Article by Regan van Rooy
Many multinational groups are currently faced with serious challenges due to COVID-19, but have you considered the transfer pricing (TP) impact on your business? We highlight below some key TP considerations linked to these volatile times.
New intercompany debt and treasury functions
Since the Covid-19 economic crisis, speculative grade financing has largely dried up, which results in much intercompany debt now being below investment grade. Consequently, from a debt capacity perspective, it could be more difficult to justify intercompany loans. If intercompany interest rates are set on the basis of a benchmarking study, it may now be difficult to successfully defend these interest rates, if these rates are not linked to rates also being impacted by Covid-19, e.g. the base lending/prime/repo rates in respect of the specific currency. Benchmarking studies are reflective of longer term averages and therefore do not necessarily cover the current position. If adjustments to interest rates, payment terms etc are considered, it is important to keep the transfer pricing considerations in mind. If intercompany agreements do not provide for adjustments to payment schedules or skipping interest payments, loans may have to be restructured, but should still reflect arm’s length behaviour under these extraordinary circumstances. Consequently, the lender should not be made worse off, unless it can be shown that a third-party lender would have accepted the change.
Contract renegotiation and Force Majeure
Many businesses are currently invoking ‘force majeure’ or similar clauses to terminate, modify or renegotiate agreements, both between third parties and between connected entities. The renegotiation of connected party agreements would clearly have a TP impact, but so too would changes to any third party agreements which were referred to as benchmarking or as reflecting open-market terms. Generally, the first step is to consider whether the current agreement provides for modification, termination etc. At a minimum, it is likely to envisage that a deferral, reduction, exemption of intercompany payments is likely to occur. The best option would depend on the extent of the circumstances and the extent of support available regarding the arm’s length nature of these changes. It is crucial that an analysis is kept at hand and also included in the relevant transfer pricing documentation which weighs up the options available, the pros and cons and the reasons for selecting a chosen method as the best option realistically available. The perspective of both parties should be kept in mind.
Furthermore, it is important to determine the extent of renegotiations and what consideration parties would expect to achieve. The OECD Guidelines state that not all modifications/ terminations would require consideration, this would rather depend on the circumstances and application of the arm’s length principle taking into account the terms and conditions of the current agreements: “For instance, a manufacturing agreement which guarantees that the manufacturer will achieve a minimum return for a certain term – in terms of such an agreement, early termination or modification would entitle the manufacturer to consideration.”
Once changes are made to the agreement, the TP Guidelines require that the agreements be updated and the changes be reflected in the transfer pricing supporting documentation. For instance, if a royalty payable by a full risk distributor is terminated, the risk profile of the distributor may change and this change would have to be reflected in the transfer pricing documentation.
In any case, taxpayers should carefully document the considerations taken into account and current circumstances when making changes to any intercompany arrangements, and maintain detailed support as to the reasons for the change as well as why it is argued that unrelated parties would have done the same.
Routine / limited risk entities
In a multinational group, some entities, performing routine functions, are entitled to routine profits to achieve a certain target margin. Given the depth of the expected recession it should be considered whether this routine margin is still applicable. As changes to transfer pricing methods have long-term consequences, careful consideration is required to determine whether a change in methods is required. The OECD Guidelines state that routine entities, under normal circumstances, should not make losses and certainly not long-term losses. However, it is clear, that we are currently not operating under normal circumstances, and many independent third parties (which could be argued to be comparable to routine or limited risk entities) are currently also loss-making. Consequently, adjustments may be required either to the transfer pricing method or the margin achieved. An analysis and documentation of the adjustments made would also be required to successfully defend any adjustments to the margins earned by routine entities in future audits.
Other considerations include:
- Intra-group goods could potentially be sold at cost to reduce duties and potential losses for distributors. This would however need to be commercially justified and adjustments would have to be made before year end.
- Additional head office services may be provided at this time, e.g. to ensure businesses have sufficient cash to operate, perform crisis management functions, supply chain functions etc. Subsidiaries may have to be charged for these services, and the shareholder service analysis should be considered.
The points above are high level only, please contact us if you would like to discuss the application to your business.