In a situation as extraordinary as the state of alarm due to the COVID-19, which socio-economic consequences are still to be defined, economic actors are being significantly disrupted, which will result in a deterioration in business performance that will force multinational groups to, at least, review their transfer pricing policies.
For the companies most affected by the consequences of the coronavirus crisis, it is crucial to review their transfer pricing policies to determine whether the assumptions that were taken into consideration when establishing such policies are still valid in this situation. This review should be carried out taking into account the fundamental premise of the arm’s length principle, what would independent parties do or could do in similar circumstances? At a later point in time, the issue of how to justify transfer pricing policies in the relevant documentation should be addressed.
One of the starting assumptions of transfer pricing is the going-concern by which entities with a business nature aim to endure over time and to do so need to make a profit. Transfer pricing policies determine how functions, assets and risks are remunerated, via price or margin, between entities throughout the group's value chain. But what if there is no benefit to be shared?
The price or margin to which related parties transfer goods or services must be the result of a comparability and economic analysis, taking into account the characteristics of the transaction and the economic circumstances in which it is carried out. But in the face of the exceptionality of the current situation, is the pre-crisis comparability analysis valid or should it be adjusted?
If it remains valid, transfer pricing policies during and after the crisis will adequately gather the distribution of profit (or loss) between related parties based on their functional and risk profile.
On the other hand, if transfer price policies lead to economically irrational results, contrary to what independent parties would be expected to do in similar circumstances, comparability analysis and thus related party transactions should be reviewed.
Imagine a distributor who only buys products from the group and its profit comes through a "standard" margin on their sales. Due to the economic downturn, its level of sales as a result of the crisis may not be enough to cover its fixed costs: To what extent should it be compensated by the group's parent company? Should it continue to purchase products from the group's manufacturing entities that continue to produce even if it cannot sell them? Are there any clauses in the contract (if any) that restrict the behavior of the parties?
Although the current situation is novel, we have also experienced a deep slowdown in the economy by previous crises or a substantial change in economic conditions in certain sectors. The actions that were implemented in these situations and the measures envisaged in the risk management systems serve as a guide to the current situation, despite its obvious uniqueness.
In order to carry out an adequate risk management derived from the coronavirus crisis by multinational groups from a transfer price perspective, some relevant questions arise that need to be asked in this scenario:
- Is there an appropriate risk characterization profile throughout the value chain into the group? The current OECD Guidelines on Transfer Pricing (July 2017 version) place control and management of risks as a key factor in determining the potential benefit or loss that each party must assume for each economically significant risk.
- Do the contractual relations between related parties set out appropriate clauses for these circumstances and can they be modified if transfer pricing policies need to be adjusted?
- If the transfer pricing policy consists of a fixed margin on the costs incurred, does it make sense to continue applying this policy in the same way? What costs were considered in the implementation of the policy?
- Should the intragroup funding scheme be reviewed? Who has access to the Group's treasury in cash pooling systems?
- In highly integrated models with policies based on profit split, are losses adequately distributed following the same scheme?
- With regard to intra-group services, does the very existence of the service make sense in times of crisis? In centralized services, should entities that have paralyzed their activities be included as beneficiaries?
- If there is an Advance Pricing Arrangement (APA) in place with the tax authorities and since these arrangements are usually based on the assumption of profits, is it still valid and does it need to be renegotiated?
There is no single answer to each of these questions and it will vary case-by-case. Subsequently, the following possible actions should be considered:
- Adjust transfer pricing policies to the current situation;
- Perform business restructurings;
- Determine an appropriate transfer pricing policy for the post-crisis period;
- Initiate negotiation and renegotiation of Advance Pricing Arrangements (APA);
- Perform risk and defensive analysis; and
- Determine an appropriate documentation strategy for the post-crisis scenario.
The effects of the current situation in the medium to long term are still unknown, but it does their existence, though not their extent and depth. Reviewing transfer pricing policies through appropriate actions may allow multinational groups to mitigate their impact or at least not be aggravated by inappropriate transfer pricing policies.
The actions to be taken in the face of the coronavirus crisis we are experiencing must be proportionate to the challenges posed. At BDO we are developing such projects for the sectors most hit by the current situation, such as the hotel sector, convenience stores in airports, luxury; among others that are being heavily affected, although there will be much sectors that will be affected in one way or another.