TP Challenges During COVID-19.

 

 

The expected spike in the number of multinationals reporting losses in the wake of the COVID-19 pandemic may seriously disrupt an international transfer pricing regime that was designed primarily for the allocation of profit.

The prospect of losses for many companies and across many sectors will likely force taxpayers and tax administrations to depart, at least in the short term, from some of the key assumptions built into the terminology and text of the U.S. section 482 regulations, article 9 of the OECD model tax convention, and the OECD transfer pricing guidelines. Neither the U.S. regulations nor the OECD guidance explicitly forbids losses for limited-risk multinational group members, but their principles and methods assume that any losses should generally be borne by the entity that contractually bears the upside and downside risks associated with the group’s performance. Allocating losses to limited-risk distributors or cost-plus service providers may also contradict multinationals’ existing transfer pricing policies, which generally guarantee such entities a fixed — but positive — return.

Some of the biggest challenges result from the widespread use of profit-based transfer pricing methods, especially the U.S. regulations’ comparable profits method and the equivalent transactional net margin method (TNMM) under the OECD transfer pricing guidelines. The CPM or TNMM is by far the most commonly applied transfer pricing method, and it typically assumes that entities that perform routine functions and bear little risk should earn a positive return. Losses also complicate the selection of comparables in a CPM or TNMM analysis, which often excludes otherwise comparable companies on the basis of losses.

Anticipated losses, and the abrupt deterioration in general economic circumstances that they reflect, also raise questions regarding taxpayers’ ability to modify arrangements formalized by intragroup contracts or advance pricing agreements. For transfer pricing purposes, taxpayers are generally bound by the terms of their own contracts and the threshold for taxpayer cancellation of an APA is high. Although current circumstances may justify modifications in many cases, little formal guidance exists on the identification of appropriate cases or the nature and extent of the modifications.

Limited-Risk Losses

For transactions involving group entities structured as limited-risk distributors or cost-plus service providers, multinationals’ intragroup contractual arrangements and chosen transfer pricing method often guarantee the entity a fixed return. The appropriate return is generally determined by applying the CPM or TNMM using the limited-risk entity as the tested party. Under U.S. and OECD guidance this must be the party that bears little or no significant risk, contributes few if any unique assets, and performs routine functions that can be benchmarked using market data. The arm’s-length return — generally expressed as the ratio of operating profit to sales, costs, or assets — or range of returns is then determined using financial data on comparable independent businesses drawn from commercial databases.

Losses, either by the tested party or by the comparables, are potentially at odds with the logic of this approach and standard practice. Regarding tested-party losses, the U.S. regulations and OECD transfer pricing guidelines generally acknowledge the validity of losses only in limited circumstances. The only such circumstance recognized by the section 482 regulations is the “market share strategy” described in reg. section 1.482-1(d)(4), which requires that the taxpayer document the nature of the upfront costs and expected future profits and establish that its losses were incurred for a reasonable length of time. Neither the U.S. regulations nor the OECD guidelines directly address the possibility of a sudden and severe economic crisis for routine entities.

And regarding comparable selection, the IRS and the OECD have indicated that the functional comparability of loss-making companies will draw special scrutiny even if losses themselves are not a sufficient basis for exclusion. The OECD transfer pricing guidelines state that losses may indicate a “previously overlooked significant comparability defect.”

“Generally speaking, a loss-making uncontrolled transaction should trigger further investigation in order to establish whether or not it can be a comparable. Circumstances in which loss-making transactions/enterprises should be excluded from the list of comparables include cases where losses do not reflect normal business conditions, and where the losses incurred by third parties reflect a level of risks that is not comparable to the one assumed by the taxpayer in its controlled transactions,” the OECD guidelines say.

In light of this skepticism of loss-making comparables, practitioners often remove what would otherwise be considered valid comparables from the final set on the basis of consecutive-year losses or an overall loss over the multiyear period examined. This approach may warrant reconsideration under current circumstances, according to Greg Ossi of PwC. Speaking on an April 23^rd PwC webcast, Ossi said public disclosures suggest that taxpayers may have few profitable comparables to select.

“We know, for example, that for some of the publicly traded companies that are typically used as comparables, if you look at their current information, they’re feeling the pressure. If you look at the typical U.S. distributors that are used as comparables, they're feeling the pressure from the economic shutdown and they're not expected to have the same economic results this year that they have in prior years,” Ossi said. “So there needs to be consideration for these kinds of companies of [the] kind of down-economy adjustments [that] should be taken into account.”

No substantive U.S. or OECD guidance exists on down-economy adjustments, when they are appropriate, or how they should be determined. However, the IRS advance pricing and mutual agreement program has been willing to accept those adjustments in the past, David Swenson of PwC said during the April webcast.

“Generally, the position of APMA in the Great Recession [of 2008-2009] was that an APA would not be opened up absent the trigger of a specific critical assumption or other facts and circumstances justifying opening up agreed advanced pricing agreements. But we did see APMA willing to consider opening certain cases based upon those facts and circumstances and the applicability to the industry or the taxpayer,” Swenson said. “The office was willing to consider more than a dozen different possible adjustments to transfer pricing methodologies, [transfer pricing methods], and [profit-level indicators] and even taking a look at what I would call different tranche approaches, by [which] I mean singling out down-economy years and testing them separately or expanding the length of time to test a period so that the effects would be evened out in a more systematic way.”

Other down-economy adjustments may include accounting for asset write-offs and idle capacity adjustments, Ossi added. Whether APMA will be equally flexible regarding the current crisis is unclear, but a May 11 IRS statement seems to suggest that it may be.

“With regard to questions about pending and executed APAs, APMA is actively discussing various substantive and procedural issues with treaty partners, including such technical issues as the application of transfer pricing methods in periods of economic distress and the impacts of current economic conditions on specific industries, types of taxpayer, regions, etc.,” the statement says. “Stakeholders wishing to discuss these and other general issues with APMA are asked to contact the appropriate APMA Assistant Director. APMA will also discuss case-specific issues and concerns with taxpayers and treaty partners.”

Whether the same flexibility will apply to future IRS examinations of the current tax year is unclear, but there are some early indications that tax administrations have at least temporarily softened their stance in light of the crisis, Justin Breau of EY said on a March 31 webcast hosted by his firm: “There's been a bit of a trend that we've heard that actually tax authorities these days seem to be a little bit less aggressive, or a bit more understanding, of the challenging situations. And we've even heard some examples where previously contentious tax audits were actually closed somewhat easier than anticipated,” he said.

But even if the IRS and other tax administrations remain open to adjustments in the future, relying on financial data for the comparable companies selected in the taxpayer’s CPM or TNMM analysis carries significant risks and limitations, Massimo Bellini of EY said during the March webcast. The financial data on current conditions necessary to calculate any adjustments will not be available in the short term, and once the data become available, they may not fully reflect the extent of economic duress faced by the tested party, he said.

“It is not guaranteed that once available, [the comparables data] will fully reflect the impact of the crisis. The experience of previous periods of crisis, such as the 2008 financial crisis, tells us that in various instances that the databases have not been fully useful because the companies went bankrupt and went out of the database,” Bellini said. “Waiting for [reliable] information — financial information and benchmark data — does not seem feasible because companies may find in several months that this information will not be supportive, so waiting may require significant ex post adjustments, which could be difficult to manage not only from a transfer pricing perspective but from other perspectives.”

Taxpayers that wish to revise the terms of their intragroup transactions may be better served by citing concurrent changes to the group’s arm’s-length contractual arrangements, according to Bellini.

“This information is more than ever the most important observation that should lead any decision and reconsideration of the policy. For example, we have been in discussions in [recent] days with companies, which are already engaging in negotiation with their independent counterparties,” Bellini said. “This is likely to be the most reliable information to assess the need for any change.”

Planning Opportunities

Although the challenges faced by taxpayers, especially regarding the treatment of routine entities, may be significant, the COVID-19 crisis may also create unique tax planning opportunities for some multinationals. As noted by Ossi, one opportunity concerns the effects of the current economic environment on intangible property valuation.

“There may be opportunities for companies to come through now where asset values are depressed [and] to think about moving assets such as [intangible property] into a tax-efficient model and take advantage of things like the current tax attributes created by the economic conditions,” Ossi said.

The extent of the current economic crisis and the uncertainty regarding its duration may offer taxpayers a justification for offshoring intangibles at a significant discount under the U.S. cost-sharing regulations (T.D. 9088). The income method, which is the cost-sharing regulations’ preferred method when only one party makes a non-routine contribution to the arrangement, values the party’s platform contribution by calculating the net present value of the taxpayer’s projected profit under the cost-sharing arrangement and subtracting the net present value of projected profit under a hypothetical “licensing alternative.”

Although the value of the licensing alternative is calculated on the basis of the same financial projections used to value the cost-sharing alternative, it assumes that the party making the platform contribution either earns a routine return determined using the CPM or pays a royalty determined using the comparable uncontrolled transaction method. Projecting significant losses in the short term would likely lead to a sharp drop in the value of the cost-sharing alternative, under which the taxpayer bears the full upside and downside risk of the intangible development activity’s profitability. However, the value of a CPM-based licensing alternative, which would allow the taxpayer to earn a positive return for the entire projection period, would be far less sensitive to the short-term crisis.

Because earlier years are weighted more heavily in a discounted present-value calculation, assuming steep short-term losses under the cost-sharing alternative and positive routine returns under the licensing alternative could significantly narrow the difference between the two values. This effect could be magnified further if the taxpayer argued that the economic uncertainty caused by the crisis justifies use of a much higher discount rate for the cost-sharing alternative than for the licensing alternative. Whether a significant number of multinationals will actually be in a position to benefit from this opportunity during the COVID-19 crisis is unclear.