The Novel Coronavirus (COVID–19) pandemic is taking a toll on the global economy (cancellation of contracts, deferment of transactions, additional costs, idle capacities, etc). To contain this pandemic, various countries have imposed lockdowns which are adversely impacting supply chains of businesses. These circumstances and counter measures are unprecedented and unplanned for. This dire need for survival of businesses has led industries including Multinational Corporations (‘MNC’) to revisit existing strategies and deploy alternative approaches to mitigate the impact. Organisations are relocating manufacturing, restructuring financing arrangements, redistributing risks, reviewing costs, resetting market strategies, and much more. In other words, businesses are restructuring to survive the ensuing economic crisis.
Navigating Transfer Pricing during COVID-19
Related party transactions form a significant part of global trade. MNCs often organise their global presence to create efficiencies, and centralise/distribute business functions, share resources, mobilise know-how, align risks, organise financial support, etc. Tax laws across the globe require a commercial arrangement between group companies for such inter-company arrangements (Transfer Pricing) to be carried out at arm’s length price; a price which would have prevailed for such a transaction between unrelated parties in an uncontrolled environment.
Transfer pricing regulations and international guidance on the subject recommend methodologies to determine arm’s length price. However, there is limited guidance on how transfer pricing can be tuned during the currently prevailing unusual and unpredictable global economic environment. In the following paragraphs, we have considered basic transfer pricing principles/ approaches and how they could be applied to the present business situation to determine transfer pricing strategies in order to deal with the unusual challenges posed to businesses.
Identify Change Triggers
Most businesses have been impacted on account of disruption in either human capital, finance, materials or markets. In order to determine a transfer pricing strategy, it is important for businesses to identify key tangible and intangible value drivers which deliver profits and are key contributors to creating value in the overall business and individual organisation. These key drivers like market, customer, vendor, material, R&D, labour, production, logistics, finance, know-how, contracts, etc. ought to be monitored for change triggers; any material change in key value drivers could necessitate a change in transfer pricing.
Impact Assessment
Once they are identified, it is important to assess how changes in key value drivers are impacting business outcomes, finances and profitability. Some ways to quantify the financial impact include comparing impacted period numbers to pre-pandemic numbers and budgets, reviewing sales, order book positions and cancellations, cost escalations, workforce efficiencies, production and inventory levels, capacity utilisation, MIS reports, etc. with no matching revenue had there been no COVID etc. At this stage, it is important for the MNC group/entity to identify key ratios which are representative of the impact and demonstrate the need for restructuring.
The assessment should be carried out for the individual local entity, and also for the MNC group as a whole. This would not only provide an overall insight into the individual and collective impact, but also provide a basis to revisit existing transfer pricing arrangements during the impacted period.
It will be worthwhile to assess and understand the impact on competition and the industry at large. Expert reports on global, regional and local industry impact may be a good basis for understanding what the MNC group and/or the individual local entity could consider while finalising its transfer pricing policy during these times. Historically, industry analysis is undermined while compiling transfer pricing documentation, but plays an important role in supplementing the change in transfer pricing, if planned.
Review Transfer Pricing Policies
Typically, transfer pricing policies in respect of intra-group transactions between constituent entities of an MNC group are determined based on functions performed, assets deployed, and risks assumed by each party to the transaction. Any change in the intra-group arrangement, would trigger a change in transfer pricing. However, in the present environment, the change trigger could be external and the change could either impact the intra-group transaction directly, or could impact the overall value chain, of which the intra-group transaction is an inseparable part.
Apart from operational changes, MNC groups may consider realigning risks or recharacterising the arrangement. As per the OECD TP Guidelines 1 , risks are allocated to the enterprise exercising control and having the financial capacity to assume the risk. However, given the existing circumstances and resulting economic downturn, it may be the case that neither party of the intra- group transaction can be identified to have control over the risk or have the financial capacity to assume the risk. The MNC group may also consider modifying the commercial arrangement between constituent entities of the group to represent its contribution in the overall outcome of reduced profits/increased losses. In addition, MNC groups may instil financial support like loan repayment moratorium, interest waiver, extended credit terms, debt/capital restructuring, subvention, etc.
During the exercise of reviewing transfer pricing policies, MNC groups need to be mindful of any functional or risk profile changes, which may trigger unwarranted transfer pricing adjustments on account of business restructuring. In case a constituent entity has entered into an Advance Pricing Agreement (APA) with any tax authorities, due consideration needs to be given to ensure critical assumptions are not violated, as it may repudiate the APA. Further, the MNC group needs to be mindful of implications on withholding taxes, customs, VAT/GST, exchange control regulations or other consequential implications while reviewing the transfer pricing policies.
Implementation & Documentation
The base for implementing any transfer pricing changes is the inter-company agreement. The agreement needs to be modified to capture the revised arrangement and should duly document the preface of the arrangement, its objective, scope, commercial rationale and risk allocations. Including elaborative explanation of factors triggering revision in arrangement, force majeure, treatment of abnormal periods, etc. will help the arrangement navigate contours of the pandemic and other such unpredictable events.
Apart from the agreement, it may be recommended to appropriately update the transfer pricing policy documents, the master file and the local file required under domestic transfer pricing regulations.
Transfer pricing documentation is the first line of defence for the taxpayer during the course of any transfer pricing assessment or subsequent litigation. Thus, while compiling the documents for the corresponding impacted period, the taxpayer must consider documenting every aspect in appropriate detail. A thorough transfer pricing document would include functional analysis, identification of key value drivers, complete value chain and relevance of intra-group transactions, result of impact assessment, industry analysis, rationale for changes in transfer pricing policies, basis of economic adjustments, alternative benchmarking strategies and other aspects relevant for justifying the transfer pricing.
As mentioned above, transfer pricing requires benchmarking the pricing of intra-group transactions to a price or outcome (profit) between unrelated parties under uncontrolled circumstances. Availability of comparable benchmarks is a huge challenge to introduce any immediate changes, especially in an environment like the current pandemic that is threatening the existence of organisations and groups. While there is no ideal or prescribed approach, in the absence of a clear benchmark while justifying transfer pricing, the MNC group could consider the following while documenting the economic analysis:
– Identifying and treating separately, non-operating and abnormal costs
– Quantifying and adjusting profits for extraordinary revenue loss
– Reviewing cost allocations and attributions
– Choice of the right period for comparability analysis to address any extremes
– Capturing appropriate segments during comparability analysis
– Making appropriate disclosures in financial statements
– Changing transfer pricing method
– Considering alternative profit level indicators for benchmarking
– Carrying out economic and risk adjustments
– Reviewing comparability filters and comparable transactions/entities
– Corroborative or alternative benchmarking
Compliance & Risk Mitigation
Timely and adequate transfer pricing compliance will help companies mitigate the risks of penalties and prosecution. The group must also ensure compliance to other relevant taxes and regulations. The MNC group may consider risk mitigation strategies like opting for safe harbours, entering unilateral, bilateral or multilateral APAs.
Monitoring
Given the uncertainty of the current situation, transfer pricing policies need to be periodically reviewed to align with the economic realities. Continuous monitoring and periodic review of transfer pricing policies would help MNC groups to navigate changes, whether internal or external, and determine appropriate course of action.
Constituting a committee and assigning responsibilities to devise, implement and oversee the changes in transfer pricing policies not only indicates good internal controls and corporate governance, but also ensures timely identification of any inconsistency or transfer pricing risks.
CONCLUDING THOUGHTS
It is a well-known fact that transfer pricing is not an exact science but does require proper judgment. However, good judgement is one which is all pervasive, well-reasoned, analytical, based on thorough understanding of facts, clear application of principles and stands the test of time. The impact of the disruption caused by the pandemic and the ensuing global economic crisis is compelling MNC groups to review their transfer pricing policies. A timely exercise will help companies to align their transfer pricing policies to economic realities, optimise value chains and avoid tax leakages. A stich in time, will indeed, save nine.
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