Transfer Pricing & Covid 19.

  

The Covid-19 pandemic has dramatically disrupted business operations and financial markets, leaving many companies scrambling to adjust to ever-changing economic circumstances. Many companies are still managing business emergencies or reorganizing operations on the fly, but as organizations begin to stabilize and plan for 2021 (and beyond), transfer pricing is one area that companies should be thinking about.

 

For companies that have reorganized operations to adapt to the evolving economic and business environment, existing transfer pricing policies may no longer appropriately reflect their corporate structure and intercompany cash flows. For example, some companies have moved parts of their supply chains (e.g., onshoring manufacturing to reduce the need to ship goods), and such a change could make transfer pricing policies—like those related to manufacturing locations—obsolete. In such cases, it may make sense to revise transfer pricing policies to better match the new organizational structure.

 

Even for companies that have not seen significant operational changes, reduced profitability or disruptions to cash flows may be straining the organization’s ability to follow existing transfer pricing policies and appropriately compensate all relevant legal entities. Consider a company in which legal entities focused on distribution have historically targeted a specific arm’s-length return (or range of returns). Now, if sales have declined locally or globally for those operations, the local distribution entity, or even the entire global business, may struggle to achieve the target level of profitability.

 

Along the same lines, carrying out new or existing cash management strategies may introduce transfer pricing risk. For instance, companies might issue intercompany debt as a means of getting cash to legal entities in need but might find that the economic and financial environment in the wake of the pandemic introduces challenges to structuring and pricing intercompany loans in an arm's-length manner. Compounding these challenges is the fact that some tax authorities may become more aggressive with audit activity, to recoup lost tax revenue following reduced country-level profits.

 

Changes to Transfer Pricing Policies

 

For all of these reasons, many businesses are considering, or have already executed, transfer pricing changes in the wake of Covid-19 and the resulting economic disruptions. In some cases, these changes are the result of management tailoring transfer pricing policies to better match their evolving operating models. In other cases, they opportunistically restructure intercompany flows to take advantage of the evolving economic environment.

Initial results from a survey being conducted by Duff & Phelps indicate that companies are actively taking steps such as onshoring—or offshoring—of intellectual property (IP), moving central services, reorganizing or restructuring sales or distribution legal entities, and changing intercompany financing policies, as a direct result of the pandemic.

 

Companies’ desire to make structural changes to transfer pricing policies may be driven by numerous factors, such as shifting consumer demands (e.g., companies shifting to virtual models), modifications to company supply chains (e.g., localization of manufacturing), or opportunistic exploitation of the economic or tax environment (e.g., the impact of the economy on IP valuations may make now the ideal time for long-considered IP transfers). Businesses in any of these situations should take several steps in evaluating, and potentially revamping, their transfer pricing.

 

First, they need to decide whether the transfer pricing policies they currently have in place still make sense—and, if not, what steps the organization should take to reconcile transfer pricing to its revised operational structures and value chains.

 

One area in which many companies are making changes is in their supply chains, both external and internal. Many companies globally have gone out of business as a result of the pandemic, requiring customers to seek alternative external suppliers for inputs and finished goods. Likewise, the slowdown in shipping times from Asia supply markets to Western economies has encouraged companies to consider third-party suppliers located in different regions. A new supplier, especially one in a different country, can impact which related party manages the transaction. Geography or language differences might mean it makes more sense for a different internal legal entity to work with the new supplier than did business with the previous supplier. Changing which related party is involved in the relationship could also necessitate a change in transfer pricing, as existing arrangements based on the previous division of functions between legal entities may now be outdated.

 

At the same time, some companies are also rethinking their internal supply chains, reconsidering which locations are responsible for functions such as manufacturing and sourcing. For example, difficulties around travel may cause some companies to switch to more localized sourcing and manufacturing. As companies modify which functions are performed by which legal entity, it will likely be necessary to modify transfer pricing positions to match the revised intercompany flows.

 

Managing Audit Risk Following Changes in Policies

 

Alterations to transfer pricing policies may be necessary for the current environment. They may also introduce risks. Changing transfer pricing policies year-over-year is often viewed as a red flag by tax authorities and, as such, could invite scrutiny.

 

Nevertheless, changes to transfer pricing policies are not, in and of themselves, disallowed if the changes are defensible, appear consistent with market behaviour, and are supported by robust documentation. Third-party businesses that transact with one another at arm's length do not treat their arrangements as static, especially as business needs evolve, so it is reasonable to suggest the same mindset should apply in the context of intercompany transactions.

 

Companies that are looking at changing transfer pricing policies can mitigate audit risk by including in their standard annual transfer pricing documentation a strong narrative describing the reasons for any changes in policies. It’s also important for the documentation to make clear why each side of the transfer pricing transaction would have agreed to the revised intercompany transaction at arm’s length.

An additional consideration is that transfer pricing agreements are often codified in legally binding intercompany contracts. The existence of such an agreement doesn’t need to be an obstacle to changing transfer prices, but it does mean the company must make sure any revisions to the arrangement would be agreed to by third parties—i.e., changing the contract is mutually beneficial to both parties, and neither is agreeing to the changes just because of the intercompany relationship.

 

Alternatively, if the changes are not mutually beneficial, they might still be permissible if there is a reason that the losing entity agrees to them—beyond the intercompany relationship. Perhaps the entity that will be worse off under the revised contract is going to be compensated for agreeing to the changes. Many intercompany agreements include language that describes the terms of dissolution and penalties for breach of contract. Companies should consult with legal counsel to understand the flexibility of such arrangements.

 

Regardless, documenting the reason that each entity would agree to the change, at arm's length, is imperative to make transfer pricing policy changes defensible.

 

Defending One-off Deviations from Transfer Pricing Policies

 

Even companies that are not making broad or permanent changes to transfer pricing policies may face extreme circumstances right now that impact certain transfer pricing arrangements in the short term.

For example, many companies have legal entities that are structured as limited-risk distributors with specific targets for operating margins. Due to demand shocks resulting from the pandemic, some of these local-market related-party distributors are earning far less revenue than expected. As such, they may be struggling to reach profitability targets, given fixed costs that cannot instantaneously adjust to match decreased demand. This shift in financials increases the risk that the tax authority in the distribution entity's country will impose an adjustment and/or penalty, claiming that the limited-risk distributor is not being adequately compensated.

 

The opposite effect could occur in industries or businesses that are seeing increased profitability during the economic downturn, such as certain healthcare or personal care companies. For these businesses, unexpected positive demand shocks could lead to perceived overcompensation of distribution entities.

 

In the first situation, the corporate tax team needs to consider whether the profit targets that existed before the current crisis are still appropriate in this economic environment. They should undertake an updated accounting of the functions, risks, and assets of all relevant legal entities and an analysis of the intercompany agreements currently governing transfer pricing within the organization. Based on these analyses, they should determine what profit margin would be expected at arm's length, given the external business climate and the allocation of risks within the accurately delineated intercompany transaction.

 

In many instances, reducing entities’ target profitability for 2020 may be appropriate to reflect the current economic circumstances. Note that profitability expectations for routine operations are usually established and defended by referencing the observed profitability of identified comparable companies. The performance of benchmark companies is likely to be quite different in 2020 than those same companies’ actual financial results of recent years. As a practical consideration, however, it is worth noting that comparable companies’ performance data for the current fiscal year may not become available until several months into 2021, depending on the organizations’ fiscal year-end dates.

 

Companies wanting to adjust internal entities’ profit targets may turn to a few sources of information, in advance of actual financial performance data becoming available. For instance, it may be possible to establish expected changes in profitability associated with decreased demand by studying the impact that sales decreases had during previous economic crises, such as the Great Recession. However, the specific circumstances of each crisis are unique, and the profit response exhibited by distributors during the Great Recession may or may not be indicative of profitability changes that have arisen in the Covid crisis.

 

Another potential avenue of investigation could lie in earnings guidance revisions or revisions to analyst earnings expectations for comparable companies. Our preliminary examination of such data indicates that distributors’ operating-margin response to a given reduction in sales may be sharper in the current crisis than it was during the Great Recession.

 

Cash Management and Intercompany Lending Considerations

 

Liquidity is an area of significant concern for treasury departments in the pandemic economy, and cash management decisions could also have transfer pricing implications. Specifically, some companies are employing intercompany financing tools such as intercompany loans or cash pools to allocate liquidity to legal entities that are facing shortfalls due to business headwinds. The unique lending environment associated with the Covid-19 crisis could create additional transfer pricing risks and considerations.

 

As always, intercompany financing tools need to be both structured and priced at arm’s length. Given current trends in interest rates, treasury departments should not assume that previously applied arm’s-length rates can be rolled forward without additional analysis. The investment-grade lending market is currently seeing historically low rates, so for investment-grade entities, arm’s-length intercompany interest rates will likely have to be lower than previously charged rates.

 

That said, for some entities, a synthetic credit-rating analysis today would lead to a lower rating than in the past. This is especially likely to be the case for businesses that need the intercompany financing tool due to a cash shortfall caused by a business slowdown. The high-yield lending market has not seen as much of a decline in interest rates, so a reduction in credit rating could lead to a higher interest rate than the organization would have paid in the past.

 

In other words, the facts and circumstances of a specific legal entity within the Covid-19 economic environment could lead to an unexpectedly low or high arm’s-length interest rate.

 

Recent guidance issued by the OECD on financial transactions emphasizes the accurate delineation of financial transactions. In short, that means tax authorities may recharacterize an intercompany financial transaction if they decide its characteristics are more consistent with a different kind of transaction. For example, if a tax authority determines that a lender at arm’s length would never have agreed to a purported intercompany loan, it may decide the transaction is better characterized as equity and treat it as such for tax purposes—and so deny the deduction of interest.

 

One important consideration is whether loans with similar characteristics to the purported intercompany loan are observed in the market. Proving that a similar loan would have existed at arm’s length may be challenging if the market for lending to the business’s industry and/or credit rating has dried up as a result of Covid-19.

 

Cash management considerations are not limited to new intercompany financing issuances; existing issuances may also come under scrutiny. Specifically, if a legal entity previously issued intercompany loans that, all else equal, would be priced at a lower rate today, there is the risk that a tax authority could claim that a borrower at arm's length would have refinanced those loans—and, thus, that the intercompany loans should have lower rates. Whether this might happen depends, in part, on the structure of the intercompany agreement: If the loan agreement does not give the borrower the flexibility to prepay the issuance, then the borrower could argue it is beholden to the loan agreement. However, if the loan agreement states that the issuance is prepayable anytime without penalty, the onus might fall on the company to defend the intercompany borrower’s decision not to refinance.

 

Flexibility Is Key in Revamped Transfer Pricing Policies

 

As companies plan transfer pricing policies for 2021, they should be thinking about whether their existing transfer pricing policies appropriately reflect current business structures while conforming to the arm 's-length standard—in terms of both pricing and behaviour.

 

Treasury and finance executives re-evaluating their approach to transfer pricing should also note that we are still in an era marked by uncertainty, due to the pandemic, the resulting financial downturn, and other geopolitical concerns including the impending transfer of power in the United States. This uncertainty is likely to extend through the coming year, if not beyond. Therefore, companies restructuring transfer pricing policies should prioritize flexibility and consider short-term policies that can be easily revisited as more information becomes available and/or further changes to the business take place.