The impact of COVID-19 on transfer pricing

August 31, 2021

This article was originally published in Accountancy Daily, view here.

Previously accepted comparables used for establishing a company’s transfer pricing policy might not be comparable due to the impact of the pandemic, warn David Whitmer, transfer pricing practice leader and Srinidhi Tuppal, transfer pricing manager at Kreston Global.

With only over 13% of the total world population fully vaccinated against the Covid-19 virus, the world economy is struggling to recover from the impact of the pandemic. As businesses grapple with employee retention, government restrictions, and other safety compliance issues, multinational entities have additional considerations concerning their cross-border transactions and taxes.

While ensuring the arm’s length standard is the mantra of transfer pricing, finding real-world data to support an arm’s length valuation for its related party transactions that are regional, functionally comparable, and at a similar stage in the pandemic might be challenging.

Due to the lack of comparables in similar industries, multinationals sometimes rely on companies that perform similar functions, eg, distribution, manufacturing, or sales and marketing functions, to determine the arm’s length range. Previously accepted comparables used for establishing a company’s transfer pricing policy might not be comparable due to the impact of the pandemic.

On 18 December 2020, the OECD published its guidance on the transfer pricing implications of the Covid-19 pandemic, intending to aid the tax authorities and taxpayers dealing with complexities due to economic uncertainties caused by the pandemic. The OECD guidelines provide clarifying comments and examples for comparability, losses, government assistance, and agreements.

For a tested party performing a distribution function, the transfer pricing analysis might include distributors from other industries performing similar functions in its set of comparable companies. While almost all industries faced supply chain disruptions, not all industries were negatively impacted by the pandemic.

According to an analysis by S&P Global, industries that were significantly affected include airlines, restaurants, clothing and home furnishing retailers. Construction industries were positively impacted, and steel and timber prices are at a record high. However, restaurants and other leisure hospitality industries struggle to keep their businesses open. A manufacturer tested party should factor in domestic circumstances, including shutdowns and labour availability, while considering companies for comparability analysis.

Allocating pandemic losses to limited risk distributors or contract manufacturers that are expected to earn a specific rate of return could raise a red flag to the tax authorities (since the entrepreneurial entity is typically expected to take on higher risk and reward based on their functional profile).

The OECD provides guidelines on allocating Covid-19 specific costs, and in some cases, there may be circumstances that warrant a low-risk functional entity to bear losses in the short term. Considering the impact of such loss allocations in the financials of the comparables and making relevant adjustments to ensure comparability, reviewing the transfer pricing agreement for the functions, risks and assets of the related entities, including the availability of force majeure clause, would serve in establishing the loss allocation criteria and help mitigate tax adjustments.

Although ensuring the health and safety of its citizens is the top priority, governments across the globe implemented assistance programmes, including financial and liquidity support, to ensure business continuity. Companies that took advantage of these measures, including preferential term financing and loan deferrals, must maintain proper books of accounts. These benefits affect the recipient’s market advantage and cost base, necessitating taking into account the receipt of government assistance when reviewing potential comparables.

Advanced pricing arrangements

One of the critical transfer pricing strategies affected by economic conditions resulting from the Covid-19 pandemic was the applicability of existing unilateral, bilateral, and multilateral advanced pricing arrangments (APAs). The key benefit of APAs is to provide tax certainty regarding international transactions for tax purposes.

In the absence of breach of any critical assumption, existing APAs must be respected and upheld. However, in some cases, the economic conditions resulting from the global pandemic may warrant a revision, cancellation, or revocation of APAs. Multinationals should review their existing APAs and consider renegotiating the terms of an APA if it results in a tax advantage. Further, multinationals should account for the time and cost impact of renegotiating these agreements. Companies in the process of renegotiating an APA should expect delays in the process.

The Covid-19 crisis will continue to evolve and have a material impact on business. However, the transfer pricing concept will not change. The profit and loss allocation will continue to be based on the related entities’ functions, risks, and assets. Companies should review their transfer pricing policy to ensure that the policies align with the new economic reality.

In a global context of digitalisation of economies, tariff wars, and economic uncertainties fueled by the global pandemic, transfer pricing represents a tool for multinationals to strategise business and tax planning. It has also put transfer pricing in the limelight for tax authorities looking to identify potential profit shifting. Proactively engaging the tax authorities with contemporaneous documentation of specific and extensive details regarding geography, timing, and the reasoning for the price setting are the key to avoiding tax penalties and adjustments.

About the authors

David Whitmer, CBIZ transfer pricing practice leader and transfer pricing network lead and Srinidhi Tuppal, CBIZ transfer pricing manager at Kreston Global