Q&A: Effective transfer pricing strategies in the COVID-19 era
November 2020 | SPECIAL REPORT: CORPORATE TAX
Financier Worldwide Magazine
November 2020 Issue
FW discusses effective transfer pricing strategies in the COVID-19 era with Jian-Cheng Ku at DLA Piper and Nathaniel Carden at Skadden, Arps, Slate, Meagher & Flom LLP and Affiliates.
FW: To what extent has the COVID-19 pandemic affected companies’ tax plans? What shifts have you observed specifically in relation to transfer pricing (TP) policies?
Ku: One of the great challenges for companies resulting from the coronavirus (COVID-19) pandemic is improving their liquidity. This has led to an increasing focus of companies on reducing the tax cash-out and filing requests for the deferral of payment of taxes due. Many of the companies that have been adversely impacted by the COVID-19 pandemic have reconsidered their transfer pricing (TP) policies. In particular, group companies that are taxed on a cost-plus basis, while making commercially no profit, are reconsidering their TP policies. The change of TP policy is mainly aimed at aligning the outcome of the TP model with current economic conditions. Dutch tax authorities have not been blind to what is happening in the world; they are very willing to discuss the impact of COVID-19 on companies’ TP policies.
Carden: Most multinational enterprises (MNEs) have adopted a ‘wait and see’ approach to COVID-19 tax and TP issues. There is simply too much uncertainty regarding the timeline for full economic recovery, particularly given recent outbreaks in France and the UK, as well as ongoing spread in the US. Until the overall impact is clearer it will be very difficult to assess whether TP positions should change, both because there is little third-party information indicating a consistent approach to repricing contracts, exercising force majeure clauses or otherwise modifying commercial contracts to reflect COVID-19’s impact. Moreover, the performance of the equity markets would make it hard to say with confidence that there is third-party evidence of changed expectations, higher capital costs or other fundamental economic shifts that would suggest that a policy update is warranted.
FW: As a result of COVID-19, what key areas do companies need to actively manage and monitor from a TP perspective?
Carden: Because of the uncertainty surrounding COVID-19’s economic impact, it is critically important to evaluate how businesses are performing in various markets and understand the impact of this performance under current TP policies, on as close to a real-time basis as possible. We are seeing very rapid changes in sales and profit levels in certain markets and industries, such that there is volatility from one month to the next. Providing overall guidance on effective tax rates or the consequences of TP changes is very challenging under these conditions. One potentially beneficial approach is to evaluate options to test TP positions over a multiple year period, which can smooth out some of these effects.
Ku: Companies need to be aware that the COVID-19 pandemic has resulted in uncertainty for their existing TP policies. The outcome of existing TP models may not align with the factual allocation of functions, assets and risks within the group under the current economic conditions. For example, companies need to actively monitor implicit additional financial support within the group or a temporary relocation of business functions and assets may require an adjustment to their TP model. Another key area that companies need to actively monitor is that it may become more difficult to find appropriate comparables for the pricing of intercompany loans and transactions as determining the standalone creditworthiness of loss-making group companies is a challenging exercise. Finally, companies need to actively manage their relationship with the tax authorities, as tax authorities typically adopt a reserved approach to accepting a change of TP policy resulting in a reduction of reported profit margins in their jurisdiction.
“Modelling, benchmarking and documentation are always important to both building and sustaining a consistent overall approach to global TP, and that fact has not been changed by COVID-19.”
FW: Is there a danger that there will be insufficient resources to maintain existing TP policies?
Ku: Current economic conditions will differ strongly from the economic conditions at the time most existing TP policies were established. Consequently, current TP policies can result in outcomes not in line with the commercial position of a company. This may lead to insufficient resources being available to maintain existing TP policies as the reported profit margins exceed the available free cash flow. Companies are re-examining their TP policies to align the TP outcome with the financial position of the company to avoid insufficient resources to pay their due taxes.
Carden: In all but a few industries, there will ultimately be no COVID-19-related reason for major changes to TP policies. While the overall global decline in sales and corporate profits has obviously been substantial, in our experience it has been fairly widespread, meaning that most MNEs are facing moderate decline, rather than a few MNEs facing severe declines. Of course, this is a very serious overall macroeconomic development, but from a TP perspective it is relatively easy for an MNE to manage – residual profit earners will bear these losses, or as seems to be more typical, simply earn less profits. However, in those industries where the impact of COVID-19 has been severe, such as travel-related sectors, tax departments will be asked to do a great deal with very limited resources.
FW: How important are modelling, benchmarking and documentation to an effective TP strategy?
Carden: Modelling, benchmarking and documentation are always important to both building and sustaining a consistent overall approach to global TP, and that fact has not been changed by COVID-19. Of the three, modelling is the one most impacted by the global pandemic, since changes in national economic conditions are occurring very quickly and many companies are facing far more volatility than what they traditionally have been required to manage. As a result, it is important to be well positioned to model changes.
Ku: As TP discussions with tax authorities can have severe ramifications, it is key that companies document all stages of their TP policy. By acting in this way, questions raised during a potential audit can be answered with reference to proper TP documentation. Furthermore, a TP policy is only acceptable insofar as a proper benchmark analysis has been performed and sufficiently documented. This is particularly important as in most jurisdictions there is a shift of burden in proof in case the taxpayer does not have sufficient TP documentation on file.
FW: What steps can companies take to properly track changes in business performance and related tax, that are genuinely attributable to COVID-19?
Ku: Companies must anticipate that in the future they will be required to explain to the tax authorities how lower profits or losses are attributable to the COVID-19 pandemic. This requires companies to perform an assessment in advance to forecast the impact of the COVID-19 pandemic on their business. The outcomes of the forecast can form the basis of the commercial rationale for changing TP policy. In this way, companies can substantiate the justification of the commercial reason for reporting a lower profit margin due to COVID-19.
Carden: For companies in many industries, properly tracking changes in business performance and related tax will be very challenging. Obviously, it is simple to make a quarter-over-quarter or year-over-year comparison and attribute the difference to COVID-19. That said, particularly as the economic effects of the pandemic continue with varying degrees of intensity, this will become less reliable as a way to isolate COVID-19 effects. However, with one important exception, we do not believe that most companies will ultimately find it critical to distinguish COVID-19 effects from other effects. For most industries, the economic effect of COVID-19 is widespread, but relatively moderate, meaning that profitability is down, even to the level of slight losses, but catastrophic results are comparatively rare except in certain heavily impacted sectors. Hence, it seems likely that group profits will fall, entities earning residual profits will have significant reductions to their local profitability, and comparables used in TP studies may also have lower overall returns. However, all these effects are manageable under most MNE TP policies, so segregating the effects of COVID-19 is unlikely to be critical. The one exception to this relates to employee locations. Tax authorities have, thus far, generally expressed a willingness to be flexible with respect to the tax treaty and TP consequences of employees who are forced to work remotely because of COVID-19. We would strongly recommend that if an MNE has significant cross-border employee location disruption due to COVID-19, it carefully documents its policies and any exceptions with respect to remote work.
“Companies need to demonstrate that the exceptional economic conditions, which were unforeseen at the time of determining their TP policy, will lead to undesired results when maintaining the current TP policy.”
FW: To satisfy a potential future tax authority investigation, how should adversely affected companies demonstrate their commercial rationale for TP planning decisions made during the pandemic?
Carden: Significant changes to TP policies that are predicated on COVID-19 need to be carefully thought through and documented. For companies in heavily impacted industries, some changes may be appropriate and obvious. However, for many companies it is not yet clear that COVID-19 will be a genuinely extraordinary event rather than just a bad year. However, a number of companies are responding to COVID-19 by reassessing their supply chains and reducing dependence on a single country as a source of supply. Those changes provide a clear rationale for reassessing TP policies.
Ku: Companies need to demonstrate that the exceptional economic conditions, which were unforeseen at the time of determining their TP policy, will lead to undesired results when maintaining the current TP policy. Assessing the undesired results needs to take place in time to avoid as much as possible carrying out adjustments after the undesired results have occurred – in some jurisdictions a true-up/down is still seen as a red flag. The allocation of losses between group companies needs to be justified on the basis of how third parties would have acted in similar conditions. Proper documentation of the economic conditions and performed assessment is key to satisfying potential future audits.
FW: Given the fluid state of COVID-19, what essential advice would you offer to companies on defending TP strategies and decisions made during the crisis? Are current TP strategies likely to be contested by tax authorities once the pandemic ultimately passes?
Ku: Companies need to keep in mind that the attitude and leniency provided by the tax authorities during the crisis may differ from the position of the tax authorities in a few years from now. Tax authorities may judge, with the benefit of hindsight, current actions over time differently than now in the heat of the COVID-19 pandemic. Companies should also take issued guidance by the tax authorities into consideration when changing their TP policy. Furthermore, consistency of adjustments made on both sides of the transactions is key. Finally, companies need to sufficiently document their policies and performed analyses to explain the reasons why the decisions as made, were justified.
Carden: Companies must stay the course. It is far too early to reliably assess the impact of COVID-19, particularly because it is not yet clear how quickly economic activity will return to normal levels. At a high level, updating TP to reflect genuine operational changes arising from COVID-19, such as moving to a more localised or diffused sourcing model, is sensible, as well as easy to defend. Companies making changes solely as a result of not meeting profit expectations may find themselves facing significant pressure on audit. Consequently, we would caution against making any rash decisions that may, in hindsight, appear to be motivated by an unwillingness to follow ex ante allocations of risk when actual results do not meet expectations.
Jian-Cheng Ku advises on international tax law and transfer pricing with a particular focus on international tax planning, M&A and private equity transactions, corporate reorganisations and planning and design of transfer pricing policies. His clients include multinational companies, financial institutions and private equity firms. He has co-authored several articles on international taxation and Dutch taxation aspects. He can be contacted on + 31 (0)20 5419 911 or by email: jian-cheng.ku@dlapiper.com.
Building on several years of experience as a management consultant with McKinsey & Co. and serving as a law clerk for The Honorable Diane P. Wood of the United States Court of Appeals for the Seventh Circuit, Nathaniel Carden specifically concentrates on the tax aspects of ongoing business operations. He works with corporate and other clients across many industries, with a particular focus on life science, healthcare and technology companies. He can be contacted on +1 (312) 407 0905 or by email: nate.carden@skadden.com.
© Financier Worldwide
THE PANELLISTS
DLA Piper
Skadden, Arps, Slate, Meagher & Flom LLP and Affiliates
Q&A: Effective transfer pricing strategies in the COVID-19 era
Equity compensation and transfer pricing – emerging cross-border issues
Cum-ex: a game of high-stakes musical chairs
Tax liability insurance in Europe: an effective solution for tax uncertainties
The partial employment schemes in the EU and in the UK