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 An existing and unmodified transfer pricing plan is now likely materially incorrect and almost instantly out of date.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.
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.
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.
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 firstname.lastname@example.org or telephone at 617-770-7286/800-685-2324. You can learn more about FJV Tax at fjvtax.com.