INSIGHT: Transfer Pricing—How U.S. Inbound Companies Can Recover and Thrive During Covid-19

The Covid-19 pandemic has been a catalyst for a severe economic downturn, including a record estimated 9.5% contraction in the U.S. economy in the second quarter of 2020. (“U.S. Jobless Claims Rise a Second Week in Sign of Growing Risks,” Bloomberg News, June 30, 2020.) Unlike most other downturns, we have a contraction of demand associated with supply disruptions. While the stock market continues to be optimistic about a fast recovery as of the writing of this article, the Covid-19 downturn has already upended the carefully constructed tax planning of many U.S. inbound taxpayers.

Transfer pricing is particularly vulnerable to these uncertain economic conditions, as taxpayers need to consider not only how to document and defend their current year transfer pricing positions, but also how to adapt to a new environment which may involve reduced profitability and losses, and manage transfer pricing disputes.

In this article, we highlight some key transfer pricing considerations related to the potential impact of Covid-19 on foreign-based multinational enterprises (MNEs) operating in the U.S.

It is important to point out that transfer pricing policies operate within a complex global tax ecosystem in which broader issues related to other tax positions must be taken into consideration. Thus, taxpayers should be mindful to include consultation with corporate, international, indirect, and other tax specialists.

RESPONDING TO UNEXPECTED BUSINESS CIRCUMSTANCES

For many MNEs, the Covid-19 business circumstances entail a significant decrease in demand and potential increase in costs, resulting in unanticipated losses impacting the MNEs’ financial results. It is therefore worth considering how to navigate such unplanned fluctuations from a transfer pricing perspective.

Benchmarking for 2020—Covid-19 resiliency emerges as the dominant comparability criterion

Taxpayers are still analyzing the business performance of the first two quarters of 2020. Because of the uncertainties associated with Covid-19, including limited easing of restrictions and continued supply chain disruptions, taxpayers are generally unable to forecast business performance for the rest of the year. However, with half of 2020 over, it is clear that this will be seen as a year of unprecedented disruption (and 2021 may be impacted as well). More importantly, the impact of such disruptions varies significantly across industry sectors, as well as within industries.

Companies that rely on human mobility, live service delivery, and discretionary spending may be more severely disrupted. For example, medical device and supply companies relying more heavily on elective surgeries or procedures performed at doctors’ offices or hospitals have seen a significant slowdown in demand, whereas companies in the same industry focusing on self-administered therapies or emergency procedures may only be impacted to the extent of supply disruptions.

One of the challenges in transfer pricing analysis for 2020 taxpayers is to find evidence regarding the financial performance of independent companies that are as susceptible to Covid-19 as their tested parties. The comparable companies selected for a “normal” year are not usually evaluated for their resilience with respect to rare and sudden demand and supply disruptions like those brought on by Covid-19. This type of approach is consistent with the sort of analysis the IRS likes to see in economic downturns.

For instance, the IRS released Transfer Pricing Documentation Frequently Asked Questions (IRS FAQ) on April 14 of this year. The example described in the first question of the IRS FAQs deals with losses incurred by a U.S. distributor due to an unexpected drop in demand for products distributed. The IRS expects that the focus of transfer pricing analysis will be on explaining how the unforeseen business circumstances experienced by the taxpayer caused the observed financial results and that changes to transfer prices followed arm’s-length practices in the industry.

Many companies that set their transfer prices for individual products at the start of the year target an arm’s-length result based on expectations at that point in time. If a company wants to take the position to keep their transfer prices unchanged, they likely need to demonstrate to the IRS that, in their industry, similarly situated unrelated parties did not change prices in response to the Covid-19 crisis.

Considering the paucity of potentially comparable companies for U.S. transfer pricing benchmarking, it may not be realistic to expect taxpayers to evaluate their comparables against hypothetical scenarios, as they might end up with no comparable companies. Put differently, for many taxpayers, the impact of Covid-19 on their tested parties and the current set of comparable companies (for 2019 or earlier “normal” years) will likely show significant variations, raising questions as to whether those comparable companies continue to be appropriate for 2020.

Such variations may be the result of differences that are seen as less important when benchmarking a “normal” year. For example, very few studies would explicitly screen for a comparable level of operating leverage (i.e., the ratio of fixed costs to variable costs) between the tested party and the comparable companies. Companies with high operating leverage normally find it more challenging to reduce costs in an environment where sales show significant declines. While differences in operating leverage may not matter as much in a normal year, they may be an important comparability criteria for 2020.

Where can transfer pricing practitioners find evidence of financial performance in the face of substantial demand or supply shocks? With Covid-19 resilience likely to be an important criteria for a reliable transfer pricing benchmark for 2020, it may be necessary to revisit original search strategies.

A reasonable starting point might be to evaluate the historical data of potentially comparable companies going back to the Great Recession of 2008 and the earlier recession of 2001, as well as other instances of industry-specific downturns. As the priority is to find evidence of financial performance during a crisis, it may make sense to relax other comparability criteria in order to start with a larger group of potentially comparable companies. Some of the comparable companies selected for this analysis might not be good comparables in a “normal” year, but their data could be used specifically for 2020 Covid-19 benchmarking purposes.

In due time, the current Covid-19 crisis may also provide similar evidence, but data coming after year end for publicly listed companies, and about a year later for privately held companies, may come too late for managing 2020 transfer pricing. Therefore, it may make sense to start with the historical data and build the appropriate screening criteria and analysis methods, and then update that analysis as 2020 financial data becomes available.

In summary, the unique circumstances of the Covid-19 crisis may require their own benchmarking exercise, one specifically developed to leverage historical data from a broader set of comparable companies. Once the data is collected, the analysis also may differ from the usual multiyear averaging. To isolate the financial impact in a single year, it may be necessary to focus on specific time periods for each comparable company or use a statistical analysis to establish benchmarks.

Managing uncertainty—transfer pricing memorandum of understanding

As taxpayers analyze the impact of Covid-19 on their U.S. operations and construct an appropriate benchmark range of profitability or pricing, they also need to address the framework for implementing transfer pricing changes. For U.S. transfer pricing purposes, the framework for implementing transfer pricing changes includes intercompany agreements, corporate policy pronouncements, and the taxpayer’s historical course of conduct.

An immediate action item for taxpayers would be to identify whether there are any provisions in intercompany agreements or company policies or precedents in the past course of conduct for changing transfer pricing in response to significant economic shocks such as those brought about by the Covid-19 crisis. If a taxpayer’s current framework allows for transfer pricing changes, the next step would be to incorporate the anticipated changes within that framework.

Once the possibility of a transfer pricing change is confirmed, the next consideration would be the change itself. In the current environment, where re-openings are followed by re-closures, it is hard to predict how the economy will perform the rest of the year. In the face of uncertainty, MNEs may prefer additional flexibility so that they can quickly respond to future market dynamics and potential opportunities and reduce any negative financial impact. With this in mind, it will be helpful for taxpayers to build in flexibility to change transfer pricing policies later in the year and not be caught off guard by a historic transfer pricing policy that may not apply to unpredictable events such as Covid-19.

A formal written memorandum of understanding between different affiliates of MNEs, drafted in consultation with the taxpayer’s legal and tax advisors and agreeing to potential changes in transfer pricing policies such as the benchmark range of profitability used for transfer price setting and testing, may assist in managing transfer pricing uncertainties later in the year. A written memorandum of understanding also helps document that any future changes in transfer pricing policy have been carefully considered and mutually agreed between related parties ex ante and may be helpful in the event of renegotiation between or among uncontrolled parties. The timing of the memorandum of understating would also document that the changes were provided for when the exact outcome of the risks associated with Covid-19 were not yet known.

Further, given the fluidity of the current situation and recovery, many MNEs may have already experienced reductions in sales and/or production, and would be likely to report substantially lower overall profitability. As such, MNEs anticipating substantial disruption may consider proactively reevaluating their current transfer pricing policies including benchmark profitability ranges for their U.S. affiliates. For example, consistent with cash preservation objectives of a non-U.S. MNE headquarters, it is possible that revisions in transfer pricing policies, which should be consistent with the arm’s-length principle, may under certain circumstances result in a reduction of current cash tax liabilities. Such revisions in transfer pricing policies should be documented now rather than after the fact.

Strategic services for crisis management

A strategic response is needed to manage the impact of Covid-19 on business performance. The response could range from negotiating contracts with suppliers and customers, delaying commercial launch of new products, identifying new sourcing locations, or managing delegation of authority, to controlling discretionary expense. Often, the team located in the MNE’s headquarters employs the resources to develop, implement, and monitor such strategic responses.

For U.S. affiliates operating outside of the routine or limited risk paradigm, it should be noted that should they receive valuable services from teams located in the headquarters country, arm’s-length service payments would need be made. A robust transfer pricing analysis is necessary to implement such a service payment from U.S. affiliates to their headquarters. The extent of the services and the transfer pricing associated with such services should also be reflected in the memorandum of understanding documenting 2020 transfer pricing changes.

OTHER CONSIDERATIONS

APA and competent authority procedures

The uncertain economic effects of the ongoing Covid-19 crisis could potentially impact current advanced pricing agreement (APA) negotiations as conceivably independent comparables could be in loss-making positions over the next few years. Agreeing to appropriate critical assumptions will be key to managing the ultimate impact.

In particular, there is the potential that an APA’s critical assumption may be breached as a result of the downturn in economy. The IRS has not publicly announced its position on analyzing the effect on existing APAs of losses due to unforeseen business circumstances as a result of Covid-19. During the economic crisis of 2008 and 2009, the IRS adopted a general policy not to re-open closed cases absent a special critical assumption on point. As a result, when negotiating current APAs, companies may want to propose a special critical assumption for Covid-19 and proactively initiate a discussion with the IRS.

Consideration of tax legislation—the Tax Cuts and Jobs Act (TCJA) and the Coronavirus Aid, Relief, and Economic Security Act (CARES Act)

An in-depth understanding of the TCJA and the CARES Act is needed to help inbound MNEs recover and thrive. The U.S. government has added another variable to the crisis response equation by enacting a provision that permits businesses with net operating losses (NOLs) arising in 2018, 2019, or 2020 to carry such losses back to each of the five taxable years preceding the taxable year in which the NOL arises. Though losses are still uncertain in the middle of the year, it is critical that MNEs proactively analyze the potential 2020 loss position of U.S. affiliates so they can make important elections under the new law.

It should be noted that U.S. affiliates with controlled foreign corporations and with a current year NOL are limited in their ability to take the tax code Section 250 deduction, which could essentially turn the preferential rates for (global intangible low-taxed income (GILTI) and foreign-derived intangible income (FDII) deduction into a 21% rate. In addition, an NOL carried back to a prior year such as 2018 or 2019 could have a significant impact on a company’s base erosion and anti-abuse tax (BEAT) liability, because the calculation of BEAT liability would include the base erosion percentage of an NOL that arises in 2020 and that is carried back to those years.

Since for many inbound MNEs transfer pricing results can significantly impact their U.S. income, including the size of an NOL, transfer pricing should be part of the overall evaluation of the company’s 2020 U.S. NOL position.

CONCLUSION

The uncertainty about the duration of Covid-19 and its impact on U.S. and global economy is likely to linger, but businesses must act to respond to the changing environment.

Now is the right time for MNEs with the U.S. operations to start planning for potential transfer pricing changes for 2020 and 2021. Given that 2020 is a unique year, the transfer pricing benchmarking for 2020 (and perhaps also 2021) may need to be built specifically to address the significant supply and demand disruptions introduced by Covid-19. Such benchmarking can and should be built in advance using historical data and updated once the 2020 financial data becomes available.

However, taxpayers may want to memorialize their intentions regarding transfer prices changes in the form of a memorandum of understanding to strengthen their documentation of how they reacted to the Covid-19 risks before the full extent of those risks is fully known. For taxpayers with existing APAs or those who are currently negotiating an APA, the same special benchmarking is a great starting point for discussions with the IRS. Given the increased complexity of the tax calculations after TCJA and the CARES Act, taxpayers should carefully evaluate the tax impact of transfer pricing changes.

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

Author Information

Aydin Hayri is a Tax Principal in Deloitte’s Washington National Tax practice. Jamie Hawes is a Senior Manager in Washington National Tax and Manoj Raj is a Senior Manager in Deloitte’s Chicago office.
Copyright © 2020 Deloitte Development LLC. All rights reserved.