TP amid COVID-19: assessment and ramifications for MNEs

August 2020  |  FEATURE  |  CORPORATE TAX

Financier Worldwide Magazine

August 2020 Issue

Tax systems, in common with many corporate processes and procedures, are currently under pressure due to the global impact of coronavirus (COVID-19), with the transfer pricing (TP) planning of multinational enterprises (MNEs) being a case in point.

“Quarantine requirements may have temporarily disintegrated the modus operandi of MNEs,” says Gaurav Jain, a director at Walker Chandiok & Associates. “However, with the eventual phaseout of the global lockdown, the inevitable need to realign and reframe intragroup policies from a tax standpoint cannot be sidelined.”

In ‘Transfer pricing issues arising from the COVID-19 pandemic’, Walker Chandiok & Associates highlights five key areas that MNEs need to focus on in the current environment: (i) supply chain management; (ii) working capital management; (iii) the arm’s length principle; (iv) reconsidering operating costs; and (v) changes in tax avoidance instruments.

“Most of the changes to MNE intragroup policies will likely be justifiable in the short term, given the present situation,” believes Priya Mani Bhutani, an associate director at Walker Chandiok & Associates. “However, the persuasive value of these changes may be contested once the tax authorities regain constancy. Like MNEs facing cash flow problems, the mindset of tax authorities that scrutinise tax matters will be affected by the economy’s cashflow. Robust policymaking, even at this time when a clear picture has not emerged, is the only hope to contain the hard impacts of this pandemic.”

In the view of Nathaniel Carden, a partner at Skadden, Arps, Slate, Meagher & Flom LLP, the economic impact of COVID-19 is such that there will be insufficient systemwide profits to implement current TP policies. “Many MNE TP policies assume that business activity is profitable on a worldwide basis, or, at very least, that there is enough system income to provide a ‘routine return’ to functions performed by each MNE affiliate,” he explains. “Similarly, tax authorities challenging the allocation of income to affiliates in their jurisdiction assume an overall system profit from which such allocations can be made.

“For many MNEs, this would result in a mismatch of income and losses across jurisdictions, while countries supporting development, enhancement, maintenance, protection and exploitation (DEMPE)-based profit splits will have to contend with the logical implication of those positions – that they must accept losses during years when government revenue is needed,” he continues. “Moreover, the economic impact of COVID-19 may vary substantially across markets, meaning that MNEs may have to evaluate whether policies that ensure a limited or guaranteed return for local affiliates in certain markets remain appropriate.”

Manage and monitor

In the years ahead, adversely affected companies will be required to demonstrate their commercial rationale for TP planning decisions made during the pandemic – ultimately to show that low profits or losses were not the result of non-arm’s length TP policies. Therefore, it is prudent to model and document the impact of COVID-19 on operating results now in order to satisfy future tax authority investigations.

“At present, monitoring results is the most important task for most MNEs,” concurs Mr Carden. “It has been less than six months since the economic effects of COVID-19 were even beginning to become clear, so most companies simply do not yet know what the overall outcome will be. However, it is important to track changes in business performance that are genuinely attributable to COVID-19, rather than other factors. Moreover, it will be important to be able to differentiate between worldwide COVID-19 related impacts – those resulting from supply chain disruptions, as opposed to market-specific effects, where local policies limit economic activity.”

According to Mr Jain, it is necessary for MNEs to lay down TP policies that are not only commercially and economically viable but are also rationally substantiated. “Robust documentation to validate any change from the existing policies is mandatory and a crucial defence against tax litigation hardships,” he explains.

Impacts and implications

Given the fluid state of COVID-19, it would seem premature to draw any conclusions at this stage as to the implications of the pandemic on the TP landscape.

“It is far too early to reliably assess what the impact of COVID-19 will be, particularly because it is not yet clear how quickly economic activity will return to normal levels,” concurs Mr Carden. “While some companies are considering departures from existing TP policies based on an argument that COVID-19 should be treated as a force majeure or ‘act of God’ event, such judgments are premature.

“Over the long term, the effects of COVID-19 on TP will follow the effects on supply chains and global trade policies,” he concludes. “Governments in many countries, including the US, are facing political pressure to increase domestic production of economically essential items. Moreover, the initial emergence of COVID-19 in China demonstrated the vulnerability of some MNEs’ supply chains to local or regional disruption.”

While it is difficult to predict the eventual business and economic impact of COVID-19, for all businesses – MNEs and otherwise – there is a critical need to ensure day-to-day operations continue as ‘normally’ as possible – to both minimise disruption in the short term and, ultimately, negate the more serious implications of COVID-19.

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Fraser Tennant