Over the last couple of years, the number of specific transfer pricing audits has risen sharply across the globe. For a number of different reasons, including government budget considerations, changing perceptions around international taxation transfer pricing combined with a changed attitude towards multinational enterprises in general the nature, underlying approaches and eventually the results of these audits have changed as well.
Controversy landscape - diverging interpretations of the arm’s length principle
Against a background of a continuously evolving regulatory framework, many of these audits can be characterized by a stark increase in diverging interpretations of the arm’s length principle. This can partially be explained by the level of regulatory change and the increased complexity around how to apply the arm’s length principle. Both governments and companies alike have not completely grasped all the nuances yet around the changes to the arm’s length principle that BEPS introduced. At the same time, many countries quickly came to the conclusion that BEPS was not sufficient and governments have shifted gear towards BEPS 2.0 and/or unilateral measures to make further changes to the tax framework. Although BEPS 2.0 still need to be finalized, some of the underlying concept already fuel current interpretations of the arm’s length principle. However, these diverging interpretations between countries also increasingly exist within countries whereby consistency between inbound and outbound perspectives is often lacking. One can ask whether or not the arm’s length principle has become too complex or even whether multinational enterprises are too exposed to more opportunistic interpretations of the arm’s length principle.
Changing audit approaches
In evaluating the outcomes of audits and resulting transfer pricing controversy cases there has been much more emphasis on the importance of people functions. This emphasis is very much consistent with the changes in the transfer pricing regulatory framework across the last decade. What has really changed is the focus on actual evidence that the functional contributions are indeed in line with what was described in intercompany contracts and transfer pricing documentation. Tax authorities started to focus more on reviewing internal communication, evidence of decision-making, alignment between managerial responsibilities and key performance indicators versus statutory results and other true business aspects either in traditional ways or through downloading information directly through access to a company’s IT systems. This focus on more detailed business aspects has contributed to diverging interpretations as well since the business facts and underlying transfer pricing conclusions are very much influenced by a more subjective judgement. However, another aspect that becomes clear when looking at these results is that in many cases, transfer pricing policies have not kept pace with the level of change in the regulatory environment. In many cases, the level of change within a company’s transfer pricing policy was (much) more limited as compared to how the approach to the arm’s length principle had evolved into. The introduction of BEPS arguably had a greater impact on the transfer pricing compliance approaches of multinational enterprises and certain aspects of their overall risk management approach instead of implementing specific changes to their transfer pricing policies.
Requirement to update and align transfer pricing policies
As part of an overall controversy strategy, the regular monitoring of transfer pricing policies should be a key priority. The evaluation of transfer pricing policies should be combined with a real willingness or preparedness to make actual changes to transfer pricing policies. In many cases, an assessment around the alignment with the current regulatory framework does entail the need for specific changes. Such changes may range from mere increases/decreases in license payments due to DEMPE alignment, acknowledgement of other non-routine contributions that require different remuneration levels or to even more fundamental changes to the choice/selection of transfer pricing methods. In certain cases the TNMM may not even be an option anymore. Also, global consistency has always been considered a key pillar of a company’s best practice approach to transfer pricing. Nonetheless, with a more prominent and fundamental divergence in approaches between the major Western economies versus many emerging economies a more tailored approach that accounts for such differences might be advisable.
Covid-19 - an unprecedented case that impacts transfer pricing policies
The Covid-19 outbreak had and continues to have an unprecedented impact on business. This outbreak and the subsequent governmental actions resulted in disruptions on the supply chain side and triggered a stark decline on the demand side in many different business sectors. This decline impacted both the business-to-business and business-to-consumer segments. Businesses were confronted with (immediate) challenges around liquidity and also both short term and long-term profitability consequences. The Covid-19 outbreak underscores why a status quo around a multinational enterprise’s transfer pricing policy is in many cases simply not an option. In assessing the regulatory framework, it is clear that this crisis has a profound impact on comparability factors that should be taken into account: economic circumstances, government actions and (responding) business strategies. In many cases, there is a direct correlation between the drop in demand and the government actions (e.g., lock-downs and actual store closures). Also, when comparing intercompany policies with actual third-party behaviour this unprecedented time highlights many disruptive changes between third parties. Most companies quickly experienced different/suspended payments terms, lease payment breaches, order cancellations, shortage/supply limits of raw materials and even complete contract cancellations/renegotiations and actual “force-majeure” cases. All this evidence of new third-party behaviour should one way or another be factored into transfer pricing policies. Time will tell whether this is a short-term or more structural long-term requirement.
Furthermore, the Covid 19 outbreak has triggered a level of “extraordinary costs” that were not foreseen in transfer pricing policies and/or specific elements pricing of adjustment mechanisms but need to be accounted for. Some price adjustment mechanisms have triggered immediate issues from a customs perspective due to the a very sharp reduction in intercompany prices to still meet target margins. Certain companies even faced examples whereby it was necessary to charge products below cost price in order to adhere to policies which triggers other challenges (like anti-dumping measures) that need to be resolved.
For many multinational enterprises across different industry segments, transfer pricing policies typically do not rely upon Comparable Uncontrolled Prices and potential CUP transactions are often easily dismissed a sufficiently comparable. The Covid-19 outbreak nonetheless does provide for a lot of (changed) third-party behavioural evidence that cannot be ignored in evaluating transfer pricing policies.
In many ways, the Covid-19 outbreak and resulting crisis is a harsh reminder that transfer pricing policies require regular evaluations and monitoring against an evolving regulatory landscape and actual business realities. In relation to the Covid-19 crisis, this triggers an opportunity to deal with both immediate business challenges and consider regulatory alignment simultaneously. On a more structural basis, it provides the foundation for being more prepared to deal with the on-going wave of transfer pricing audits and to pro-actively ensure a company’s transfer pricing practices has kept pace with the evolving interpretation of maintaining the arm’s length standard.