obtaining inventory of goods) than the de facto buyer (of those goods) that in and of itself may be considered a service. It is not unlikely that these practical solutions to safeguard the business as a whole will be scrutinized for their transfer pricing consequences. If the tax authorities believe that adjustments are due, those will reflect assumed intercompany transactions to make sure the company operating in their respective jurisdictions operate at arm’s-length.

Adjustments along the lines of those presented in the examples above, will likely lead to double taxation. To obtain avoidance of double taxation as a result of these (primary) adjustments imposed by tax authorities, relief can be requested through mutual agreement procedures, which once resolved, generally result in a second (secondary) adjustment. As the surplus income reported in one country somehow needs to be “returned” to the other country, once the relevant competent authorities have agreed on what the appropriate income allocation between the countries should be, a “secondary adjustment” is required. The title of that secondary transaction may generally be a deemed dividend distribution between the respective entities, a deemed capital contribution, or on occasion, a deemed loan.

Indirect Tax Considerations

As regards the abovementioned transfer pricing adjustments, it should be considered that from an indirect tax perspective, the “correction” to the initial transaction (like a service fee or payment for goods purchased) may have indirect tax consequences. For example, can the original VAT—if overpaid—-be recovered? Since transfer pricing adjustments tend to take place years after the transactions take place, namely once the corporate tax return is audited, that will generally not be possible. To the extent the transfer pricing adjustment triggers a secondary adjustment, however, that adjustment will independently need to be considered from an indirect tax perspective. It may be that some of these adjustments will fall outside of the statute of limitations (i.e. the time limit for making an adjustment) from an indirect tax perspective, which will need to be considered on a country-by-country basis.

As regards Brexit, it can be observed that many businesses have been preparing for that for some time now, and therefore many will by now have processes in place to deal with the changes that are due to come into effect from Jan. 1, 2021. There will be border checks when goods enter the U.K. from the EU, and businesses need to be prepared to either import goods themselves, or engage a customs agent to do the importation for them. Some businesses have already altered supply chains in order to avoid the potential backlog at U.K. and EU border controls. If an income stream is deemed “transferred” from one business to another as a result of a change in supply chain, the VAT treatment of that transfer should be considered. This may very well be considered a transfer of trade and assets, in which case the Transfer of a Going Concern provisions could result in the supply being treated as outside the scope of VAT. However, alternatively this may be a taxable supply, or there may be no supply at all.

Covid-19 adds another level of challenges to businesses, however. To the extent that Brexit changes were already implemented, supply chains may abdruptly have had to be altered again so that goods are delivered from different locations, to different locations. The price of goods and services may have changed to meet the fall, or a rise in demand. Businesses may be operating from different countries, as we adapt to the “new normal” and the reality that some key personnel may be working from home for the foreseeable future. Unfortunately, all of this gives rise to VAT and indirect tax considerations.

To delve into some of these questions a bit further, with regards to pricing adjustments (both for transfer pricing and customer transactions), care will need to be taken to ensure that the business is classifying any price reduction correctly from an indirect tax perspective. Pricing adjustments can manifest themselves in different ways. There could be a direct discount against the price of goods or services in which case the business may need to reduce the value on which they have accounted for VAT and/or customs duty and subsequently identify how to process that VAT adjustment. There may be a barter arrangement, whereby a discount is given in return for something else. This will also need to be analysed to determine whether the barter transaction gives rise to a VAT charge, even if no money changes hands.

Furthermore, we are starting to see businesses failing to meet contractual targets in the tough economic environment, resulting in a breach of contract and liquidated damages. Often overlooked is that the contractual terms need to be analyzed carefully to determine whether these liquidated damage payments truly represent liquidated damages (which are often treated as outside the scope of VAT), or are in fact consideration for an underlying supply that is taxable. Furthermore, many contracts are being terminated, both at the consumer and the business level. This is a particularly topical issue at the moment (see Vodafone Portugal ECJ Case C-43/19). There will likely be quite some debate across tax authorities within the EU, as to when a termination charge should be subject to VAT, or can be treated as being outside the scope of VAT. These are just a few examples of pricing adjustments, but there will be many more forms that all may have different indirect tax aspects.

With regards to location of personnel, many authorities across the EU rushed to make statements that no fixed establishment for VAT purposes (or permanent establishments for corporate tax purposes, for that matter) would be created when key staff or directors have to work from home. While some of these “exemptions” are by their terms, temporary, others may not be. However, it is still entirely unclear what will happen when Covid-19 ends (if it will “end” at all). Supposedly the exemptions will terminate yet businesses may very well adopt a new way of (remote) working for the future.

The appeal of low office rents, and the extra time that employees get to spend with family by reducing their commuiting time may very well result in a permanent shift in working patterns, according to widely publicised observations. Combining that with Brexit, and the potential difficulty (and added cost) of moving people across the U.K. border, we are likely to see more businesses operating with a remote workforce.

It is entirely unclear how tax authorities will deal with this on an ongoing basis, but it is clear that raising tax revenue will be a key responsibility and requirement for those same authorities, action is required. While everyone certainly hopes that a “Post-Covid-19” period will commence sooner than later, businesses ought to start carrying out risk assessments to identify whether a fixed establishment for VAT purposes (and corporate tax purposes) might be created in another EU country where their key personnel operate.

As Brexit has collided with Covid-19, it has created a maelstrom of issues for businesses doing business in or with U.K. parties from an indirect tax perspective.

What to do now and what to do at year-end

Before year end
It is recommended to inventory intercompany contracts in place and the status of those agreements:

• What are the relevant clauses in intercompany agreements that impact transfer pricing and indirect tax treatment;
• Check if intercompany agreements also include force majeure/termination/breakage or renegotiation clauses, as those may come in helpful in managing and calculating buy-outs;
• What are the contractual options available, if any, to improve (extend) payment terms with contracting parties to improve cash flow? Those might impact profit margins temporarily as well; and
• Check if intercompany agreements stipulate:
  • the basis for the transfer price/remuneration between the related parties;
  • the risks assumed by the parties; and
  • if approval is required of related budgets (e.g. targeted sales, operating expenses and transactional net margin method (TNMM) results), and a comparison of required budget to actuals analysis (variance analysis) to justify transfer pricing adjustments, it should be considered what the allocation of the variance will be.

Consider if transfer pricing adjustments may be needed at year-end. Ideally the impact of changed economic circumstances should be assessed on a more frequent basis, rather than be a single adjustment at the end of the year, but some level of retroactive year-end adjustments may be necessary. Consider how this is aligned with intercompany contracts and any indirect tax impact.

After year end
It is highly recommended to update transfer pricing documentation relating to 2020 (and possibly onwards) to account for the impact of Covid-19. It may in some circumstances be advisable to maintain an overview of the government Covid-19 instructions issued in the relevant jurisdictions where the MNE conducts business for transfer pricing documentation purposes for evidence purposes if need be and for purpose of presenting how other companies deal(t) with the crisis.

If and when it appears that the Covid-19 and IT-related aspects/remote working environment have de facto led to a business restructuring the overall transfer pricing impact of changes to/new operating and governance models may need to be analyzed.

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

Author Information

Monique van Herksen is a partner in the Amsterdam office of Simmons & Simmons LLP and Jo Crookshank is a partner in the London office. The authors work in the Financial Markets practice group of Simmons & Simmons LLP. Any errors or omissions are those of the authors, and this article is written in their personal capacity. They can be reached at monique.vanherksen@simmons-simmons.com and Jo.Crookshank@simmons-simmons.com.