The outbreak of COVID-19 has led to a global healthcare crisis that is having ripple effects across the world economy. The actions taken by most governments to contain the spread of the virus resulted in an unprecedented disruption of global supply chains, a general decrease in the aggregated demand and a reduction in the supply capacity of most companies. Risk aversion has increased, and business and consumer confidence have dropped dramatically. All of this has heightened liquidity and credit constrains for many businesses.
MNEs have taken immediate mitigations measures and have put their focus on evaluating recovery strategies for their businesses. Recovery measures range from those required to address their businesses' shorter-term liquidity needs, to the ones that will bolster the resilience of their global supply chain. There is also a broader question about whether purchasing habits and global demand will shift permanently to more sustainable products, lower consumption and online products and services.
The aim of this article is to describe a number of transfer pricing considerations and opportunities that MNEs may consider when developing and implementing their sorter and longer-term recovery strategies. The article further discuses points of consideration for MNEs looking to adjust their intercompany arrangements and transfer pricing policies and highlights the importance of having robust documentation in place to ensure their proper and smooth implementation and avoid potential tax implications resulting thenceforth.
Financing and liquidity
While most governments worldwide are enforcing immediate measures to address businesses' liquidity and credit concerns resulting from the sudden demand shock, businesses are exploring options to generate or save cash in the short term, while making selective use of relief measures offered by various governments worldwide. The economic downturn has led MNEs to reassess their existing intercompany financing arrangements and to devise appropriate structures for cash and liquidity management.
Intercompany financing arrangements could be used by MNEs to deploy cash to the location where it is needed. Existing or new cash pool arrangements could serve as useful liquidity management tools in times of economic stress1. Cash pooling practices enable group companies to make efficient use of their available cash while reducing external funding costs, including transaction costs, and maximizing the group's total return on short-term cash. In the current economic environment, MNEs may consider practical solutions, such as increasing the balances of participating entities in the case of zero balancing cash pools, and reducing or not charging interest on short term debit positions at least temporarily. The new Chapter 10 of the OECD Guidelines on Financial Transactions ("OECD FT")2 provides guidance on a number of important consideration, e.g. (1) when certain debit or credit positions of cash pool members will be treated as long-term deposits or loans, (2) how to determine and allocate cash pool benefits, and (3) how to determine an arm's length remunerations for the cash pool leader3.
The OECD FT highlights the importance of considering the lender's and borrower's perspectives and their options realistically available when analysing their commercial and financial relations and the economically relevant characteristics of an intercompany loan.4 Going forward, such considerations should be assessed by MNEs when modifying the terms of existing intercompany loans and entering into new financial intercompany arrangements.
In order to manage the impact of the sudden economic downturn to their current cash position, corporate borrowers are looking to reassess the terms of their external financing arrangements. MNEs looking to reassess and modify the terms of their intercompany loans should consider third party behaviour, including any modification or renegotiation of the group's third-party debt. Possible adjustments may include the deferral of interest and periodic principal payments, a payment-in-kind option, or temporarily waiving the application of financial covenants. The OECD FT introduces the possibility of renegotiating the terms of intercompany loans when macroeconomic factors affect and change the financing costs in the market.5 Taxpayers should proactively assess potential tax consequences resulting from a modification or adjustment to the terms of their intercompany loans.6
In the longer term, group companies may conclude new intercompany financing arrangements to access capital within an MNE. To accommodate the group borrowers' continuing liquidity issues, MNEs could consider provisions included in their third-party debt arrangements, such as the option for a payment-in-kind, and assess the possible introduction of similar provisions to their intercompany financing agreements.7 For new intercompany loans to be issued to group borrowers that had their credit profile impacted by the crisis, robust documentation, including an analysis of the debt capacity and credit profile of the borrower, as well as a search for third-party debt extended to similarly credit-rated borrowers, could help support the arm's length nature of the contemplated transaction.8
Third party debt and guarantees
In the current market conditions, parent guarantees may be required for subsidiaries that borrow directly from third-party financial institutions. Section D of the OECD FT provides guidance on how to accurately delineate and determine an arm's length price for an intercompany guarantee.
MNEs will need to determine if a parent guarantee provides an incremental economic benefit beyond implicit support to the borrowing subsidiary, and, if so, consider an appropriate intercompany charge for such benefit. Consistent with the guidance from the OECD FT, a transfer pricing analysis will need to distinguish between guarantees that allow for more favorable terms, i.e. in the form of a reduced interest, and the ones that increase the borrowing capacity of a group company. Guarantees on loans that expand the borrower's capacity may risk having part of the loan recharacterized as being provided to the guarantor and subsequently contributed as equity to the borrower.9
Impact on transfer pricing policy setting and testing
MNEs are trying to address the impact of the sudden disruption and proactively evaluating future changes that may be required in their supply chain. In particular, MNEs that have been exposed to an abrupt demand shock (fashion retailers, restaurants and hotels, any company in the leisure and event management sector) are questioning how to apply existing transfer pricing policies with targeted profit margins in order to reflect this unexpected economic disruption. MNEs looking to bolster the resilience of their supply chains are evaluating their existing global footprint, i.e. reducing manufacturing capacity or relocating warehousing closer to the consumer, and consequently considering changes that could impact their current transfer pricing policies.
In the short term, taxpayers setting up their transfer prices for 2020 using transfer price policies designed during an economic expansion phase are being faced with challenges when updating their "comparability analysis": how to account for the current economic circumstances, and any related changes in the business strategies.10 One important limitation is the lack of real time data for the comparable companies. In particular, financial data used for setting and testing various profit margins is generally only available with a lag of 5 to 6 months for North American databases, and up to 18 months for EMEA and other databases.11 To account for this limitation, different approaches could be considered. These approaches range from (a) using the most recent financial data (e.g., 2016-2018 or 2017-2019) and using financial and other comparability adjustments to account for the sudden economic disruption, (b) using 2020 quarterly or half year data of public companies, to (c) using the margins from previous recessions (e.g., from the 2008-2009 financial crisis). Each of these approaches has different pros and cons and may be more or less suitable per geographic region.
In the EMEA region, some taxpayers are considering the use of the most recent comparable data (e.g., 2016-2018 or 2017-2019 financials) with appropriate adjustments to account for the availability of data and the current economic conditions. A more practical approach could be an adjustment of the targeted margin to a lower point within the arm's length range of results. More elaborate approaches suggest the use of regression analysis that assess the correlation between certain economic indicators and the margins of the comparables. Such regression model would then allow MNEs to extrapolate and project the adjusted profitability of comparable companies.
In the medium term, once data for 2020 becomes available MNEs may consider adjusting their search strategies to include the most recent data in order to better support the results of 2020. In determining their future benchmarking strategies, MNE's should consider revisiting the industries and geographies included in their search strategies to account for the diverse effect of the economic disruption between companies, industries, or markets. Also, using one year of data instead of three years may be more appropriate to support MNEs transfer pricing positions for 2020. Furthermore, adjusting traditional benchmarking strategies that reject loss making companies may allow to partially mitigate but not completely exclude concerns of having a survival bias in the comparable sets that would skew the observed arm's-length range.
Supply chain changes
In the current turmoil many MNEs are required to revisit their global operations and assess the commercial viability and the future resilience of their supply chains. The contemplated actions differ per industry. Companies that have been negatively impacted by the sudden disruptions are taking immediate steps, such as downsizing or temporarily shutting down operations in various jurisdictions, while others are looking to manage the more long-term consequences of the current healthcare crisis by creating more agile and flexible sourcing strategies and digitalizing their business models. On the other side of the spectrum, companies with businesses that have been benefiting from this crisis (e.g. technology, life sciences, food, or home entertainment) are scaling-up or even starting up new business operations to fulfil demand. Tax departments need to work in close cooperation with the business in order to identify possible tax opportunities and risks resulting from any business changes.
Important transfer pricing considerations that need to be addressed include, the calculation and allocation of local restructuring costs, i.e. extraordinary asset write off, redundancy costs and people lay-offs, the remuneration for a loss of a future profit potential, or any other indemnification upon the termination and/or the substantial renegotiation of an existing arrangement (e.g. manufacturing arrangements and distribution arrangements), which may or may not involve a cross-border transfer of something of value.
Chapter 9 of the OECD Transfer Pricing Guidelines12 outlines the framework for the transfer pricing analysis of business restructurings. This analysis includes (a) the accurate delineation of the restructuring transactions, and the identification of the functions, assets and risks analysis before and after the restructuring, (b) the identification of the business reasons and the expected benefits, including any synergies, resulting from the restructuring and (c) an analysis of the bargaining position and the options realistically available to the parties involved at arm's length. The analysis should not just consider the commercial rationale from the group's perspective but also consider the perspective of the restructured entity.13
The starting point for MNEs looking to downsize their operations would be to consider the relevant terms of their intercompany agreements.14 In the absence of an indemnification clause in favour of the restructured entity upon termination or non-renewal, the parties will need to consider whether such indemnification clause would be considered in a third party situation and try to mirror this conduct in the intercompany arrangement. If the terms of the modification or termination of a contract are consistent with third party behaviour, the agreement should be respected as arm's length.15 When no comparable transactions exist, the OECD Transfer Pricing Guideline stipulate that the bargaining positions, i.e. the options realistically available of the transferor and the transferee, will need to be considered.16 In addition, the analysis of the arm's length nature of the indemnification term will need to consider the remuneration received by the restructured entity.17 The OECD Transfer Pricing Guidelines highlights the case whereby the restructured entity, e.g. a manufacturing entity, has undertaken a significant and specialized investment in order to be able to perform its obligations under a contract. In a third party situation, the manufacturer assuming and controlling the risk inherent in the investment made would negotiate a term that would allow him to recover and make a profit on its capital expenditures and manage the risk of an early termination through the introduction of an indemnification clause or through the agreed pricing/margin for its services.18
Once the arm's length indemnification amount has been determined the next question is who should bear these costs. Deductibility of such costs could allow MNEs to limit their tax liability and improve their overall cash position. In the case of local restructuring costs, it is expected that the entity controlling and managing the economically significant risks related to this business decision and the one that ultimately benefits from this decision will bear these costs.19 For example, a contract manufacturer with no control over market risk, capacity utilization and supply chain risk would not be expected to bear these restructuring costs, such as write-down, and closure costs. On the contrary, a manufacturer could bear such costs if they would have control over these risks or there was no option realistically available to the restructuring.
Related party contracts
The business reality during COVID-19's outbreak has forced many third parties to modify, revisit, or even terminate some of their contractual arrangements in order to address their urgent needs and requirements.
In the case of intercompany contractual arrangements, MNEs may consider invoking a common "force majeure" doctrine that is typically found in agreements. Force majeure is defined as an event that no human foresight could anticipate or which, if anticipated, is too strong to be controlled. Such event prevents either party from performing its obligations under a contract. A form of force majeure clause (similar but not identical to the common law and civil law concepts of the term) is included in Article 7.1.7 of the UNIDROIT Principles of International Commercial Contracts. The latter provided that a relief from performance is granted "if that party proves that the non-performance was due to an impediment beyond its control and that it could not reasonably be expected to have taken the impediment into account at the time of the conclusion of the contract or to have avoided or overcome it or its consequences."20
In the medium to long term and prior to any contemplated changes in their supply chain, MNEs are required to evaluate whether the termination, non-renewal or substantial renegotiation of any of their intercompany agreements would give rise to any form of compensation or indemnification.
As the COVID-19 outbreak is evolving, the way of doing business is drastically changing. Immediate mitigations measures and strategies are being assessed and implemented by MNEs. In this article the authors outline a number of transfer pricing considerations and opportunities that MNEs should consider in their shorter and longer-term recovery strategies. In particular, the authors discuss transfer pricing considerations for companies looking to address their immediate liquidity and financing requirements, the operational changes in their supply chains and the revision of related party contracts. Furthermore, the authors outline some of the approaches that MNEs could consider when trying to adjust their current transfer pricing policies in the current economic environment.
Tax and transfer pricing will become all the more important in future years as changes in governments' fiscal policies will be required to manage looming deficits and restore public finances. In this respect, more audits and scrutiny of intercompany transactions is expected. Well supported and documented transfer pricing policies may allow taxpayers to manage future scrutiny from tax authorities.
1. Rui Fan, Sherif Assef, Raj Bodapati, and Andrew Vickrey, Addressing Liquidity Issues during Covid-19 Using Intercompany Pricing Tools, KPMG, 2020, page 4, available at: https://assets.kpmg/content/dam/kpmg/us/pdf/2020/07/tnf-wnit-tp-july20-2020.pdf.
2. OECD, Transfer Pricing Guidance on Financial Transactions, OECD Publishing, Paris, 2020.
3. OECD FT, section C.2.
4. OECD FT, section C.1.1.1.
5. OECD FT, paragraph 10.60.
6. Rui Fan, Sherif Assef, Raj Bodapati, and Andrew Vickrey, Addressing Liquidity Issues during Covid-19 Using Intercompany Pricing Tools, KPMG, 2020, page 2, available at: https://assets.kpmg/content/dam/kpmg/us/pdf/2020/07/tnf-wnit-tp-july20-2020.pdf.
7. Rui Fan, Sherif Assef, Raj Bodapati, and Andrew Vickrey, Addressing Liquidity Issues during Covid-19 Using Intercompany Pricing Tools, KPMG, 2020, page 3, , available at: https://assets.kpmg/content/dam/kpmg/us/pdf/2020/07/tnf-wnit-tp-july20-2020.pdf.
8. Mark Bonekamp and Neil Schaatsbergen, Transfer Pricing of Financial Transactions and the Impact of COVID 19, 2020 (Volume 27), No. 4, 2020, page 4.
9. OECD FT, paragraph 10.161.
10. A "comparability analysis" is at the heart of the application of the arm's length principle and it becomes all the more important under the current environment. An update of the "comparability analysis" requires a review of (a) any changes in the functional profile of the tested parties, (b) the intercompany contracts for pricing provisions and other terms, (c) the current economic circumstances, and (d) the business strategies pursued.
11. Bob Clair, Brian Cody, Hilary Eisenberg, Steve Galginaitis, and Gianni De Robertis, COVID-19 and Transfer Pricing Policy: A Lookback Analysis Of Routine Returns, KPMG, 2020, page 1, available at: https://assets.kpmg/content/dam/kpmg/us/pdf/2020/06/tnf-tp-wnit-june8-2020.pdf.
12. OECD, Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations, OECD Publishing, Paris, 2017.
13. OECD Transfer Pricing Guideline, paragraph 9.37.
14. OECD Transfer Pricing Guideline, paragraph 9.81.
15. OECD Transfer Pricing Guideline, paragraph 9.83.
16. OECD Transfer Pricing Guideline, paragraph 9.84.
17. OECD Transfer Pricing Guideline, paragraph 9.85.
18. OECD Transfer Pricing Guideline, paragraph 9.88, 9.89 and 9.90.
19. OECD Transfer Pricing Guideline, paragraph 9.93.
20. UNIDROIT (2016), UNIDROIT Principles of International Commercial Contracts, Art. 7.1.7.