Bloomberg Tax
Dec. 23, 2020, 8:01 AM

Tax Scrutiny and Transfer Pricing: What You Can Expect in 2021

Mimi Song
Mimi Song
CrossBorder Solutions

Tax scrutiny is hardly new to the world of transfer pricing. In the last few years, tax authorities have taken a fine-tooth-comb approach to multinational enterprises’ (MNEs) transfer pricing documentation, routinely questioning the finer points of where and how profits land among entities. Although by now, multinational companies have grown accustomed to conducting intercompany transactions under hawkish revenue officers, most haven’t experienced the kind of aggressive tax surveillance that is expected in 2021.

Between government-appointed shutdowns, supply-chain disruptions, and falling demand in products and services, Covid-19 has shocked global value chains as violently as it has countries and their infrastructures. Unemployment has increased. MNEs have postponed investments plans. Liquidity issues have buried companies in debt and losses. And tax authorities haven’t fared much better. Government relief programs—guarantees, tax holidays, subsidies, and 2020 audit respites—are costly, and tax authorities will need to recover revenue lost to Covid-19 support, as well as from decreased taxable income. The OECD’s Tax Policy Reform 2020 discusses the importance of tax policy to “restore public finances in a fair and sustainable way after the crisis.” Transfer pricing, a somewhat subjective vehicle for allocating group profits and losses, is an obvious place to do it.

Most of us have never experienced a global pandemic, but we have certainly lived through depressed economic times—and for transfer pricing experts, there’s much to learn from them. In 2009, the IMF noted the effects of 2008’s Great Recession—a tax gap created by bankruptcies and loss-ridden companies, which, thanks to understaffed tax departments and limited resources, led to non-compliance. Fast-forward to 2021 and tax authorities will be expecting a replay of weakened efforts by MNEs to comply with transfer pricing regulations, positioning tax authorities on the offensive even more.

Well before the pandemic and the need to recover Covid-relief revenue, tax authorities had been vocal about stepping up transfer pricing audit resources and homing in on cross-border transactions. Covid-19, however, has intensified those efforts. Many countries that had put transfer pricing audits on hold as a form of economic support, have already resumed them—even with the pandemic still going strong. The National Tax Agency of Japan, for example, has strengthened its transfer pricing audit program, taking a risk-based approach and bundling transfer pricing examinations as part of corporate income tax audits, making more taxpayers susceptible to transfer pricing microscopes. Not surprising, the country has already ended its audit hiatus.

The U.K.’s HM Revenue & Customs (HMRC) had also suspended transfer pricing investigations due to the coronavirus. But in September, HMRC relaunched them by sending letters asking certain multinational companies how confident they were that their transfer pricing was “appropriate.” The Financial Times recently reported HMRC also announced that 2,000 of the largest businesses in the U.K. may owe an additional $42.3 billion (34.8 billion euros) in tax, claiming that local profits don’t accurately represent the value created in the U.K.

While tax authorities around the globe may be on the transfer pricing hunt, they’re still aware that losses may be justified due to 2020’s extraordinary circumstances. After all, Covid-19 has been as much an economic virus as it has been a respiratory one. The question is where should those losses fall? Revenue officers will argue that lost tax dollars should remain outside their jurisdictions, leaving MNEs on the defensive and prone to exorbitant transfer pricing adjustments, and double taxation. Now more than ever, it’s important for multinational companies to be proactive about transfer pricing, and diligent documentation is key—especially given tax authorities’ expectations of non-compliance. MNEs may find they need to go beyond traditional approaches to economic analyses in defense of their arm’s-length positions. The following strategies, geared specifically for 2020 documentation, promise to help reduce the risk of audit in extraordinary times.

Pay Extra Attention to Benchmarking

It’s no secret that the Coronavirus continues to affect industries and individual companies differently. The problem that presents for transfer pricing is that every transaction is based on the arm’s-length standard, which is determined by comparing intercompany transactions to third parties. If those third parties haven’t been affected in the same way as the tested party, there goes the arm’s-length range. Redoing a comparable search may not solve the problem (though it’s still worth trying), thanks to the lag time between a fiscal year and when an MNE’s information is available on public databases. In fact, if conducting a traditional benchmarking analysis, MNEs may find themselves with an overall shortage of comparable companies, and therefore, a vulnerable arm’s-length range.

Tax authorities, of course, are on to this, and they’ll be taking a hard look at 2020 benchmarking analyses, lending a close eye to misaligned comparables. So, transfer pricing experts will want to explore every avenue to prove that comparable companies are, in fact, still comparable. Here are a few strategies to consider:

Embrace the past

Covid-19 has created such extraordinary circumstances that comparables from 2017-2019, which were not affected by the virus, might not be relevant. Consider including comparable transactions from past years that also endured economic hardship. Data from times of economic downturns or recessions may present stronger comparability to the tested party. Of course, you’ll have to explain the market changes that took place between now and then, and why, given 2020’s extraordinary circumstances, it was necessary to turn back the clock.

Include companies in loss positions in your comparable set

Granted, normally, tax authorities aren’t fond of including start-up companies or those in the red as part of a comparable set. But then, there’s nothing normal about 2020. Fair market prices should reflect actual market conditions, and companies in a loss position may demonstrate 2020’s reality best. So, think outside the box. Can you play with the maximum number of years that a company can show losses? What about the size of the losses themselves? Have you justified loss inclusions in the application of the economic analysis? The goal is to represent actual market conditions to uphold the reliability of your comparable companies, and you may require a little flexibility to do it.

Look to comparables in similar markets

Yes, some countries—most of them, in fact—mandate local comparables, which can be tricky in the best of times as they may or may not exist. Now, however local comparables become even more complicated because Covid-19 has uniquely impacted each country. For example, local market conditions may be impacted by government support. While the benchmarking should continue to focus on local comparables—expanding beyond the country may be necessary to corroborate differing economic impacts on a transfer pricing analysis. But be sure to explain how and why foreign comparables provide a corroborating analysis that might better align with the conditions of the tested party’s market.

Define Covid-19 Costs for Your Business

In the last year, multinational companies have been forced to buy masks, gloves, plexiglass dividers, and hand sanitizers, among other products, just to keep their businesses going. Some have retrofitted office or factory space, and many have paid for routine deep-cleaning services and maybe even air-filtration systems. And while no one questions why these supplies are suddenly necessary, accountants may wonder, ‘where will they be listed on corporate P&Ls?’ Some companies characterize such expenses as one-time costs, claiming they’ll disappear once a vaccine arrives—but in the meantime, the characterization is inflating non-GAAP earnings. Now three quarters into the pandemic and many experts think Covid-19-related costs belong under the usual costs of doing business and so, will have no effect on non-GAAP earnings. After all, who knows how long such expenses will be necessary? Either way, the judgment call has implications for transfer pricing.

Along with costs, expenses will need consideration, as well. Tax policy changes, as a result of government stimulus packages, such as the CARES Act Paycheck Protection Program, have transfer pricing implications of their own. For example, the IRS has indicated that payment of expenses covered by a forgiven PPP loan will no longer be deductible, which begs the question, should these expenses be captured as reimbursable intercompany charges if they are not deducted locally? In terms of transfer pricing, the treatment of costs and expenses could be challenged since they impact profit-level indicators, as inconsistencies will lead to unreliable results. Complicating things more is the treatment of costs and expenses by comparable third parties, creating vulnerabilities with the benchmarks. Be sure to see where Covid-19 costs are booked by independent third parties to determine true comparable companies and make sure to align your accounting or apply adjustments accordingly, so the reliability of benchmarks cannot be challenged.

Revisit Transfer Pricing Policies

For many MNEs, the pandemic has affected financials, business models, and supply chains, and every group will need to take stock of how the business has changed and make sure it’s reflected in the transfer pricing policy. The goal is to be sure the policy reflects the company’s present or future economic reality—not the past. Functions and risks may have found new homes in the supply chain. Royalty or interest payments may be on hiatus, and financial relationships may have changed. All of this should be reflected in the transfer pricing policy, so that transfer pricing outcomes demonstrate where value is created in the supply chain today. Transfer pricing policies could also uncover hidden opportunities. For example, how much risk can limited-risk entities take on? Can those entities share in pandemic-related losses? Is the company bound to a fixed rate of return? Where is the flexibility in your MNE group?

Are Advanced Pricing Agreements Still Advantageous?

Advanced pricing agreements (APAs) are contracts between tax authorities and taxpayers that stipulate in advance the transfer pricing criteria that a taxpayer should apply to avoid adjustments, penalties, and disputes with tax authorities. Taxpayers often rely on these agreements as a form of tax certainty. But in the year of Covid-19, there is no such thing. In fact, these contracts, intended to offer relief, are instead causing problems of their own. Given the pandemic, it’s impossible for an advanced pricing agreement to both offer long-term protections and accommodate short-term economic disruptions. For example, these agreements are usually drawn up on the basis that a taxpayer’s functions, assets, and risks will remain much as they were described in the contract. However, the pandemic has caused many taxpayers to shift these functions, assets, and risks, which could present a breach of a critical assumption. A taxpayer may consider reaching out to the IRS or foreign tax authorities to revise APAs, so they include a way to adjust static pricing and responsibilities to reflect the pandemic-induced realities of the business, but of course, the process could be arduous and painstakingly time consuming.

Financial Transactions

No doubt intragroup financing—loans, cost-sharing, treasury functions, guarantees—has proven a helpful tool during the pandemic, offering quick cash-flow relief. Unfortunately, it seems that liquidity alleviation comes with increased compliance burdens. Tax authorities are stepping up efforts to scrutinize financial transactions due to country-specific legislation, the OECD’s new guidance, and the many questions that financial transactions, during Covid-19, raise. Strategies? To start, document financial transactions contemporaneously. As with any intercompany transaction—in good or bad times—documenting contemporaneously is helpful in keeping track of current market circumstances. In terms of Covid-19 transfer pricing, contemporaneous documentation will be instrumental in demonstrating a nexus between balance sheet items and the pandemic’s impact on the company’s financials and its overall tax position.

Usually, intercompany loans are a relatively straightforward analysis as arm’s-length interest rates are stable and readily determined. Enter Covid-19, however, and fair-market interest rates are harder to ascertain. Businesses have been impacted in disproportionate ways—some even for the better—and so has perceived credit worthiness, as a result. Complicating the situation further is the fact that changes in the business environment may be fleeting should vaccines send the world back into “normalcy.” Combine fluctuating credit risk with volatile interest rates and arm’s-length interest rates are suddenly a very gray area. Is it an interest rate that goes to a risky borrower? Or an investment-grade rate based on the assumption that issues are temporary? And how reliable are third-party comparables in terms of strengthening an arm’s-length position, given their own states of ambiguous solvency?

Robust documentation explaining the decisions forced by the Covid-19 pandemic will be imperative. The new OECD guidelines on financial transactions recommend an “accurate delineation analysis” to determine the amount of debt to be priced for tax purposes. Credit ratings, currencies, maturity, payment rank and terms must be considered to determine the transfer price. How is financing characterized—is there a risk that loans could be characterized as equity? Are arrangements logical from both the borrower’s and the lender’s point of view?

In economic downturns, companies may have trouble repaying intercompany loans, so it may be worth renegotiating the terms. Postponing debt repayment or interest payments could be the answer but be sure to find third-party comparables that demonstrate that the practice reflects the current market. Also, document changes in the terms of the loans and the options that were available.

Contemporaneous Documentation

For many countries, contemporaneous documentation is not only recommended, but also required. Even in countries where it isn’t part of the regulations, it’s a worthwhile practice as tax authorities aren’t exactly generous in terms of turnaround times once documentation is requested. Just having the documentation prepared by the time the corporate income tax is due may offer penalty avoidance and may count towards certain pandemic-relief measures from governments. But even without those rewards, contemporaneous documentation puts you in a better risk position as documenting the facts in real time adequately represents true market conditions.

Revisit Intercompany Agreements

Covid-19 has disrupted supply chains, displaced workers, and decreased economic demand. Any of those circumstances could be responsible for an entity underperforming, not performing, or being unable to pay for materials or services it’s receiving—in other words, failing to fulfill its contractual obligations. Many businesses that can employ a force majeure clause—a legal exit strategy due to unforeseen circumstances—will. However, intercompany agreements don’t always include them, the thinking being that related parties won’t need the same protections as independent companies. So, renegotiating contracts may be the best option.

The trouble with renegotiating intercompany contracts is that the amendments often benefit one side of the relationship at the expense of the other. Still, related parties may be willing to negotiate to preserve the relationship or because the particular business needs could be difficult to fulfill elsewhere. In any case, an MNE will have to consider the transfer pricing implications. Tax authorities can challenge intercompany amendments, but courts generally accept them as arm’s-length based on the premise that third parties would have to renegotiate terms as well. Review contract revisions through a transfer pricing lens, based on the facts, circumstances, functional profiles, allocation of risk, and whether the current business practices and underlying economic substance are reflected in the terms of the intercompany agreements.

2021: Time to Embrace Technology

In the best of times, transfer pricing technology makes transfer pricing documentation more accurate, more efficient, and less subjective. But, for a year like 2020, it seems like technology is more of a necessity than a luxury, as companies are forced to control internal costs while continuously managing external risks. Pre-Covid, businesses were operating with lean tax departments, and now, even smaller, these departments are being tasked with the impossible.

The only way to do more with less is by enlisting technology. Transfer pricing-specific software can update professionals about international transfer pricing requirements, evaluate the impacts of tax policy and reform, calculate changes in the transfer pricing framework, and prepare accurate documentation—in other words, streamline the whole transfer pricing compliance process. Further, with the advent of machine learning and artificial intelligence, consumption and analysis of data is much quicker and more meaningful, resulting in real-time actionable steps that can help MNEs mitigate risk, optimize opportunity, and maximize control.

Transfer pricing-specific software can be especially useful in terms of benchmarking, as it can produce fresh benchmarking searches based on country-specific criteria instead of taking a generic one-size-fits-all approach. Given the pandemic’s special circumstances, tax professionals will need fresh benchmarking searches reflecting current market conditions, or they may want to evaluate more historical periods that can provide better market insights. But with depressed budgets in MNEs’ tax departments, outsourcing benchmark searches to high-priced consultants may be out of the question. When you consider that transfer pricing is a discipline focused on functions, a Google search for competitor information may not be the best source of benchmarking support. Transfer pricing-specific software that employs AI can make the benchmarking process as easy as a click of a button.

With so many transfer pricing red flags to choose from, tax authorities will have their pick of reasons for issuing information document requests (IDRS) to MNEs. Risking non-compliance just makes it easier for them. Covid-19 promises to heighten tax scrutiny—but that doesn’t have to lead to audits and adjustments. With active and informed management of transfer pricing requirements and the help of technology, the savvy tax department will be able to navigate transfer pricing 2020 as smoothly as any other year.

Mimi Song is a chief economist at CrossBorder Solutions. She has more than 20 years of experience developing innovative and intelligent transfer pricing solutions for multinational corporations. As a practitioner with both consulting and industry know-how, she understands the administrative burdens imposed on taxpayers and the delicate balance between long-term sustainability and external risk management of international tax compliance. Her experience developing the end-to-end transfer pricing framework across people, processes, and technology uniquely positions her to understand how technology can be effectively applied to maximize budgets and minimize risk.

As CrossBorder Solutions, Song is responsible for managing client relationships and ensuring the successful completion of all work. At the original iteration, she served as Vice President of Professional Services. Following the sale to Thomson Reuters, Song was a Vice President at Duff & Phelps and served as the Head of Transfer Pricing at the Bank of Tokyo-Mitsubishi UFJ.

Mimi Song can be reached at

Learn more about Bloomberg Tax or Log In to keep reading:

Learn About Bloomberg Tax

From research to software to news, find what you need to stay ahead.

Already a subscriber?

Log in to keep reading or access research tools.