As the coronavirus (Covid-19) spread throughout the world, it caused unprecedented pandemic-driven illness and death. With the use of self-isolation as the primary tool to slow the contagion, nations everywhere saw their economies grind to a halt.
As this is written, we are only beginning to see the profound ripple effects of the widespread economic freeze on various sectors of our economy. The complex nature of multinational enterprises (MNEs) means they are likely to see impacts throughout operations, regulations, and governance. Several of these impacts will likely have transfer pricing implications.
Though perhaps not one of the first challenges to come to mind, transfer pricing implications of responses to the Covid-19 crisis carry substantial risk to how MNEs do business and avoid regulatory-driven financial risk. The MNEs that ignore the transfer pricing issues and merely choose to wait until the tax authorities send notice could face an adverse adjustment, penalties, or time-consuming litigation.
The Covid-19 crisis is much more intense than the 2008 financial crisis. Within a month since the start of the Covid-19 crisis, the number of people seeking unemployment benefits has risen to nearly 17 million, compared to a peak of 6.6 million that was reached after several months into the financial crisis.
As these unprecedented economic and social conditions continue, large numbers of MNEs are likely to face significant changes in customer demand as well as further disruptions to their supply chains. Even as economies start reopening, the different timing and extent of reopening could necessitate a temporary rearrangement of supply lines. The Covid-19 crisis might force some MNEs to reassess functions performed by their various related entities and make permanent changes to their value chains to mitigate the impact of future crises. While considering all these changes, MNEs need to keep transfer pricing implications in mind.
The 2008 financial crisis brought the transfer pricing arrangements of MNEs under intense public scrutiny as cash-strapped governments sought ways to increase revenues. As governments worldwide now approve massive stimulus packages to revive their respective economies, they are required to pursue strategies to fund such measures as well. It won’t be surprising to see tax authorities perform heightened scrutiny of transfer pricing arrangements made by large businesses and MNEs. The tax authorities may propose reallocating profits for both the years currently under audit and future years using the ad hoc risk borne by various entities during the Covid-19 crisis as a basis for assessing risks assumed by those entities under normal operating conditions.
For example, transfer pricing regulations often require subsidiaries, designated as performing routine functions, to earn stable returns. Fluctuations during the Covid-19 crisis could be used to argue that the subsidiary is entitled to higher returns due to higher risk.
Further, given the out-sized role played by Chinese manufacturing in economies around the world, several countries are incentivizing their companies to move manufacturing out of China. For example, Japan is assisting its companies with $2.2 billion to move manufacturing out of China. This trend of companies, including the U.S. and European ones, leaving China had started prior to the Covid-19 crisis and is likely to accelerate.
However, in the short run, it is natural for many businesses to contemplate temporarily shifting more functions to their Chinese subsidiaries as China’s economy is already starting to open.
If such shifts, whether temporary or permanent, were to occur, they would raise transfer pricing related issues.
In general, we will likely see tax authorities outside the U.S. aggressively applying new Organization for Economic Cooperation and Development (OECD) guidelines in their scrutiny of transfer pricing documentation and proposing adjustments that may not necessarily be consistent with the arm’s length standard.
Potential Business Issues
Some of the potential business issues that MNEs might deal with and which may have transfer pricing implications are the following:
- There might be a change in functions performed by a subsidiary, which might necessitate re-characterization of the subsidiary’s role.
- For example, a manufacturing subsidiary may not be able to do some or all of the required manufacturing due to social distancing. Instead, the subsidiary might need to procure a lot of finished goods (instead of raw materials) from some other geography.
- A related entity may be forced to delay or alter interest payments on inter-company loans.
- A parent may need to move cash, provide technical, logistical, or other support across geographies to help hard-hit subsidiaries survive—all of which would likely be considered by tax authorities as a value transfer, requiring an arm’s-length compensation under the transfer pricing rules
- A parent may need to access a subsidiary’s cash, or seek technical, logistical, or other support across geographies to either help its operations and or help other hard-hit subsidiaries survive—again likely to be considered by tax authorities as a value transfer requiring an arm’s length compensation under the transfer pricing rules
- Difficult or altered circumstances might cause companies to consider carving out specific portions of their business. From either a buyer or a seller’s perspective, a well planned carve-out methodology and corresponding financials may be needed to defend transfer pricing arrangements.
In short, the functionality, assets, and risks borne by different entities within a company are likely to change. Regardless of whether changes are temporary or permanent, MNEs will need to reassess and revise their existing transfer pricing approaches and as well as the underlying economic and functional assessments. Both the U.S. and OECD transfer pricing guidelines emphasize the need to make adjustments that can be justified given the economic circumstances in question. Accordingly, each company will need to carefully consider how the Covid-19 crisis has altered the economics of its specific business.
Transfer pricing documentation is often written under an implicit assumption of normal operating conditions for businesses. MNEs may want to review whether their existing documentation addresses the risk arising from extraordinary events in general or that from pandemic-related deterioration in business conditions.
MNEs may also want to examine whether the functional allocation and the risk assumption, delineated under the current transfer pricing documentation, remain reasonable, given the changed market conditions.
There are several critical questions that MNEs should ask:
- Is the actual response to Covid-19 consistent with the transfer pricing documentation?
- Does the documentation address the possibility that low-risk entities might face considerable fluctuation in their income (and profits) in the presence of extraordinary macro-economic risks?
- Do the critical assumptions underlying existing advance pricing agreements still hold? If not, are the changes temporary or permanent? Is there a need to discuss possible revisions with tax authorities?
- Do intercompany financing policies need to be reevaluated (in tandem with both the U.S. and the new OECD Guidance on Financial Transactions)?
- What impact will local government decisions have on routine functions? For example, an entity may need to perform tasks that are different from its routine functions.
- What will be the impact of a subsidiary accepting aid from the local government on its characterization as a low-risk entity?
MNEs would also need to ensure that entities are properly compensated for any transfer of value across different tax jurisdictions. MNEs must not ignore the transfer pricing implications of all pandemic-driven changes to supply chains, other service agreements, and inter-company financing arrangements among various related entities.
In addition to reviewing their existing transfer pricing structure, MNEs must appropriately document the relevant decisions. While recording the economic rationale underlying a specific transfer pricing approach is always important, it becomes more so during a downturn or a recession. During such times, businesses will need to substantiate how the losses incurred by the various entities reflect arm’s-length transactions—based on the functions, assets, and risks assumed by each entity.
Given the retrospective nature of tax audits, MNEs should archive all related emails, voicemails, and paper trails that help demonstrate the temporary or permanent nature of changes to supply chain arrangements and functions performed by various entities.
We recommend that MNEs consider revisions to their transfer pricing documentation for fiscal years that include any months in 2020 and for the future. The economic evidence to support any changes in an MNE’s arm’s length pricing (and other transfer pricing related decisions made during this time) will likely face heightened scrutiny in an audit. Providing appropriate economic evidence will probably be challenging for multiple reasons.
- It will likely be hard to determine a proper comparable set for 2020 since Covid-19 can impact even similar businesses differently, given the disparate impact across geographies and periods.
- It will be hard for MNEs facing systemic losses to attribute losses to specific units.
In addition to the above-discussed measures, MNEs could also benefit from communicating proactively with their relevant tax authorities.
Given the urgent issues that the Covid-19 crisis is raising every day, it is easy for MNEs to ignore or overlook the transfer pricing consequences of the decisions made by their various management teams. MNEs need to understand that taking a cohesive approach to their transfer pricing related decisions is required as they reconfigure their systems and supply chains across the globe. We recommend considering transfer pricing implications while formulating the responses to the Covid-19 crisis and reviewing the implications of decisions already made as soon as reasonable, given other business needs. The MNEs that merely choose to wait until the tax authorities send notice could face an adverse adjustment, penalties, or time-consuming litigation.
This column does not necessarily reflect the opinion of The Bureau of National Affairs, Inc. or its owners.
Dr. Alok Khare is a Senior Managing Director in the Dispute Advisory Services practice within the Forensic & Litigation Consulting segment at FTI Consulting. Dr. Khare is a financial economist who specializes, among other things, in transfer pricing, securities, valuation and econometrics. He leads FTI Consulting’s U.S. transfer pricing team based in San Francisco and provides consulting services on complex economic and financial issues related to legal disputes, including tax controversies, and other business matters.
Ms. Sreevidhya Devarajan is a Senior Director in the Dispute Advisory Services practice within the Forensic & Litigation Consulting segment at FTI Consulting. Ms. Devarajan has extensive experience assisting clients with the evaluation of economic damages in complex disputes related to transfer pricing, breach of contract, valuation, class certification, intellectual property, and other commercial damages matters.
The views expressed herein are those of the authors and do not necessarily represent the views of FTI Consulting, Inc., or its other professionals. FTI Consulting, Inc., including its subsidiaries and affiliates, is a consulting firm and is not a certified public accounting firm or a law firm.