Eunice Kuo (transfer pricing partner) and Victor Zhang (transfer pricing director) are with Deloitte Shanghai/ Hong Kong, China. The authors’ views are their own, but not Deloitte's official position, nor do they constitute advice to any companies.
The transfer pricing ("TP") practice aims to mimic the intercompany arrangements and profits allocation by reference to independent parties in similar circumstances. As the new coronavirus outbreak has made significant unexpected impacts on the global economy, the TP practice may not have sufficient precedent case reference under similar situations, and inevitably it may lead to challenges and potential controversies of the taxpayers' TP arrangement.
In order to relocate and leverage resources to address different priorities, the authors are of the view that the taxpayers could identify the concerns at different stages over the short, middle and long term along with the business cycle to respond, recover and thrive. The authors would also share some strategic thinking over the possible changes in the TP practice.
Respond stage: current-year reallocation of profit and loss and pre-audit preparation
For the multinational companies ("MNCs") using the "entrepreneur + limited risk entity" TP model, the immediate question is whether the limited risk entities should be entitled to a "guaranteed" return in this special period. If a local taxpayer is characterized as limited risk entity, naturally the tax administration would have the tendency for the view that the local entity should not bear a loss in the downturn, especially if the MNC group would not compensate the local entity more when the value chain has excessive profit.
Quite often the practice would use the analogy of the relationship between business owner and employee to describe the relationship of entrepreneur entity and limited risk entity in a TP context, with the conclusion that the employee should get paid regardless of the residual profit or loss attributable to the business owner. Interestingly, from the recent public news this conclusion may not necessarily hold up in the COVID-19 period: we read the news that some soccer players agree with a large salary cut due to the suspension of soccer leagues in Europe; we also read the news that some restaurant employees in China had to take unpaid leaves as one of the measures to keep the business from immediate bankruptcy risk during the lock-down period.
While the authors do not get access to the labour contracts for those in the news stories, it could be reasonably expected that the force majeure clause could be relevant in the negotiations, and likely one of the key driving factors of the final decisions. For reference of TP practice, this evidences the importance of reviewing the current intercompany agreement.
In an intra-group context, rather than solely relying on the contract terms, the practice requires functional analysis to determine whether the contractual assumption of risk is consistent with the actual conducts, and the parties have the ability/ financial capacity to control/ assume the risks.
The major supply chain risks arising from the current COVID-19 period may include how to recover the fixed cost in the absence of business volume (capacity risk from outbreak), the financial impact due to the market price risk reduction, shortage of raw material supply, raw material price increase, etc. While no tax administrations would welcome the local taxpayers suffering operating losses, the starting point of the risk-taking analysis would be the examination of the intercompany agreement and the functional/risk analysis. This could support the technical basis of the taxpayers' decision on the profit allocation or loss sharing during the special period of time, and also build up the ground of pre-audit preparation.
Recover stage: realignment of the new supply chain and TP policy
Revisit the key value drivers of the business
In a traditional value chain analysis, depending on industries but quite often the MNCs would attach importance to the R&D technology and/ or the brand marketing as the key value drivers in the business, and often those functions are provided with the residual if the overall value chain has excessive return in the "normal" time.
In the special COVID-19 period, some less visible factors would possibly play more important and even dominant roles, and therefore would be worthwhile to revisit the value chain of the business with the "abnormal" situations as well. At the time of global supply chain being interrupted, the ability of maintaining a stable supply chain for the group's business would become very critical for cost control and business continuity. In particular, in the event of lock-down, the customers would only pay for vendors that could deliver the goods or services. This could not be achieved overnight, but has to rely on the long-term strategic relationship with supplier network, supply chain system design and implementation, and workforce management skill, etc.
While the TP practice has been paying more attention to such supply chain functions and operational know-how (instead of a very simple cost plus return), if those are proved to be the key differentiators for a firm in the special situations (and one cannot really predict when would a sudden crisis take place), their relative contribution should be re-assessed in the future TP analysis.
In addition, many MNCs are restructuring their business arrangement to cope with the difficulty of long-distance logistics and cross-border travel limitation. In the event that the business would adopt a more decentralized operational model as a legacy impact of COVID-19, the MNCs may also need to update their current value chain contribution study.
More tolerance of flexibility in profit allocation
The observation in the COVID-19 period could refresh some of the mind sets of "limited risk"/ "risk-free" entities for both tax administrations and taxpayers. For example, from the news stories it seems the employees, even in a (relatively) fixed return agreement with the business owners, would consider bearing partial loss in certain situations. There could be quite a few economic and/or social factors driving such decision, but the realistic alternative analysis must be one of them: if not bearing some of the loss with the hope of sustaining the business, the employees may not have another better option in the special period.
The lessons for the TP practice is that more tolerance of flexibility could be needed for the "limited risk" arrangement set-up. While the one-sided TP method could still hold up, likely a more thorough study is necessary to define the allocation of operational risks. For example, a contract manufacturer may get a higher or lower return if it could manage the manufacture process more or less efficiently, and a limited risk distributor could also have some profit fluctuation depending on the economy of scale. If the relatively simpler entity under the transactional net margin method (i.e., the tested party) is responsible for significant fixed expenditure, this should be taken into account as one of the comparable factors and the TP model design, meaning the entity is exposed to both the risk of cost recovery and the profit potential.
A "risk-free" arrangement could be even rare, only with the exceptional cases whereby the contractual arrange and the people function could all support such. Picking a typical Hong Kong offshore back-to-back trading model as an example, there is no people function in the trading entity and the Hong Kong entity would solely act as a re-invoicing role, which would be perceived "risk-free" and would be compensated by cost recovery method with minimal profit.
Thrive stage: post-COVID-19 TP model management
Alignment of the business performance with TP outcome
The COVID-19 threats would be gone (hopefully sooner than later), and business would be thriving again, while TP controversies would be going on. If the business unfortunately suffers significant loss arising from COVID-19 impacts, logically the taxpayers may think about tax loss utilization planning, but need to align the TP outcome with the actual value creation.
The TP practice often leverages third party information from external public databases as "benchmark" to support the intercompany profit allocation. This approach makes use of the public information available to all parties and creates a common ground of communications, and understandably could be widely used.
Back to our news stories, while some soccer players and restaurant employees would have the pay cuts in the special time, as part of the compensation package likely they would also get additional performance-driven bonuses when the business climbs up.
Accordingly, there could be another angle to review how the MNCs would decide the internal allocation of operating result based on management performance. From time to time, the MNCs would set up key performance indicators ("KPI") to different functions and locations as the basis of management performance review, or different business units within the group would negotiate on the profit allocation (similar to independent partners negotiating in a joint-venture). On the basis that the "units" in the management performance review could be mapped out with the TP analysis at the legal entity level, such internal management performance information could provide quite useful insight to the TP practice, since such internal allocation is independent of any tax consideration and is closely relevant to the interest of stakeholders.
If there is good documentation to show all functions and locations in the group substantially suffer from the COVID-19 impacts, it may not be reasonable to expect a legal entity must be guaranteed with certain profit return. Correspondingly, if an entity's local management is highly rewarded for achieving high profitability from management performance perspective, it may be difficult to explain why the local entity not rewarded with any excessive profit at all.
Operational TP transformation with digitalization mechanism
In practice, it has been a common challenge for MNCs to land the year-end result with the targeted TP policy, due to the changing financial data, the adjustment hurdles like indirect tax and foreign exchange, etc.
If some of the changes discussed in this article are realized and become permanent, the taxpayers in particular large MNCs would need to assess what would be the "incremental" impact on their daily TP operation. The management with digitalization mechanism could become one of the necessary operatons, for example:
- In order to allow for more flexibility on the profit allocation, more parameters would be used in the TP setting, and timely data/ result output for review and adjustment would be required.
- The management of TP in a more decentralized operation model may call for an effective system to consistently implement the MNC group's TP policy.
- If the MNCs intend to reference management performance result and align the TP outcome, depending on whether this would lead to a relatively complex profit split, the use of digital tools could be even more useful in designing the profit allocation model and keeping track of the TP.