As the novel coronavirus shutters restaurants, grounds planes, and closes offices worldwide, businesses face unprecedented losses that will require them to rework their intercompany tax planning.
For the vast majority of multinational companies, the economic disruptions from Covid-19 will turn the booking of profits and losses among related parties upside down—forcing many to redo their documentation and raising the risk that tax authorities will challenge the new allocations.
“It’s not going to discriminate, just like the virus, against who it impacts,” said Margaret Critzer, a senior adviser at Alvarez & Marsal Taxand LLC in San Francisco. “I think it’s going to impact almost every company out there.”
Multinationals follow transfer pricing rules that require them to value assets they buy and sell between their related parties in the same way unrelated parties would—acting at arm’s length, based on examples of comparable transactions. Companies allocate the majority of profits to the entity that takes on risks, performs critical functions, makes investments, or develops or holds intellectual property.
But with economies around the world grinding to a halt, companies may see their related parties booking losses instead. The question arises whether those losses should go to the headquarters company or be spread across the multinational group, which could raise the chances of disputes with tax authorities, practitioners said.
“2020 will be different because at the end of the day, we all know there will be just losses,” said Friedemann Thomma, chair of the international tax practice at Venable LLP in San Francisco. “It’s no longer an income allocation, it’s a loss allocation.”
Companies might struggle to convince tax agencies that those losses are allocated at arm’s length, when they had previously based their transfer pricing models on allocating profits, said John P. Warner, a shareholder at Buchanan Ingersoll & Rooney PC in Washington.
Multinationals with limited risk distributors—related parties in other countries that merely make sales—might be particularly likely to face difficult questions about loss allocation, said Marc Alms, managing director at Alvarez & Marsal Taxand LLC in New York.
Limited risk distributors are usually given a small, set return because they don’t assume financial risk for the success of the product or service they’re selling.
“But now you have this extraordinary, once-in-a-century situation where those risks do eventuate,” Warner said.
An intercompany contract might push some losses onto the distributor. Companies must be prepared to show tax authorities why they’re booking losses in that jurisdiction, he said.
As companies revise their transfer pricing documentation to account for their unexpected losses, they may also have a hard time finding good examples of real-world unrelated-party transactions to refer to.
Transfer pricing calls for companies to look to comparables—examples of how unrelated parties would value a similar transaction—to ensure their related-party transactions are actually at arm’s length.
Comparables are always a “lagging indicator,” based on the previous year’s data, said Sean Foley, a principal in transfer pricing services at KPMG LLP in California. That could make it challenging to find appropriate comparables for 2020.
“The comparables are often not sitting in the same space as the company in this awful shock,” he said.
‘Can’t Just Sit Back’
It’s likely too soon for tax administrations to offer guidance about how companies should treat coronavirus-related losses when they file their 2020 returns, as governments first turn their attention to immediate issues, several practitioners said.
But in the meantime, companies that book losses now in countries where they previously had profits should take steps to reduce the risk of tax authorities challenging their transfer pricing in a few years, they said.
Companies should also be working on new forecasts of their financials, so they can show contemporaneous documentation of changes if they are audited, Critzer said.
For example, if a company has a distributor entity that makes no sales, the company should adjust an intercompany agreement that assumes the entity earns revenue, she said.
“The more information you can gather and maintain with your transfer pricing that is contemporaneous, the easier it’ll be to justify any changes you’ve made during this current time,” Critzer said. A company that usually reviews and adjusts the levels at which it remunerates its entities every six months could consider doing do so every month now, she said.
“You can’t just sit back and see where the chips fall,” Critzer said.
Dramatic changes to a company’s transfer pricing could also invalidate any advance pricing agreements—contracts companies sign with governments to pre-approve their transfer pricing arrangements over a set period of time.
In that case, companies may be able to invoke clauses in the agreements that say the contracts only apply if “critical business assumptions” are met—and the extraordinary circumstances of a pandemic might not, Warner said.
It’s possible that tax authorities could give some relief to companies that would otherwise be penalized for breaking the terms of the pre-existing agreement, or be willing to discuss companies’ circumstances, he said.