05/05/2020 The Covid-19 pandemic has caused states to close entire sectors of the economy for the first time. As the virus fuels economic crises around the world, serious questions have arisen over how transfer pricing policies of multinational companies will be affected.
Multinational companies (MNEs) must anticipate the effects of the crisis in order to effectively manage the associated risks as soon as possible. The importance of these risks could be reduced through a diagnosis of the situation and the preparation of substantiated documentation. In this context, MNEs should determine: whether it is relevant to change their transfer pricing policy in 2020; how to assess the consequences of the crisis on their comparable studies and the safe harbors that they use; and how to evaluate the impact on their advance pricing arrangements.
How should manufacturers, distributors and service providers with low risk be remunerated in 2020?
MNEs will likely have to review and modify their transfer pricing policies because of the economic crisis. Already, many of them have structured their transfer pricing policy around an entrepreneur and limited-risk entities. The latter have a guaranteed profit, while the entrepreneur gets the residual profit or loss. In this context :
- Manufacturers with limited risk which have been remunerated up to now on a cost-plus basis will have to put in place effective measures to monitor production costs and potentially assume losses if the MNE to which they belong to is in an overall loss situation.
- The level remuneration of distributors with limited risks which have been remunerated until now through a guaranteed operating margin could also be revised downwards depending on the 2020 result of their group.
- Head offices or corporate shared services centres that bear personnel or other costs may not be able to provide the usual services due to travel restrictions or containment measures. In addition, it will be difficult for companies which ordinarily receive these services to demonstrate to tax authorities the economic value of the services in question and their market price ("Benefit test"). Alternative approaches could be considered.
- MNEs may also have set up central procurement companies. As they are generally remunerated based on a commission on the purchases made, their profit should be mechanically reduced in the event of a decline of the MNEs’ turnover.
The remuneration to be granted to manufacturers, distributors and service providers with low risk will have to be re-evaluated on a case by case basis and properly documented in order to pass future transfer pricing audits.
How should restructuring costs be allocated?
Multinational companies whose 2020 financial aggregates will be strongly affected by the Covid-19 crisis, both in terms of turnover and results, could be required to restructure their supply chain and relocate some activities resulting in a reduction of activity or even the closure of manufacturing sites abroad.
These restructurings will affect the transfer pricing policies of multinational companies. As a result, MNEs will not only have to review the remuneration of the new supply chains but also organise the allocation of restructuring costs between their subsidiaries. In this context, it will be important to attribute restructuring and closure costs in accordance with the arm's length principle. In particular, compensation related to the rupture or renegotiation of intra-MNE contracts will have to be carefully examined, taking into account the existence of possible compensation clauses in existing contracts. This allocation of restructuring costs will have to be duly documented in order to be prepared for future transfer pricing audits.
How should intra-group financing be set in 2020?
As a result of the economic crisis, multinational companies will most certainly have to adapt their intra-MNE financing facilities. For example, certain parent companies may have to provide emergency financing to their subsidiaries and/or provide explicit guarantees on the bank loans of their subsidiaries. To finance supply chain restructuring and relocations, multinationals will also likely have to borrow.
In the current environment, the set up of a market interest rate to remunerate intra-group financing could become an even more complex exercise in the future. This could be the case in particular if market transactions become less frequent as a result of central bank intervention.
Moreover, to reflect the current financial situation, multinational enterprises may also be required to adjust the interest rates on their existing intra-MNE loans. In addition, the crisis is likely to have an impact on the credit ratings of multinational enterprises and/or their subsidiaries.
In this respect, if intra-MNE financing policies are established on the basis of historical credit ratings, the relevance of such a practice will have to be re-considered. In any case, the methods used to determine credit ratings when setting interest rates for loans and other intra-group financial transactions will have to be duly documented.
Finally, some macroeconomic factors could have a permanent negative impact on the price of market financing, for example, in the event of central bank intervention through the acquisition of existing debt or the subscription of new debt, or the injection of massive liquidity or the general credit market tightening.
In this changing environment, multinational enterprises will likely be required to change the level of interest charged on existing or new intra-group financing and may have to provide explicit parent company guarantees and/or cross-guarantees in order to reduce the future cost of financing their subsidiaries or of the MNE as a whole.
The financing options taken will also have to be well documented to pass upcoming transfer pricing audits. Thus intra-group financing is nowadays generally included in the scope of a tax audit.
Will royalties for brand licensing and other intellectual and technical property have to be reduced in 2020?
As many multinational companies are likely to experience a reduction in turnover in 2020, it is highly probable that the level of their royalties will be reduced automatically since the basis for calculating royalties is generally based on turnover. In addition, MNEs may consider reducing their royalty rate(s) in 2020. Finally, due to the crisis, licensees of intra-group license of the right to use trademarks or more generally intangible assets may request to their licensor a temporary suspension of the royalty payments. Such suspension could be granted by the licensor on the condition that it can demonstrate that such measures exist between independent companies and that they constitute a normal act of management.
Is it appropriate to opt for a profit and loss sharing method in 2020?
For those MNEs whose transfer pricing policy is usually based on the use of the Net Transaction Margin Method (NTMM or TNMM), it may be appropriate to change transfer pricing methods in 2020. Thus, some of them could decide to suspend the application of the TNMM method under conditions to be defined by the subsidiaries in order to allocate the MNE's overall losses appropriately. MNEs are again advised to document properly any changes in transfer pricing policies in order to pass future transfer pricing audits.
What will be the impact on benchmark studies?
Regardless of the method used to determine an arm's length price, its confirmation requires a comparison with a transaction or result realised by an independent company (the comparables). This confirmation of transfer prices by reference to independent comparables will have to consider the effects of the economic Covid-19 crisis.
In order to validate that a current or a future transfer price is set in accordance with the arm's length principle, a search and selection of comparable companies whose financial data is most often available on databases with a time lag of one year is generally carried out. In an economic crisis context, companies are therefore facing the difficulty of having to validate the level of their transfer prices by reference to comparable data that does not consider the impact of the crisis. As a result, comparability studies carried out in 2020 may not reflect current economic conditions and so prevent the setting of a fair arm's length price for future transactions. The fact that tested parties and comparable companies can react differently during the Covid-19 crisis, particularly in terms of demand and sales, could also compromise the reliability of TP methods.
As a consequence, benchmarking strategies may need to be revised by targeting subsets of comparables that are closer to the tested party (both in terms of sensitivity to an economic downturn, as well as general characteristics and timing). These subsets can be arrived at by refining existing comparable companies’ sets, by eliminating companies that did not face similar adverse economic conditions or that do not have sufficient financial data. MNEs should also consider broadening search criteria to include companies with similar sales declines by removing certain screening criteria that would allow for the identification of comparables experiencing financial distress (i.e., bankruptcy or operating losses).
Moreover, MNEs should apply certain screens to ensure that highly profitable comparables that are not impacted by the economic crisis are not included in the comparables sets. In addition, the use of a multiple-year approach might not be suitable any more for generating reliable comparables in all cases.
MNEs and tax administrations may evaluate whether the use of a year-by-year approach could better to capture the effect of events causing dramatic changes in the market in a given year. There are instances, however, in which the use of multiple-year averages or pooled financial results for years in which comparables suffered from similar economic conditions (whether or not sequential/concurrent) could help to develop a more reliable range.
Again, MNEs will have to adjust their benchmarking approaches in 2020 and will have to be able to justify these changes when they are subject to a tax audit of the year 2020. That is why before taking actions, MNEs should consider performing financial simulations using their best forecasts of 2020 in order to figure out the required adjustments.
In addition, MNEs will need to analyze the gap between their fixed costs and the turnover decline during the crisis in order to determine any adjustments that need to be made.
Finally, MNEs may consider making adjustments in 2021 on the basis of comparable studies covering the financial year 2020. Considering the complexity of taking into account the impact of the economic crisis when conducting comparable searches, we recommend to MNEs to contact transfer pricing experts.
What will be the impact on Safe Harbors used by MNEs?
Some countries have adopted Safe Harbor rules. These rules generally allow smaller companies / or less complex transactions to follow simpler rules for setting their transfer prices i.e. The Safe Harbors.
The advantages and limitations of these Safe Harbors will have to be analyzed in the context of the Covid-19 epidemic. MNEs will have to determine whether it remains advantageous for them to continue to use the Safe Harbor rules or not.
Finally, as Safe Harbor rules vary from country to country, multinational enterprises will need to keep abreast of legislative and regulatory developments relating to Safe Harbors in the States where they operate.
Should MNEs proactively contact the competent authorities for APAs ?
Because of the economic impact of the crisis on the financial results of taxpayers, the said impact on APAs already in force, new APAs or those under negotiation will have to be carefully examined by the MNEs concerned.
Taxpayers may have concluded APAs covering more than one fiscal year allowing them to have legal certainty of a legislative nature (Article L 80 B-7 of the tax procedure book) avoiding any questioning of the transfer pricing methodology if the terms of the agreement are respected.
However, the transfer pricing method covered by the agreement may need to be adjusted or modified in the event of the occurrence of circumstances that alter the terms of the agreement, such as the existence of an economic recession such as the one linked to Covid-19. In this case, the French tax authorities' doctrine provides that the agreement will be amended by mutual agreement between the parties or suspended from the date of occurrence of the event.
According to this doctrine, companies and competent authorities will be able to renegotiate their prior agreements in order to consider the impact of the economic crisis related to Covid-19 and to provide legal certainty on a potential new transfer pricing method.
Under these circumstances, it is recommended that companies contact the competent authorities to discuss with them how the impact of the economic crisis can be considered in their APAs.
Adapting on a case-by-case basis
In 2020, the Covid-19 epidemic will require multinational companies to adapt their transfer pricing policies on a case-by-case basis.
MNEs will also need to adapt their approaches to comparable studies.
MNEs will also have to reassess the benefits of the Safe Harbors that they apply.
Finally, they will have to determine whether they need to contact the competent authorities regarding their APAs. In this evolving context, it is important for MNEs to document in real time the changes introduced in 2020 through different elements - through e-mail correspondence, minutes/presentations of the board of directors, reports and more.