ACCOUNTING & TAXATION
COVID-19 enhancing the Transfer Pricing Risk
The Coronavirus (‘COVID-19’) pandemic has already caused major health crisis in almost entire world and has led to disruption of the global economy. The situation has resulted in economic slowdown and is likely to get worse in coming time. The International Monetary Fund (‘IMF’) has stated that the global economy has already entered into a recession that could be worse than the one caused by the financial crisis of 2008-2009. It has already become clear that the COVID-19 pandemic has resulted in a huge shock in supply and demand throughout global industries, inevitably having a far-reaching economic impact.
This article addresses some key Transfer Pricing (‘TP’) challenges which may emerge as a result of such crisis and how it can be proactively managed.
During economic slowdown, many companies experience huge decline in turnover and capacity utilization which leads to profit erosion. There may be a situation wherein some potential comparable are not affected in the same way as the taxpayer or the up-to-date results for comparable are not yet available. Broadly, the two challenges faced by the companies are:
- Ensuring that comparable data are correct in terms of both comparability and reflecting true economic realty; and
- What approach to be followed if profitability of the company is lower than the Arm’s Length Range or such range is negative?
The companies are devising contingency plans to counter such impact which may result in changing functions and risk across the organization which directly affects the Transfer Pricing analysis. Since reward is directly linked to the risk, risk are assumed to earn higher rewards. However, a challenge arises in situation of a loss resulting out of economic downturn wherein no entity would like to assume risk. This possess additional challenges to the Group wherein TP Policies has been settled on the basis of allocation of profits.
The proactive approach to manage the Transfer Pricing Risk arising out of COVID-19 would be primarily to access the impact of COVID-19 on the Group Companies and rework the financial forecasts. Further, all the Inter-Company Agreements and Advance Pricing Agreements needs to be reviewed in view of the present situation. The helpful steps may be:
Revisiting the Transfer Pricing Models
The Group companies shall redraft their existing TP models in view of the economic downturn. In case of a group company providing shared services to the other group entities and have already incurred personnel or other associated costs may not be able to provide their services due to many constraints like lockdown, travel restrictions etc. In this case, apportion of cost to group entities would become challenge since such intra-group services would fail to pass the benefit test. In such cases, these cost may be treated as Shareholder Cost and may be allocated to a level which can be justified through benefit test. The royalty paying group entities shall be given Royalty-Free period if they forecast to make losses.
Advance Pricing Agreements (‘APA’)
All the existing APAs should be re-examined and new ones should be re-considered due to the impact of the COVID-19 on the Group. APA provides certainty on agreed transfer price or profit margin for multiple years, as long as critical assumptions are met. The critical assumptions are agreed by taxpayers and tax administrations, which in case are not met, allows them to reconsider the APA. If, due to the COVID-19 or otherwise, the agreed critical assumptions are no longer met, the APA would get terminated. As an alternative, taxpayers and tax administrations might renegotiate the APA.
Steps can be taken to eliminate companies which are not affected by COVID-19 by comparing the decline in sales of tested party and the comparable companies. Companies can also be screened based on Capacity Utilization. Since the analysis done is mainly based on past data, the effect of economic downturn may not be considered in the comparable data. Hence, it is suggested to use interim or forecasted data.
Further using multiple year data may not be appropriate since the last two-year data would not reflect the impact of COVID-19. This would further pose challenge in cases wherein present year data is not available before the date of filing of tax returns. Hence, it is recommended to use only present year data and reject multiple year data, if such option is available. In countries like India, wherein such option is not available, the Government may modify the rules allowing such option for the current year at least.
Lastly, for the better comparability, the financial data of the comparable can be adjusted to take into effect the current situation. For example, an adjustment based on median PLI differentials.
While transfer pricing is always subject to challenge, if proactive steps are taken, these risks can be managed. As COVID-19 continues to cause global economic downturn, it is important for the companies to take early actions on this. There are high chances of transfer pricing scrutiny during economic downturn, hence by taking early steps to consider the potential impact and revise their TP Policies accordingly, the companies will be better positioned to mitigate TP risks related to COVID-19.