Reconsider Transfer Pricing in Response to COVID-19’s Impact

While companies take stock of the impact of COVID-19 on their financials, business models and supply chains, taxpayers may face tighter budgets for tax compliance and defense in general. From a transfer pricing perspective, companies may want to revisit their existing transfer pricing models to streamline and identify cost-effective solutions to manage their transfer pricing risks and compliance. During this global pandemic, transfer pricing areas to reconsider include:

• Transfer pricing policies for so called routine return entities that receive “guaranteed profits”
• Applying economic adjustments in calculating the 2020 intercompany amounts
• Ensuring robust transfer pricing documentation is in place to support deviations in policies

Revisiting Transfer Pricing Approaches

The global epidemic situation calls for reassessment of the existing transfer pricing approaches adopted by taxpayers in terms of functional analyses, econometric theories and methods, industry analyses, and comparability analyses. The frequently debated aspects in a comparability analysis during global turmoil involves reviewing the comparable companies selected, revisiting the screening techniques adopted and performing economic adjustments to factor in the impact of the global pandemic. Some examples include:

• Accepting loss-making companies in the comparable sets
• Applying financial ratios to the results of the comparable companies to align with the tested party’s increased expense ratios (e.g., fixed costs/general and administrative costs to total costs)
• Potentially adopting a loss-split approach, bearing in mind the potential challenges by taxing authorities
• Adjusting tested-party financial results to carve out certain extraordinary expenses incurred due to the global pandemic
• Using regression analysis to make adjustments to comparables financials to estimate the effect of change in sales on the change in return on total costs for the manufacturing comparables, and the effect of change in sales on the change in return on sales for the distribution comparables. Other comparability adjustments can be made for differences related to inventory, working capital and excess capacity as a result of the impact to business operations caused by COVID-19.

The United States and OECD transfer pricing guidelines emphasize the need for making reliable economic adjustments to account for differences in economic circumstances so that a comparability analysis can adhere more closely to the arm's-length principle. The U.S. and OECD guidelines allow using established statistical and econometric techniques for making appropriate economic adjustments. The crucial evaluation points before making such adjustments are determining the nature of adjustments, in-depth search for reliable comparable data to determine the crisis impact, determining the adjustment amount and documenting the rationale that supports such economic adjustments.

Transfer Pricing Documentation

During a challenging time in the economy, it is almost necessary to provide more-than-enough documentation to support the potential losses and additional expenses in the tax structure of a multinational enterprise (MNE). Tax authorities will scrutinize intercompany payments more aggressively since local governments want to recover as much tax revenue as they can. In addition, waiting for tax authorities to present their position could result in an unfavorable adjustment, steep penalties or time-consuming litigation. That being said, taking a proactive approach to documentation is extremely important as it will demonstrate the severity the taxpayer has taken to support the losses/expenses in the tax structure and it will give the taxpayer a greater chance if a tax audit were to arise, which could occur years later.

Having in place robust and contemporaneous documentation ensures that taxpayers have considered the local transfer pricing requirements, provides tax administrations with information necessary to conduct an informed transfer pricing risk assessment, and provides tax administrations with useful information to employ in conducting an appropriate, thorough audit. Especially during a downturn in the economy, taxpayers need to explain why the losses in the tax structure reflect arm’s length transactions based on the functions, assets and risks assumed by each related party. The documentation requirements may be different between jurisdictions, and more explanation is recommended to describe the “before, during, and after” of an economic downturn.