OECD

New Transfer Pricing Opportunities in the COVID Environment

September 23, 2020 by Frank Vari, JD. MTax, CPA

Frank J. Vari, JD, MTax, CPA

We have previously written on transfer pricing opportunities in the COVID environment and, as the COVID pandemic continues to impact global supply chains, and our multinational clients in our transfer pricing practice continue to reap economic benefits via proactive transfer pricing adjustments. Multinational taxpayers that fail to actively change existing supply chain transfer pricing strategies will meet upended treasury strategies where cash needs no longer match cash sources as well as simple tax inefficiencies that can be avoided. It is our belief that, as we wrote in April, there will continue to be transfer pricing opportunities in the COVID environment with international tax benefits as well.

Global transfer pricing strategies are traditionally built on multi-year models in normal operating times. It is not uncommon for these transfer pricing plans/policies to only be updated on an annual basis. None of these plans, or the economic models upon which they are built, were designed to proactively address a seismic supply chain event like the COVID pandemic. An existing and unmodified transfer pricing plan is now likely materially incorrect and almost instantly out of date. The question is then what can be done to modify, or create, a transfer pricing strategy that reflects current conditions as well as the opportunities these new strategies present.

Finance and tax professionals should perform a detailed review of the business operations to mitigate TP risks and identify the TP opportunities to help management deal with their cash and operational concerns.

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Best Practices For Transfer Pricing Planning

Successful tax strategies are always based on communication and knowledge of the taxpayer’s operating environment. That has never been truer than now as this is the most dynamic and fast moving international business environment in modern times. Supply chains are changing very rapidly including the reallocation of associated functions and risks. Tax professionals must keep track of these business changes in order to ensure that their transfer pricing reflects the new reality and that cash balances and tax bills don’t create problems for the group.

Functions and Risks

The cornerstone of any transfer pricing analysis is the functional analysis that describes the allocation of functions and risks across a global supply chain. Some functions and risks stand out as significantly impacted by the COVID environment. Those we see are:

Liquidity – This is the most critical factor for many clients as they struggle to balance global cash flows where financial markets are in turmoil, customer orders are imperiled due to global shutdowns, and operating costs rise across the world to meet new safety concerns.
Supply Disruptions – Traditional suppliers, internal and external, have been taken offline either by government mandate or workplace safety issues. Alternative suppliers have had to step in at much higher costs to ensure supply chains operate properly if at all.
Logistics – Global transportation networks have been placed under significant stress resulting in product shortages in end markets and backed up inventories in production facilities. This has resulted in new supply chains not contemplated by existing transfer pricing plans.
Services – Global service providers ranging from legal, HR, IT, and other areas have changed to meet a crisis environment. Services traditionally performed in house have been outsourced, or vice versa, resulting in significantly increased costs for global corporate services as well as new service providers.

The allocation of functions and risks supports the economic underpinnings of a multinational transfer pricing strategy and the related tax and treasury results.

Transfer Pricing Opportunities

The very first step is to review existing transfer pricing documentation to understand any differences in the current environment to those facts supporting the economic comparables in place. In addition to the documentation, any intercompany contracts agreements for sale of goods, services, or the use or development of intellectual property must be analyzed to understand if unusual or unforeseen risks such as COVID have been covered and how they should be allocated between participants.

One common fact we see changing is the location performing intercompany services. Government mandated lockdowns and other related factors are forcing these changes. As a result, the modification of intercompany services contracts must be performed immediately to ensure that documentation and compliance are maintained. This is but one example of the multiple changes impacting documentation.

Force Majeure Clauses

The documentation review discussed above must consider if each party is able to fulfill their contractual responsibilities under COVID or whether force majeure should be invoked to alleviate either party’s obligations during the pandemic. This would allow related parties to seek relief from payment of recurring charges such as management fees or royalties. An excellent way to support the arm’s length nature of an intercompany declaration of force majeure is to determine if force majeure provisions have already been invoked with third party suppliers or customers of within the taxpayer’s industry.

If there is no force majeure clause in the intercompany contract, alternative legal remedies or renegotiating contracts to deal with nonperformance issues or other extraordinary circumstances should be evaluated. Courts have accepted that renegotiating intercompany agreements is consistent with arm’s-length dealings which, when coupled with the existence of third party force majeure invocation within the industry, provides solid support. Further, the local tax authorities may understand that a contractual restructuring is a better option than going out of business altogether even if short term profitability is impacted.

Create COVID Specific Policies

In the short term, policies can be created to address major changes and disruptions. These changes are highly dependent on the operational nature of the business. They can range from credit protection to expanded compensation for headquarters or shared services. It is very important to note that any changes must remain arm’s length which places the burden on the taxpayer to monitor developments with third parties and within their industry to determine what allowances are taking place. .

If the operational changes appear to be longer term, there is likely a case for an overall supply chain restructure. Many reading this may ask what exactly this new supply chain will look like which is a greet question in the fog of crisis. However, proactive tax professionals will be looking for the first clearing in the fog to make immediate corrections to global supply chain agreements and economics.

Benchmarking Adjustments

It is probably obvious by now that the use of a multiple year approach may not be suitable for generating reliable comparables in the COVID environment. A global taxpayer should evaluate whether the use of a year-by-year approach could better capture the effect of dramatic changes in their markets. There are certainly cases where the use of multiple year averages for years where the taxpayer’s comparables suffered from similar economic conditions that could help to develop a more realistic range.

Another more practical approach may be to expanding the acceptable range of results beyond the current interquartile range. These changes must be assessed on a case-by-case basis and are very fact dependent and local country transfer pricing rules must be reviewed.

Government Relief Programs & Policies

We are now seeing a number of countries offering relief programs to support faltering economies and we expect to see more if indeed a second COVID wave develops. Multinational groups must very closely monitor any local country tax news to determine if relief is being provided in some shape or form to their global supply chain. It may seem like this goes without saying but we do see these programs or policies often being implemented without the tax team’s knowledge and, as such, they are failing to properly evaluate or take advantage of these often very favorable programs. Specific to transfer pricing, information releases at both the OECD and local country levels must be monitored closely.

Conclusion

As the COVID supply chain effects continue to evolve, we will continue to identify ways to ensure that transfer pricing policies support both tax and treasury goals. The thoughts and ideas presented here represent just a few of the strategies out there to ensure that goals are met. Because each strategy is fact specific, no single strategy applies to all. We encourage multinational taxpayers to stay tuned in this ever evolving environment and remember that the arm’s-length principle comes always comes down to the idea that independent enterprises must always consider the options realistically available to them especially in times of crisis.

Frank J. Vari, JD, MTax, CPA is the practice leader of FJV Tax which is a CPA firm specializing in complex international and U.S. tax planning. FJV Tax has offices in Wellesley and Boston. The author can be reached via email at frank.vari@fjvtax.com or telephone at 617-770-7286/800-685-2324. You can learn more about FJV Tax at fjvtax.com.

Global Tax Authorities Are Sharing Information – What’s Happening and How to Be Ready

November 6, 2018 by Frank Vari, JD. MTax, CPA

Frank J. Vari, JD, MTax, CPA

It was not that long ago that a multinational taxpayer could report information differently to one taxing authority than to another even within the same country without significant concern. How often did a value reported for customs and duties purposes match the transfer pricing value for income tax purposes? Probably not very often and what difference did it make? Back then, not very much difference. Now, it makes a huge difference.

What’s Changed in Information Sharing?

The road to where we are today has not been difficult to follow for those that have been actively involved in international tax for the last decade or so. Global tax authorities have been becoming considerably more aggressive for years and that is not a trend that shows any signs at all of abating. Tax authorities have long sought complete transparency in the taxpayer’s supply chain taxation both in the home country and elsewhere. It makes their job much easier and it forces multinational taxpayers to full disclosure of their global tax positions.

There have been many governmental bodies actively pushing these efforts for some time now but the three biggest, at least to U.S. taxpayers, have been the Organization for Economic Cooperation and Development (“OECD”), the EU, and the IRS. Our clients feel this most directly with their Base Erosion and Profit Shifting (“BEPS”) and Foreign Account Tax Compliance Act (“FATCA”) filing requirements.

For U.S. taxpayers, this means a sharing of not only information gleaned from their Form 1120, Forms 5471 and 5472, and customs and duty filings but also what they are reporting on similar non-U.S. filings. When you add government filed transfer pricing filings to all of this you can see how quickly a very significant database of highly confidential and valuable business and financial information can be created and shared.

The Impact of Electronic Filing

Most multinational taxpayers are slowly becoming attuned to the fact that what they are reporting to one country has a significant impact in other countries as well. What many are not sufficiently aware of is that their tax and financial information can now be quickly cross-referenced and shared among numerous governmental taxing authorities with the click of a button.

Electronic filings and sophisticated digital data collection methods allow tax authorities to reach deeper than they ever have before into the taxpayer’s supply chain data. Multinational taxpayers must electronically submit a variety of data that goes beyond tax records in formats specified by different tax authorities often within the same country, e.g., customs, duties, income tax, and VAT. All of these authorities now utilize sophisticated data analytics engines to discover filing discrepancies and compare data across jurisdictions and taxpayers. These governments then issue tax and audit assessments based on these analyses.

It is essential that multinational taxpayers understand the shift from a single country filing view to a global filing view. Tax filings simply have to be viewed as being globally transparent in terms of information sharing, comparative risks, and tax controversy strategy and resolution. Very little if anything is hidden and not shared.

The drivers behind this are numerous. Over 100 countries have signed onto the OECD’s Country-by-Country reporting initiative. The OECD’s Multilateral Convention to Implement Tax Treaty Related Measures to Prevent BEPS (“MLI”) desires to update over 3,000 double tax treaties to incorporate BEPS changes. It went into effect in July 2018 with 75 countries on board. The MLI requires a principal purpose test for a multinational taxpayer’s tax positions and creates a simplified limitation of benefits provision to curb treaty abuse. This means that tax treaty benefits will be denied when procuring a tax benefit was a principal purpose of a business arrangement.

The OECD is offering a new tool aimed at taxpayer certainly in this new environment. The OECD created International Compliance Assurance Program (“ICAP”) is a voluntary pilot program where, in return for transparency of their tax risks, taxpayers receive some assurance that they will not be targeted by governments participating in the program. In theory, a successful ICAP result provides multinational taxpayers more certainty and a reduced overall global tax risk profile. It is a program with promise but it is being rolled out as a pilot program only in the face of an ever more aggressive tax environment that is not a pilot program.

Tax Adviser Rules

One very significant change impacting practitioners both in the U.S. and worldwide is the EU’s recent update of the Directive on Administrative Cooperation (“DAC”). Under the new DAC rules, intermediaries such as tax advisers, accountants and lawyers that design, promote or implement tax planning strategies are required to report any potentially aggressive tax arrangements directly to the tax authorities. Very concerning , mainly due to the broad scope of definitions provided in these rules, is that reportable arrangements may include arrangements that do not necessarily have a main benefit of obtaining a tax advantage. These new mandatory disclosure rules will have material implications for both advisers and their clients.

According to the DAC, a “reportable cross-border arrangement” refers to any cross-border tax planning arrangement which bears one or more enumerated features listed in the DAC and concerns at least one EU Member State. The enumerated features are broadly scoped and represent certain typical features of tax planning arrangements which, according to the DAC, indicate possible tax avoidance. Certain transfer pricing arrangements must be reported even if they do not have a primary purpose or benefit of obtaining a tax advantage. This include arrangements that involve hard-to-value intangibles or a cross-border transfer of functions, risks, or physical property.

Creating A Global Tax Risk Strategy

Multinational taxpayers that are relying on traditional global compliance practices and reporting models will ultimately lose control of their own tax narrative. These antiquated – and now dangerous – practices feature single country income tax reporting that is not coordinated with operational tax reporting like excise taxes and customs reporting.

When one takes into account decentralized management teams, non-integrated mergers and acquisitions, and information systems that are not coordinated or unable to provide required information in a timely manner, one can see the true scale of the problem. Tax risk must be managed on a global basis. Local, or even regional, management is simply not sufficient.

As tax reporting becomes even more digitally interconnected, existing problems will only grow creating more economic and legal risks to international business strategies. What we are now experiencing has been long perceived and is the future of tax and financial reporting. There really is no getting around it.

Practical Strategies

We are often asked by our clients how to best manage this new global environment. We advise that multinational taxpayers strategically address these issues proactively on a global basis. The risk of not doing so is to hand over important financial data to numerous tax authorities without a clear understanding of how they’ll use it or how it will impact the taxpayer’s core business strategies.

There are steps that can be taken to minimize the impact of these new rules. in a consistent and strategic way will be better equipped to manage controversies as they arise. Specific steps businesses can take to adopt a more consistent global approach to tax controversy management include:

Centrally manage global tax filings to ensure consistency and understanding of what is being disclosed and where. This involves enhanced communication and processes between global reporting teams that may not have existed before. This is, in practice, a cultural shift in how global finance teams address tax matters.
Modify, update, or create information reporting systems that can timely comply with global reporting rules while still allowing time for appropriate tax leadership review prior to filing. Never has the need for information systems to be responsive to tax needs been higher. These systems must not only produce data but do so in a coordinated and strategic manner.
Design and implement a global policy relative to tax compliance, reporting, and response to tax authority inquiries. This policy must not only be nimble but it must fully comply with increasingly complex local rules.
Involve senior management, Board leadership, and even internal audit teams to create a corporate governance plan that complies with SOX requirements but also allows swift communication of tax related risks to strategic business plans and financial reports.
As an adviser/intermediary or taxpayer, understand when a transaction qualifies as a “reportable cross-border arrangement” under the DAC. Unless a legal professional privilege applies, disclosure is necessary. If multiple advisers are involved, each adviser must comply with the reporting obligation unless a report was filed by another adviser.

Even the most sophisticated taxpayers are having trouble keeping up with these new rules and requirements. It truly represents a cultural shift that has been long coming and shows no signs of abating. Only by maintaining awareness of new global reporting rules and creating strategies and processes to ensure both conformance and strategic awareness can economic risks be minimized and global business strategies preserved.