Validation of the Transfer Pricing for the Pandemic Year

Coronavirus News, Fiscal News

The global pandemic generated by COVID-19 is not only having a brutal impact on human lives and convalescent patients, but the economic effects on employment levels, public and private debt, business profitability, etc., will be felt long after the vaccines make us forget the nightmare we are living through.

Multinational groups can prolong this nightmare during the statute-of-limitations period of the 2020 tax year if they do not take into consideration the economic effects of the pandemic on their transfer prices and their mandatory documentation before year end.

The validation of the transfer prices for the year 2020 will require an additional effort

The most important aspect is the justification for the tax losses or the sudden drop in profitability of individual group companies due to lockdowns, supply chain disruptions or lower revenues. Those groups planning this year-end closing as usual (eg., compare a subsidiary’s profitability ratio with a sample of “comparable companies”), will have an unpleasant surprise: the data of the comparables that will be available at year end and even for the preparation of the tax return will refer to years prior to the pandemic, and the economic models to adjust them require certain degree of subjectivity, and therefore may be rejected by the tax authorities. Consequently, the validation of the transfer prices for this year will require an additional effort from companies. We can mention the following key points:

  • Evaluate the economic impact of the pandemic on the economic activity at a global level and in the sector/country in which each group company operates.
  • Identify the specific issues that have impacted the accounts of each company: days of lockdown, drop in activity due to the pandemic, additional actions to maintain activity, etc.
  • Quantify the impact on the accounts of the additional costs incurred (re-establishment of activity, health measures, teleworking, etc.) and of “operational idleness”, i.e. the fixed structure costs associated to the difference between the normal level of activity and the level of activity in 2020.
  • Re-evaluate whether intra-group service charges or intra-group royalties can be maintained on the usual terms or require exceptional adjustments.
  • Assess whether operational measures to maintain or reassign activity have led to a shift in functions, assets and risks between group companies that qualifies as a business restructuring, and its tax consequences in terms of compensation of the restructured entity.
  • Review intra-group contracts to determine the allocation of these additional costs within the group, or whether such contracts should be “clarified” or modified in the light of the new circumstances.

This assessment of losses arising from the pandemic is absolutely essential in groups with low risk companies (limited risk distributors, contract/toll manufacturers) or with captive service companies (shared services centres, R&D centres), as the tax authorities could challenge the deduction of losses at these entities.

Extra effort in closing transfer pricing and preparing documentation

Another important aspect concerns loans to finance losses generated by COVID-19.  Many business groups are obtaining additional funding from markets or public institutions to finance the additional costs of the pandemic. This external financing is usually obtained by the group’s parent company and distributed through subsidiaries that need it through intra-group loans. In February the OECD added a new Chapter X on the transfer pricing aspects of financial transactions, which not only affects how interest rates on intra-group loans are calculated, but also all other conditions for internal financing, in particular the repayment capacity of the borrowing company. Business groups must take this new guidance into account when structuring their cash management for 2020 and for the coming years.

These and other issues will mean that the closing of transfer pricing and the preparation of supporting documentation will require an additional effort in 2020. In the most complex situations, prudence will recommend that such justification goes beyond the mandatory tax and transfer pricing documentation requirements and that defence files are prepared to support specific aspects or circumstances in detail.

The tax closing of the “annus horribilis” of the pandemic requires extraordinary work by multinational groups in their transfer pricing. But it is absolutely necessary to prevent the nightmare from being revived in the form of tax audits and long (and expensive) disputes with the tax authorities.

 

Claire Sanga

Managing Partner of Transfer Pricing Specialist (TPS)

clairesanga@international-tps.com

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