INSIGHT: Transfer Pricing in the Covid-19 Crisis—an Exceptional Situation

The current unprecedented economic crisis has already had an important impact on market conditions and must be taken into account in the transfer pricing policies of multinational enterprises (MNEs) to reflect an arm’s-length situation for fiscal year 2020.

In this respect, and considering the fact that economic analyses are by nature carried out on the basis of historical data (which will be pre-crisis in the case at hand), it is interesting to analyze how the exceptional economic circumstances currently faced by market players could be integrated in transfer pricing studies to properly remunerate routine companies—and more particularly routine distributors—for their fiscal year ending in December 2020.

It is fairly common practice among MNEs to organize transfer pricing operations around a principal operating company (also called “main entrepreneur”) and routine entities. More specifically, the main entrepreneur is the company that assumes the main risks (whether or not they materialize), makes the strategic decisions, performs complex functions and, in general, owns the key intangible assets (trademarks, patents, know-how, etc.) and bears the related expenses (i.e. research and development, trademark management and marketing).

Conversely, routine entities perform limited functions, bear non-significant risks and hold non-strategic assets. As such, the main entrepreneur receives the residual profit, i.e. the profit (or loss) remaining after all the routine entities have been appropriately remunerated.

In order to determine the remuneration to be attributed to the routine entities, and in application of the transactional net margin method, MNEs conduct searches for independent comparable companies (comparables) on public databases (also called “benchmarking studies”) and compute an appropriate profit level indicator for each of the identified comparables to determine an arm’s-length range of margins in which the margin of the routine entities must fall.

These benchmarking studies necessarily rely on the use of historical financial data since there is a lag in time between the closing date of the comparables’ financial statements and their availability in public databases. As an example, the latest financial data of comparables that will be available to determine the remuneration of a routine entity for its fiscal year ending December 2020 will usually be those covering their fiscal year ended December 2019.

In a stable economic environment, the use of the historical financial data of the comparables is considered as relevant and usually allows reliable approximation of the remuneration to grant to routine entities.

However, considering the current economic crisis caused by Covid-19, the remuneration of routine entities, when tested at year-end as regards their 2020 performance, may be relying on comparables’ (pre-crisis) results that do not reflect the exceptional economic circumstances currently faced by the market players.

This situation could lead to granting non-relevant (and most likely excessive) profits to routine entities, while, at the same time, main entrepreneurs will, through the application of the transfer pricing method, suffer from the amplified effects of the crisis.

Consequently, in an unstable economic period, approximating the remuneration to grant to routine entities using pre-crisis financial data of the comparable companies may deviate from the arm’s-length standard, since the economic circumstances of the markets in which the parties operate are key to conduct reliable comparability analyses.

The question raised in these circumstances is how to determine the remuneration to attribute to routine entities for their fiscal year ending December 2020 while taking into account the impact of the economic crisis related to the Coronavirus.

This article will focus on the remuneration to grant to routine entities acting as distributors and which use the operating margin as an appropriate profit level indicator.

Exceptional Circumstances Require Exceptional Adjustments

Considering the exceptional economic circumstances observed on the market, comparability adjustments that mitigate the timing issue described above are made possible by the Organization for Economic Co-operation and Development (OECD), which states that comparability adjustments should be considered to increase the reliability of the results of a comparability analysis (OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations, July 2017, Section 3.50 (the OECD Transfer Pricing Guidelines)).

As such, comparability adjustments applied directly to the 2019 financial data of the comparable companies, with the objective of simulating the impact of the economic crisis on their accounts, might be considered. The adjusted operating margins obtained for each comparable company would then be regarded as appropriate and would allow for a reliable comparison to determine the remuneration to be granted to a routine entity acting as a distributor (also referred to as the “tested party”) for its fiscal year ending in December 2020.

A Possible Four-Step Approach

To do so, a four-step approach could be used. First, the decrease in turnover (if any) observed at the level of the tested party between its fiscal year ended in December 2019 and its fiscal year ending in December 2020 could be applied to the 2019 turnover of the comparables (Step 1).

As next steps, the impact of this sales decrease must be simulated on the operating costs for each comparable company; this is where complexity comes into play. Indeed, a distinction needs to be made between variable costs (i.e. primarily purchases of goods) and fixed costs (i.e. in particular rents and wages/social security charges) since these two categories of costs evolve differently in relation to sales volume. Specifically, while variable costs vary almost proportionally to the sales, fixed costs may well only be moderately affected by variations in turnover, at least in the short run.

Regarding variable costs, an analysis of the historical gross margin of each comparable company could potentially be considered as a reliable indicator to anticipate the decrease of the purchase of goods in correlation with the previously simulated decrease in turnover (Step 2). Regarding fixed costs, a regression analysis of historical operating costs below the gross margin in relation to sales for each comparable company may provide a relevant approximation of the evolution of fixed costs in relation to the previously simulated decline in turnover (Step 3).

Such adjustments performed would therefore allow to emulate the impact of the current crisis on the adjusted operating profit of each comparable company (Step 4) and would lead to the definition of an arm’s-length range of adjusted operating margins applicable to determine the remuneration to be allocated to the tested party for its fiscal year ending in December 2020.

Case-by-Case Analysis Required

In any case, such exceptional comparability adjustment, which is considered as a crisis adjustment, is only one of various possible approaches, and must result from a thorough study of the tested party’s situation and its economic environment. Specifically, a case-by-case analysis is necessary to determine what types of adjustments should be made in order to obtain the best possible understanding of the market conditions observed between third parties and to determine as reliably as possible the remuneration to be granted to the routine entity.

Furthermore, due to the significant decrease in sales volume in certain industries, while substantial fixed costs would be maintained on a short-term basis, it is expected that the ranges of adjusted operating margins obtained by applying the approach described above might lead to observing loss-making positions at the level of the comparables.

Whatever the case may be, one should use extra caution in determining the relevance of situations where routine entities would be facing a loss-making position while assuming only simple functions and/or bearing only limited risks. Specific care should be taken in determining whether such a situation would be considered, from a conceptual point of view, as conflicting with the application of the concept of “main entrepreneur,” pursuant to which it might be expected that the consequences of major economic risks crystallizing in the market would have to be borne by the main entrepreneur, in a crisis period as well as in more regular times.

As regards this specific issue, it would be key to determine whether the exceptional economic circumstances caused by Covid-19 allow, on a case-by-case basis, developing a convincing economic justification and provide arguments to demonstrate that the losses incurred by the tested party at a local level reflect an arm’s-length situation.

As an example, in cases where it could be shown that gross margins of comparable independent parties were not impacted, it could be argued that, at an equivalent gross margin level between 2019 and 2020, the losses generated by the tested entity are not the consequence of a change in the transfer pricing policy but result from risks inherent in a distribution activity (such as the volume risk, the price risk and the bad debt risk) which naturally materialize in a period of crisis and which consequences are attributable to the tested party.

Similarly, in a period of severe recession, it could be accepted that third parties agree to share losses to avoid a bankruptcy situation, i.e. short-term losses are in some cases necessary to preserve profits in the long term. In this respect, the OECD Transfer Pricing Guidelines (Sections 3.75 to 3.79) provide for interesting guidance as regards transfer pricing analysis over multiple years, in situations where a long-term view would prevail, between independent parties in comparable circumstances, over a strictly short-term one.

As regards the above, the OECD Transfer Pricing Guidelines (Section 1.129) also accept that associated enterprises, like independent enterprises, can sustain genuine losses due to unfavorable economic conditions. In any case, if the application of a particular transfer pricing policy in 2020 leads to allocation of losses to routine entities—which, as discussed above, should be considered with extreme caution—then this situation would also need to be assessed over time to determine whether or not, notwithstanding these genuine losses, the routine entity would be able to generate a positive overall profit over a multi-year period (i.e. if it can reasonably expect to offset these losses with sufficient past or future profits, while at the same time generating an overall multi-year result in line with the arm’s-length principle).

At the end of the day, irrespective of the comparability adjustments made on the basis of historical financial data, a corroborative analysis should ideally be conducted ex-post (i.e. at the end of 2021) when comparable financial data for 2020 will be available, in order to confirm the relevance of the adjusted results obtained a priori, and to support the reliability of the adjustments performed.

Planning Points

Even though the Covid-19 crisis is public knowledge faced by all economic players, MNEs will have to thoroughly justify any reduction of remuneration for their routine entities. Particular attention will have to be paid to transfer pricing documentation, which should contain detailed explanations of performed adjustments, the reasons for the adjustments being considered appropriate, how they were calculated, how they changed the results for each comparable, and how the adjustment improves comparability.

In this respect, and considering that the financial data of comparable companies for 2019 will be available in public databases as of September/October 2020, MNEs should hopefully have the time to analyze, in advance of their 2020 closing, the situation of their affiliates on a case-by-case basis with the objective of making reliable comparability adjustments that are necessary to reflect the market conditions associated with the crisis.

In addition, even though the current exceptional economic circumstances require exceptional adjustments, it is to be hoped that the Covid-19 crisis will only last for a few months. Hence, in the event of a recovery in economic activity and a return to a “normal” situation in 2021, for instance, MNEs that have made crisis adjustments similar to those described above will have to maintain intellectual rigor and perform similar adjustments in the opposite way for their 2021 results (i.e. when basing an analysis on 2020 market data, due to the aforementioned time lag, simulate an increase of the sales of the comparables or use historical data that reflect a “normal” economic situation).

Finally, this economic crisis could be an opportunity for MNEs to review their inter-company agreements in order to ensure that the determination of the arm’s-length remuneration of routine entities can—as far as possible—be adapted to the occurrence of exceptional events.

Arnaud Le Boulanger is Attorney-at-law, Partner, and Chief Economist, Alexis Bernard is Attorney-at-law and Clément Herr is Attorney-at-law with CMS Francis Lefebvre Avocats.

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