INSIGHT: It’s Different This Time—Pandemic-Induced Recession Drives Transfer Pricing Changes

Many recent articles and webcasts attempt to explain how multinational enterprises (MNEs) with lower-than-expected profits or losses in certain jurisdictions are going to persuade tax authorities that these results were not driven by non-arm’s-length transfer pricing. We think this approach focuses on the wrong initial concern.

Tax professionals should immediately begin a re-evaluation of transfer pricing approaches and results to address the impact of the pandemic-induced recession, and cease forcing profit outcomes based on pre-pandemic expectations. As the “pandemic recession” is a unique event causing material changes in the behavior of unrelated parties, transfer pricing must be re-evaluated based on such observed changes in accordance with the arm’s-length principle. Tax authorities, experiencing the pandemic recession with the rest of us, should be receptive to explanations about unexpected outcomes—provided taxpayers can show that those outcomes were the result of the crisis rather than aggressive transfer pricing. In other words, tax professionals should first focus on doing what is correct under the arm’s-length principle and then turn to explaining the outcomes to tax authorities.

NOT JUST A RECESSION THIS TIME

The Economics of Covid-19

The current pandemic and related recession are affecting business operations in ways never seen before. Due to the Covid-19 pandemic, most national governments and all U.S. states issued stay-at-home orders and ordered most companies to conduct operations remotely or in some cases cease operations entirely. Most schools and universities were closed for in-person attendance and various kinds of social restrictions were implemented to prohibit large gatherings. The result was an immediate, severe labor supply shock that morphed quickly into an aggregate demand shock with negative multiplier effects reverberating back-and-forth throughout the global economy. The pandemic-induced depressed demand impacted almost all countries through severely negative effects on public health, employment, income, trade, tax revenues, debt, and GDP. Almost all companies have been negatively impacted by depressed demand with a few exceptions including certain digital services companies, biotech companies, and processed foods manufacturers, which found new profit streams from the pandemic.

This recession bears little resemblance to any of the relatively recent recessions such as the stock market crash of 1987, the 2000-02 dot-com bust, or the 2008-09 financial crisis. The difference this time is that the pandemic recession was not triggered by any excess in a market sector such as high-tech or real estate, or by overly aggressive financial practices paired with poorly managed risks or unsustainable debt levels. The root cause of this recession is a non-financial event, the devastating global Covid-19 pandemic, an external event that has materially altered the functions and risks of all business operations. The governmental response has been both health-focused and operations-focused, meant to reduce both the life-threatening impact of the global pandemic and the sudden and deep economic downturn.

The economic fallout from the pandemic recession rivals any in recent history. The U.S. unemployment rate reached 14.7% in April (27.6% if all unemployed job seekers had been counted) compared to 24.9% during the Great Depression. GDP contracted at an annual rate of about 35% in the second quarter of 2020, after contracting at an annual rate of about 5% in the first quarter. As two successive quarters of negative GDP growth normally define a recession, the first half of 2020 was not only a recessionary period but the deepest recession since the Great Depression. Overall, the U.S. economy is expected to shrink by 6-7% this year and the global economy by 5% or more (triple the damage sustained in the 2008 financial crisis). It will take several years to return to 2019 levels. Compounding the problem is a huge reduction in international trade and an expected reversal of globalization, with negative effects on productivity. Every country will feel the effects, with emerging markets expected to suffer most. The crisis could be thought of as a prolonged natural disaster, although it is much broader in impact than the closest analogue, the Fukushima nuclear tragedy.

Coming out of this pandemic, we will witness a wave of defaults, bankruptcies, reorganizations, and restructurings. At the same time, we can expect to see a new preference among businesses for risk aversion, resiliency over efficiency, redundancy in supply chains, greater automation and artificial intelligence, and greater interest by governments in national self-sufficiency. Reorganizations and restructurings that produce businesses with more resilient supply chains, increased reliance on robotics, and less outsourcing will bring about a wholesale change in the functions and risks of many MNEs’ head offices, subsidiaries and affiliates.

Intercompany Policy Uncertainty

In the midst of this chaos and in light of suddenly altered competitive market behavior and results, tax professionals are understandably concerned with a host of pressing issues. With regard to transfer pricing, the questions revolve around what changes to intercompany behavior and results are appropriate and how the tax authorities will ultimately react. Some of the genuine concerns around intercompany relationships and operations are:

• Certain points along the supply chain are failing, certain controlled entities have stopped functioning efficiently, and a restructuring strategy is required to rebuild the supply chain;

• An intercompany contract does not have a force majeure clause, or it contains such a clause but the triggering event (such as a pandemic) is not a listed event;

• An intercompany contract specifies compensation of a certain positive but low margin or markup for a “limited-risk” entity such as a distributor, contract manufacturer, or service provider, with no exception for an economic downturn;

• A residual profit split allocates the residual profit (or loss) to the entities that perform the DEMPE functions after full compensation of the entities performing routine functions, with no exception for an economic downturn;

• Increased intercompany credit must be extended to certain controlled entities or credit guarantees extended, but the value of credit guarantees has increased markedly;

• Management services charges, including those for health-related crisis management, need to be charged out if beneficial to the recipient entities.

In all cases, transfer prices need to be re-evaluated and possibly altered to align again with supply chains and to recognize changes in value contributed by location. Entire transfer pricing systems may need to be redesigned, given new sources of value creation and a cessation of some of the prior points of demand and supply.

One big taxpayer concern revolves around the eventual tax authority view of new or changed transfer pricing systems and results. Put differently, how are taxpayers and their advisors to best prepare for the expected tax audits and income adjustments? How will they defend the allocation of losses within their multinational groups and explain changes to existing systems? Recent articles and webcasts have focused on various ways to reframe the transfer pricing analysis so that the range of profits produced by the set of comparable firms can accommodate the now weaker tested party profits, thus supporting an arm’s-length result. These presentations often follow the direction of articles written in the 2008-09 timeframe and have covered everything in the comparables search strategy and list of downturn adjustments:

• changing the analysis window,

• putting back loss comparables,

• targeting the full range of comparable results or a range below the interquartile range (i.e., the 25th to 75th percentile levels),

• altering comparable results based on tested party financial changes between last year and this year,

• reducing the range of comparable results in the same proportion as the range decreased during the 2008-09 recession,

• running linear regressions of comparables’ and macroeconomic data to obtain factors by which current comparable results might be reduced, and

• altering tested party results to separate out the effects of the crisis or adjusting certain financials to pre-crisis levels.

Not only is the pandemic recession considerably more devastating than recent recessions, it is also unique in its disruptive impact on functions and risks. It cannot properly be informed by past events and behavior—including tax authority opinions. This crisis needs to be analyzed differently and a new and thorough analysis may well support different transfer pricing outcomes. If properly explained with supporting factual and analytical backup, tax authorities should not require taxpayers to produce results consistent with an out-of-date range. In fact, taxpayer attempts to satisfy transfer pricing methods and ranges unchanged for the pandemic recession could actually increase exposure to transfer pricing risk. In other words, things may be different this time.

What remains true, as a general rule and regardless of the market environment, is that controlled taxpayers must conduct themselves in a manner consistent with third-party behavior.

TRANSFER PRICING STANDARDS AND THE CRISIS

The Arm’s-Length Principle

By definition, controlled parties do not interact at arm’s length. In order to prevent manipulation of taxable income among controlled parties, the arm’s-length principle (ALP) has been set as the governing standard for transfer pricing. Practical application of the arm’s-length principle is overwhelmingly based on operating results; for example, comparison of a controlled party’s operating margins with those of uncontrolled firms found to be comparable over the same time period. This type of analysis is inherently imperfect for several reasons, including an often incomplete description of the tested party’s and comparable firms’ functions and risks and a lack of true comparability with the set of uncontrolled firms identified as comparable. Nevertheless, the results-focused analysis works well enough to identify taxpayers that may be violating the arm’s-length principle, when markets are functioning normally.

Both the OECD Transfer Pricing Guidelines (guidelines) and the U.S. Treasury regulations under Internal Revenue Code Section 482 subscribe to the ALP and provide voluminous guidance on the application of arm’s-length concepts. Similarly, both the guidelines and the U.S. Treasury regulations under I.R.C. Section 6662 describe the requirements for transfer pricing documentation, which give the taxpayer an opportunity to analyze its own transfer pricing relative to the ALP in a look-back analysis covering the prior fiscal year. However, neither the guidelines nor the regulations specifically address how intercompany transactions might change in the face of a global health or economic emergency while still remaining true to the ALP. The guidelines and the regulations are similarly silent regarding when the impact of a crisis would require/allow a taxpayer to depart from its anticipated look-back analysis as a result of a departure from its prior transfer pricing policy.

Implicit Transfer Pricing Assumptions

The guidelines and I.R.C. Section 482 regulations both rely upon certain assumptions in the performance of transfer pricing analysis, one of which is the “going concern” assumption. It is implicitly assumed that the tested party is a continuing operation and, therefore, the appropriate comparable third-party benchmarks would need to generate a long-run steady-state positive result. For this reason, when searching for comparables, it is common practice to screen out companies with more than one year of operating losses during the prior three years, regardless of functional and risk similarities with the tested party. This common practice creates a host of issues when companies are in the midst of an economic downturn and experiencing lower profits or losses. One improvement to transfer pricing analysis would be to revisit the underlying going concern assumption in difficult times, and reevaluate the comparables criteria and search strategy.

An additional obstacle to altering transfer pricing policy is that information from the comparable firms is generally not available until after the fiscal year has ended (e.g., comparable data for a calendar-year-end taxpayer only begin to be available the following spring); thus, taxpayers do not have real time data and information on the comparables’ returns.

Third-Party Responses to Changed Circumstances

Faced with a sudden change in market circumstances, MNEs must seek answers to transfer-pricing-related questions—what would comparable third parties do, what are they actually doing (to the extent there is visibility), and what market data and evidence are available? One thing is certain in the current pandemic recession – companies are not engaged in business as usual. They are changing prices, changing margins and markups, furloughing or laying off workers, cutting salaries, suffering reduced profits or losses, securing credit guarantees and accessing credit lines, testing the validity of their contracts and cancelling or renegotiating certain contracts, and rearranging sources of supply as necessary. Companies’ reactions differ widely depending on the demand they face and their workforce availability, cost structures and supply chains, particular industries and locations, and status as essential or non-essential.

The impact of the crisis on supply chains alone is completely different than a standard downturn given the rapid movement of the pandemic around the world, forcing companies to immediately respond to ensure the near-term sustainability of their operations. This development has placed a massive strain on companies’ operations and costs, and has substantially heightened risks.

Controlled Party Responses to Changed Circumstances

The issue of defending controlled party behavior to tax authorities is distracting, as it is not directly relevant to the actions that should be taken now. If there is reason to believe that the planned controlled margins and markups no longer resemble arm’s-length results, appropriate transfer pricing changes need to be made. For example, if controlled rent or lease payments are higher than arm’s-length equivalents, these can be re-negotiated. If fees for related-party credit guarantees are lower than the market would dictate, these can be raised. If intercompany contracts are no longer indicative of arm’s-length negotiations, as comparable contracts have been altered, the intercompany contracts should be revised.

Regarding contracts and their continuing validity, tax practitioners can glean some general insight from the contract “force majeure” clauses and some transfer-pricing-specific insight from the “critical assumption” language used in advance pricing agreements (APAs). Force majeure clauses are general commercial contractual provisions that excuse the delay or non-performance by a party due to an “act of God” or extraordinary event that prevented that party from performance in accord with the contract. In the context of the Covid-19 pandemic, force majeure clauses are receiving a great deal of attention with regard to contracts between unrelated parties where the impact of the pandemic prevented a party from performing.

The “critical assumption” clause of an APA serves much the same purpose as a force majeure clause, but in the narrow context of a taxpayer negotiating an APA with the IRS. A taxpayer requesting an APA must propose critical assumptions—facts outside the control of the taxpayer or the IRS, the continued existence of which are material to the outcome of the transfer pricing methodology. Critical assumptions might include, for example, a particular corporate or business structure, a range of expected business volumes, or the relative value of foreign currencies. One general-purpose critical assumption is included in most APAs:

The business activities, functions performed, risks assumed, assets employed, and financial and tax accounting methods and classifications [and methods of estimation] of Taxpayer in relation to the Covered Transactions will remain materially the same as described or used in Taxpayer’s APA Request. A mere change in business results will not be a material change (emphasis added).

In the aftermath of previous recessions (e.g., 2008-2009) the application of this general critical assumption was discussed with the IRS in numerous APAs, in an attempt to excuse taxpayer adherence to the results dictated under the APA. However, the authors are aware of few modifications allowed pursuant to this critical assumption.

DOES THE PANDEMIC RECESSION JUSTIFY RECONSIDERATION OF TRANSFER PRICING?

Extraordinary Situation

If the pandemic recession were a standard economic recession, without the supply shock caused by the health emergency and attendant changes in functions and risks, tax authorities might be unwilling to entertain changes to transfer pricing policies resulting in reduced profitability or losses. Clearly, transfer prices should be altered to be consistent with the arm’s-length principle, but it might be difficult to convince the tax authorities in a revenue-losing jurisdiction of the appropriateness of the change or unexpected low profits or losses in that jurisdiction. The outcome should be different this time for these reasons:

• A government-mandated shutdown is extraordinary, and its effect on physical business operations cannot be ignored;

• The highly negative effects of the shutdown on national economies, supply chains, and demand are clear;

• Companies will be able to document the effects of the crisis on their operations through data they possess on sales revenue, costs, and expenses;

• Comparable firms in situations similar to tested parties ultimately will show lower 2020 operating results in most industries; and

• A growing body of reports will be forthcoming on issues regarding force majeure clauses, reduced consumption, production cutbacks, retail store closings, and Chapter 11 filings.

Defending the Change to Tax Authorities

The IRS and the OECD have each received questions about how MNEs should think about their transfer pricing policies in 2020, given the reality of unexpected losses. The IRS responded in an April 14, 2020, Frequently Asked Questions (FAQ) document that companies should stick with their existing transfer pricing methods and comparable sets in a downturn, and find other means to explain their results. That is a reasonable approach; however, some of the companies in any tested party’s comparable set may have failed or will fail this year (or be acquired), thus skewing the arm’s-length profitability results upwards and creating “survivor bias”. The impact of survivor bias on comparable results should be explained as part of any documentation of 2020 results.

More generally, the effect of the pandemic recession on the tested party and the comparable firms must be carefully explained in 2020 documentation. Defending the MNE’s behavior and results to a tax authority will be much easier if attempts were made during this recessionary period to conduct related-party business as if at arm’s length. Of course, each action should be explained in a running journal, and all records kept along with supporting evidence.

The tax authorities should be willing to accept these explanations, provided the taxpayer has prepared sufficient analysis to show the effects of the crisis. Tax authorities will understandably be looking for aggressive taxpayer attempts to use the confusion generated by the pandemic recession to shift income to low-tax jurisdictions. Taxpayers can expect heightened scrutiny, but should respond with comprehensive, data-rich documentation proving that unexpected low profits or losses were the result of the pandemic recession, not tax avoidance.

Even if tax authorities agree with a re-allocation of risk during the crisis, they might insist on a new post-crisis transfer pricing approach. For example, tax authorities could argue that the entities branded as limited-risk distributors that were forced to bear losses during the pandemic recession should earn higher returns after the recession.

Re-evaluation of Transfer Pricing

MNEs should set transfer prices as close to arm’s length as possible, given limited real time information. In some cases, the market gives off clear signals regarding what controlled taxpayers can do to align with the market. In other cases, the market is silent and the taxpayer must decide what action to take. Several examples follow:

• A limited-risk distributor has been receiving a fixed profit margin of 2% as a result of the transfer prices set by its related-party supplier. The uncontrolled distributors in the same market are losing money due to the crisis as their supply and other costs have not fallen in line with consumer demand. The related-party supplier should consider the derived demand for the product being sold to the distributor and reduce transfer prices based on the economics. This will not provide a 2% profit margin, but will cushion the distributor’s loss. The sharing of losses between companies based on their supply and demand curves is the normal competitive market result.

• A parent company charges its controlled distributors a royalty rate of 5% of final sales for the use of a valuable brand name. Due to the crisis, unit sales have shrunk, retail prices have fallen to a level equivalent to those of a commodity product, and as a result, there is no longer a “profit uplift” connected to this particular brand name. Continuing to pay the royalty would cause the controlled distributors to have results below their uncontrolled competitors and accentuate losses. At arm’s length, the royalty rate would be renegotiated.

• A residual profit split agreement causes several non-routine entities to split residual profits based on relative R&D spend, after compensating the routine entities. However, each of the non-routine entities has experienced the crisis differently, with one doing fine, another unable to continue operations, and the others struggling to varying extents. At arm’s length, the non-routine entities would no longer be able to split profits or losses per the pre-existing agreement and would seek to renegotiate the allocation based on differential outcomes.

Controlled taxpayers can adopt arm’s-length behavior even if detailed, current information on comparables is not available. The answer is either readily apparent or the controlled taxpayer can model out an answer given an informed understanding of its own demand and cost situation in the current market. If necessary, the taxpayer can then change transfer prices to be in accord with perceived arm’s-length behavior when better information becomes available.

The question of tax authority acceptance remains. Although tax authorities should make accommodations given the nature of the crisis, some may not. Faced with this possibility, an MNE should review each tax authority’s policy and prior history with the company. For additional insight, the MNE could make use of its country-by-country reporting matrix, customized to contain both expected and projected income by country location and a factor reflecting the MNE’s perceived risk level in regard to each country’s tax authority.

CONCLUSION

The current pandemic-induced recession constitutes a unique event in economic history. In a more typical economic downturn, MNEs would be worried that lower-than-expected profits or outright losses put them at risk of dispute with affected tax authorities. MNEs would be thinking about upcoming transfer pricing documentation and analyzing adjustments that would include their results within a range of comparable results.

This time is different. The crisis caused by the pandemic recession is well-known and understood by everyone, including the tax authorities. Taxpayers should immediately work to align their tax and transfer pricing approaches to current business realities and objectives, which would include ending, revising, and adding certain intercompany transactions. Although taxpayers can expect heightened scrutiny from tax authorities, it is better to alter and document transfer prices to align with new arm’s-length realities than to continue legacy transfer pricing approaches that rely on pre-pandemic expectations.

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

Author Information

Steven D. Felgran is the founder of Felgran Economic Consulting LLC in New York. He specializes in transfer pricing consulting and litigation support.

Steven C. Wrappe is the National Technical Leader of Transfer Pricing in Grant Thornton’s Washington National Tax Office and an adjunct professor at New York University School of Law.