Covid-19 has had significant and lasting impacts: the pandemic disrupted, restructured, and digitalized global supply chains and decentralized work-from-anywhere staffing models. These shifts have reshaped business models, supply chain footprints and the intercompany transactions between group companies, creating transfer pricing risk where remuneration no longer matches the functional profiles, substance, or value creation in group companies.
In addition, there is greater complexity and increased risk of disputes, against the backdrop of ongoing global tax reforms and increased transparency through global reporting.
As we now look beyond Covid-19, what are the transfer pricing risks and what should taxpayers do to manage these risks?
This article will consider three factors that have impacted transfer pricing post Covid-19:
- Global supply chain disruption and restructuring (including the pivot to digital commerce) to change group entity functional profiles and remuneration.
- The shift to the work-from-anywhere model which led to decentralized value creation and profit attribution, as well as substance issues.
- Increased transparency through global reporting, resulting in an increased risk of disputes and a possible voluntary compliance response.
This article reviews the transfer pricing risks and the steps that taxpayers can take to manage them.
Supply Chain Disruption and Restructuring
Covid-19 has seen global supply chains disrupted, prompting a review of supply chains to adapt by restructuring or relocating operations to deliver a more flexible and resilient supply capability. Tangible changes that are here to stay include diversifying suppliers and supply base and increasing inventory holdings, typically closer to customers and operations—even where the costs of doing so are higher.
As supply chain business models and footprints evolve, so do intercompany transactions between group supply chain companies, requiring an adaptation of the transfer pricing approach. For post-Covid supply chains, it is important to understand whether group companies’ functional and risk profiles have changed. For example, for limited risk distributors which were previously risk-insulated pre-Covid and now assume greater business and transfer pricing risks, has their remuneration increased with the increased risk?
Another outcome of Covid-19 is the establishment of smaller regional hubs for certain activities and functional management such as logistics, to manage important supply decisions centrally. Such hubs, established through circumstance, may persist beyond Covid-19. Further, where no central function currently exists, the change may prompt groups to seek opportunities to capture the value of adjusted priorities in centralizing strategic purchasing functions.
It therefore becomes important post Covid to assess entire value chains, including existing and new principal (hub) structures, to determine in which entities activities are undertaken and key business decisions are made. With these insights, groups can better determine where value chain adjustments are required to realize additional value.
As a result, a redefinition of transfer pricing policies and remuneration schemes is required to compensate all group entities on an arm’s-length basis for risks borne. Post Covid, the profit split method may be a more appropriate response to compensate distributed group functions, whereas other methods are currently preferred.
Increased digitalization in the supply chain—including the use of new virtual technologies such as artificial intelligence and 3-D printing—is another outcome of Covid-19. The use of new technologies requires an assessment of which companies undertake the important DEMPE—development, enhancement, maintenance, protection and exploitation—functions (as covered under the OECD TP Guidelines 2022, Ch. 6 and specifically 6.34 on intangible transactions that leads to value creation), to ensure these companies are appropriately compensated for the value they create. In addition, where procurement or other key functions use online platforms, it is important to review and align remuneration with the overall supply chain.
With an eye to the future, the Organisation for Economic Cooperation & Development (OECD) Pillar One reallocation to markets may result in groups creating permanent establishments where they have a market (but no physical) presence to determine profits using traditional transfer pricing methods versus residual income allocation. In addition, the Pillar Two global minimum taxes and substance rules may reduce the benefits of extended supply chains based on low costs and high volumes, supporting regional supply chain models.
Environmental, social, and governance considerations and carbon footprint are likely to impact planning and increase supply chain costs over time.
To manage evolving supply chains effectively, groups need to review and monitor the changes and adjust their supply chains for resilience. As business models change, to capture value opportunities and manage unplanned tax consequences, transfer pricing needs to be part of the decision-making regarding holistic business planning for cash mobility, economic substance, operating cost management, and alignment of tax with business outcomes.
A robust transfer pricing policy that fits the company’s changing business model and priorities is necessary to minimize risks of transfer pricing adjustments post Covid and withstand public scrutiny. This also requires coordinated inputs from stakeholders across the business to develop and agree on the transfer pricing road map.
Working From Anywhere
As supply chains have evolved, so has the workplace, with the trend of working from anywhere becoming a new norm. Although initially a requirement to manage the spread of Covid-19, working from anywhere with technology adapted for remote collaboration has resulted in companies learning to work effectively irrespective of where staff are based.
There are both near-term and long-term consequences of this trend. In the near term, this model is complex and raises several tax and transfer pricing risks, which need to be managed.
The recent global tax reforms have more closely aligned income recognition to physical presence. Tax risks arise where staff movement due to Covid-19 results in group companies either no longer having sufficient substance to warrant income recognition, or creating a permanent establishment where staff are located—potentially impacting income attribution and obligation to pay tax in a number of countries. There are also personal and social tax obligations that may apply in the jurisdictions where staff are based.
What Are the Transfer Pricing Risks?
The transfer pricing risks broadly lie in any changes to the substance of pre-Covid intercompany arrangements, as evidenced by where the staff who make the risk-bearing decisions regarding those arrangements are based.
The OECD guides us that the senior group staff are responsible for decision-making and control of risks in key functions in companies that drive profits and create value. Profits follow the control of risk; therefore, if the senior staff who control key risks are based in multiple countries post Covid, a portion of the associated profits created potentially should be recognized in the countries in which these key staff are based. Is the profit split method, then, the best method to recognize the value creation and is there likely to be an increase in the claims on profits by multiple jurisdictions on this basis?
The increased provision of digital services by companies to their customers was one outcome of Covid-19. Where the service provider companies use a work-from-anywhere staffing model, a potential transfer pricing risk arises where intellectual property (IP) is created on a decentralized basis. Which jurisdiction (or jurisdictions) beneficially own the income associated with using the IP created? A DEMPE analysis will be required to determine what share of profits is attributable to each group company with staff involved in the IP development, based on their contribution.
Another consequence of the work-from-anywhere staffing model is the potential pressure on principal or central structures where key decision-making staff or executives cannot attend meetings or take decisions in the locations they were expected to. Does this outcome impact where profits are attributed?
What Is the Long-Term View?
It is widely thought that the pandemic has accelerated the implementation of the workforce of the future, as companies have responded to the technology and security challenges created by Covid-19—and staff have learned new capabilities. But will this trend stick?
As noted by Paul Volodarsky—DFDL’s senior legal adviser for corporate and real estate—there has been a shift, with a permanent downsizing of office occupation in locations such as Singapore (the traditional hubs) and a flex to increased use of hot-desking and meeting spaces for both internal and client meetings, for staff who will continue to work from home. However, this trend may not be as extensively adopted in Asia companies, as primary manufacturing or outsourcing businesses typically require on-site work, or staff prefer to work in the office rather than their high-density housing for productivity, post Covid.
While locations such as Singapore and Hong Kong continue to play an important role in the Asia regional operations of multinational companies, a central hub providing all executive, entrepreneurial, and operational control may not match the post-Covid reality. Instead, with more dispersed working conditions post Covid, companies will likely opt for a multi-hub structure in the region, with the hubs established where staff are located, and previously centralized regional functions are now decentralized.
Under this scenario, it is likely that the profit-sharing method will increasingly apply where control of important risks or value creation activities occur across multiple locations, or there are multiple principals in the region, each receiving a return for their activities.
The work-from-anywhere trend is already a reality, and with the trend set to continue (with some moderation for Asia companies), the multiple principal regional model and application of the profit split method future is more a case of when, not if. Importantly, this future requires careful planning to navigate and manage the tax and transfer pricing impacts and ensure valuable intangibles are not inadvertently transferred among jurisdictions.
Tax Transparency and Voluntary Disclosure/Compliance
So, where does this leave us?
Against the background of changing global tax rules, the restructured supply chains and changed workforce footprint outcomes from Covid will likely result in increased transfer pricing risks for companies. Further, when coupled with increased transparency and cross-border cooperation by tax authorities, companies face an increased likelihood of multilateral audits as governments seek to raise income after the pandemic.
The level of transparency for companies is increasing significantly—with country-by-country reporting and transfer pricing master and local files prepared by more taxpayers, and the requirement for related party transaction disclosures in various countries.
Further, the automatic exchange of taxpayer information provides tax authorities with ways to supplement the more subjective scrutiny of tax auditors. Such audits may arise from the scrutiny of documentation and more rigorous investigation of multilateral issues or entire value chains, including IP-related issues, permanent establishment, and management services transactions. Additionally, the Pillar One requirement for global annual reporting and the Pillar Two requirement for data beyond tax (including financial accounting, tangible assets, payroll and employees) provide additional information to tax authorities.
With an increasing level of detail in audits and automatic assessments, the burden of proof is on companies to demonstrate the compliance of their transfer pricing position. However, as companies under audit prepare their defense strategies, it is likely that due to the increased transparency (through reporting and sharing of global data) tax auditors already have significant information beyond the audit jurisdiction.
Therefore, companies should consider voluntary compliance as a practical response to avoid an increased number of audits, and for tax certainty.
There is already a model for such a process. The OECD ICAP provides a voluntary sit-down program to facilitate open and cooperative multilateral engagements between multinational groups to engage actively and transparently with tax administrations in jurisdictions where they have activities. The ICAP program—with Australia, Japan and Singapore tax administrations participating—should reduce the resource burden and mean fewer disputes requiring resolution through mutual agreement proceedings.
Covid-19 has had significant and lasting impacts—restructured and digitalized global supply chains, and decentralized work-from-anywhere staffing models. Business models, supply chain structures and intercompany transactions have changed, requiring transfer pricing approaches also to adapt.
What can companies do now to manage transfer pricing risk?
- Assess their value chains to determine where activities are undertaken and the key business decisions are made, and adjust transfer pricing policies and compensation.
- For digitalization and technology implementation and IP development activities, assess where the value creation (DEMPE) functions are undertaken to determine the appropriate compensation.
- As business models change to capture value opportunities and manage unplanned tax consequences, ensure transfer pricing is part of the decision-making process.
- Develop a robust transfer pricing policy (with stakeholder inputs) that fits the company’s changing business model and priorities.
- Consider voluntary compliance as a practical response to avoid increased audits and provide tax certainty.
This article does not necessarily reflect the opinion of The Bureau of National Affairs, Inc., the publisher of Bloomberg Law and Bloomberg Tax, or its owners.
Christine Schwarzl is Director, Regional Transfer Pricing, with DFDL.
The author may be contacted at: firstname.lastname@example.org