Uncertainty is something all businesses will grapple with today and into the future now that COVID-19 has changed the rules of the game.
This uncertainty is multiplied for multinational organisations as they juggle the market impacts across several jurisdictions. Historically, multinationals relied on transfer pricing policies to provide clear direction for their dealings in other countries. Today, different governments’ responses to the pandemic means that operating and managing multinational organisations is more challenging than ever.
A multinational organisation’s functions, assets and risks underpin all transfer pricing policies. Now that we’re starting to see the pandemic’s true impact on these businesses, the likelihood that current (and longstanding) transfer pricing policies are still fit for purpose is questionable. During previous major market disruptions like the global financial crisis for example, the common response captured in these policies has been simply revising margins or profitability to reflect a down-turn in group profitability.
However, COVID-19 has not only caused recessions, it has shaken up supply chains, and in many industries, affected employees’ ability to work efficiently which has ground business operations to a very painful halt.
In some cases, this has meant common inter-company agreements and transfer pricing policies create unnecessary financial burdens for multinational groups. Here are some of the common transfer pricing challenges that we’re seeing.
Entities being guaranteed reimbursement of costs plus a margin
This margin ensures an entity achieves an arm’s-length profit for performing straight forward functions and bearing minimal risk. During this pandemic, we have seen entities’ costs significantly increase or remain constant, and efficiency significantly drop away due to either being shut down or needing to find other ways of operating. Without applying significant adjustments to the transfer pricing policy, a distorted level of profit is derived by the entity when the wider organisation is possibly in a loss position.
Organisational structures which involve intra-group fixed sales-based royalties
These arrangements generally involve an entity paying a royalty and retaining the residual profit (essentially operating as an entrepreneur). If this entity derives losses due to significant market disruption, then whether a royalty should be paid becomes questionable. Formal intercompany agreements may force these payments to be made, leaving the organisation and group incurring unnecessary losses.
Use of historic benchmarking to determine an appropriate level of profit
Pre-COVID-19, it was common to use comparable entities or transactions to benchmark arm’s-length pricing or returns for an entity of a multinational group. In today’s environment, historical comparisons could be redundant if an entity being tested has been significantly impacted by COVID-19.
These examples resemble square pegs now being inexplicably forced into round holes.
The pandemic has impacted every industry differently. In some sectors we are seeing reductions in revenue, extraordinary costs and adverse profit outcomes. In others, the impact has been relatively minor or possibly positive. But for multinational organisations, the transfer pricing issues arising are wide-ranging with no cookie cutter fix.
It’s now mission-critical to have transfer pricing policies in place that consider our new business landscape, altered functions, different ways assets are being utilised and the actual risks organisations are exposed to.
Tax authorities around the globe will now be asking how COVID-19 has impacted an organisation and whether the taxpayer can sufficiently evidence support for tax positions which involve cross border related party transactions.
If explained with appropriate supporting evidence, tax authorities should not require taxpayers to produce results consistent with an out-of-date historic policies or benchmarking. In fact, trying to force square pegs into round holes could increase the risk of a tax authority transfer pricing audit.
New Zealand’s standpoint
Inland Revenue has confirmed that transactions must continue to be conducted in accordance with the arm’s-length principle. While they have acknowledged that there may be practical issues in doing so, an organisation must do everything in its power to continue to apply it. Inland Revenue has also outlined that the impacts of COVID-19 should be included within transfer pricing documentation, such as:
- evidence of the nature, duration and extent COVID-19 related impacts have had on the organisation as a group globally and locally
- the group’s global and local responses to mitigate the impact of COVID-19
- changes in functions, assets and risks including exposure and mitigation
- changes in intra-group transactions and contractual terms
- rationale for any changes
- the impact on overall organisation profitability.
The onus is now on every multinational organisation to not only continuously measure the impact the pandemic has had and will continue to have on their organisation, but to also keep on top of their transfer pricing policies and ensure that their finance teams are explicitly aware of updates and changes.
Transfer pricing documentation has become more important than ever. All policies need to be reviewed in the context of whether they will stand up to Inland Revenue’s scrutiny.
If reviews are conducted and transfer pricing policies are updated to reflect the impact of COVID-19, then at least multinationals can claw back some level of certainty around cross border related party dealings.