Prepared by Transfer Pricing Team
The global recession, due to COVID-19, is likely to have disruptive effects on the economy, as well as on commercial and financial relationships among enterprises, including those belonging to Multinational Groups. The latter, to face the crisis, may need to modify their business models and the related transfer pricing policies. In fact, both the definition and implementation of transfer pricing policies within a Group must consider the relevant economic scenario, as well as the organizational and strategic solutions adopted for dealing with the sudden change of the relevant market and industry sector.
In such scenario, in both the short and medium-long term, it is key to identify and manage the economic and tax implications deriving from the changed conditions induced by the crisis under which the Group have to operate, compared to those considered at the time when the transfer pricing policies were set.
Furthermore, the current “extraordinary” context, requires the Group to evaluate:
- on one hand, actions aimed in the short term at managing the reduction of the Group’s profitability linked to the economic crisis triggered by COVID-19, jointly with the need to identify, based on the current functional profile, entities among the Group that should share such negative effects, and
- on the other hand, in the medium-long term, in case of the ongoing of the crisis, to intervene on the current functional profiles of the Group’s entities even through business restructurings with the aim of overseeing the Group’s profitability.
Here below some key aspects to consider:
Sales’ reduction, extraordinary costs and sharing of negative effects
Generally, in the majority of the Groups, high value adding functions (e.g.,, DEMPE functions) and the main strategic and operational decisions (i.e., active decision making functions) are centralized in the head of one or more entities (more complex from a functional profile point of view), whereas productions, distributions and services activities are allocate to other Group’s entities (less complex from a functional profile point of view) to which is guaranteed a target margin in line withof their limited functions and risks profile.
In this regard, it is of crucial importance the identification of the Group’s entities to which the negative economic consequences deriving from: (i) the reduction (or zeroing) of sales and related profitability, caused by the lockdown imposed in the majority of Countries and by the subsequent consumption crisis, and/or (ii) the extraordinary costs borne for employees’ health and security (e.g., reclamation costs, safety devices or extraordinary maintenance operations), or for the advanced termination of agreements/orders (e.g., penalties), as well as for the interruption of manufacturing processes.
The main issue to be addressed is whether limited risk associated enterprises shall incur in negative impacts deriving from such crisis, of an extraordinary and unpredictable nature (COVID-19 pandemic), by considering the risk analysis process and the behavior third-party independent companies would have in similar circumstances – as clarified in transfer pricing OECD Guidelines.
In this context, transfer pricing policies based on the Transactional Net Margin Method (“TNMM”), as well as on the related transfer pricing adjustment (“TPA”) mechanisms, are particularly “impacted”, mostly with reference to the “if” and “how” sharing negative results among the principal and limited risk associated parties (whether they are distributors, manufacturers or service providers).
From the Italian principal’s point of view, considering the pandemic risk among those borne by the principal, the application of the TNMM would result the full assumption of the negative consequences related to COVID-19, also with significative accounting, profitability and financial impacts, that will grow proportionally to time (e.g, as a percentage of the closed fiscal year influenced by the pandemic phenomenon) and geography (i.e., in terms of relevance of the “infected” markets in which the Group operates).
Nevertheless, it shall be considered that it cannot be excluded that tax authorities of the Country in which the principal is located may challenge the choice of allocating on the latter all negative effects related to COVID-19, hence requiring the “sharing” of such risk, and of the related effects, with other parties belonging to the same Group.
On the other hand, should the principal opt for a different TPA policy, allocating negative COVID-19 consequences also to limited risk entities (e.g., no recognizing, partially or totally, the target margin), it will be crucial to analytically investigate and support, in all Countries in which the Group operates the reasons underlying such choice, also based on the behavior which third parties would adopt in comparable circumstances (e.g. force majeure clauses impact on contractual obligations) or which would be adopted towards third parties.
Similar considerations, mutatis mutandis, shall be made in case of limited risk companies operating in Italy and remunerated, as of today, through the implementation of a TPA granting them a target profitability.
Supply chain and ordinary business crisis
The worldwide supply crisis, also due to the interruption (or slowing down) of the supply chain, is causing significant negative impacts on goods and services supply, production capacity and global mobility of goods and services.
This may imply, on one hand, the need to incur in extraordinary costs to grant the ordinary business activities and, on the other, the need to introduce new intercompany transactions to deal with the temporary supply crisis (as a way of example due to the warehouses lockdown), particularly in Groups that opted for business models based on the centralization of production or warehousing activities. Such circumstances may imply a re-allocation, even if temporary, of the activities among the various Group entities, with a potential impact on their functional profiles.
Liquidity crisis and the impact on financial intercompany transactions
Several companies to manage liquidity crisis may have to reconsider both external and internal funding sources. Regarding the latter, they may be called to re-design cash-pooling structures, together with terms and conditions underlying intercompany loans and guarantees.
This requires an in-depth analysis, also in light of the new Chapter X of OECD Guidelines on financial transactions.
Benchmarking analyses and Advance Pricing Agreement (“APA”)
In challenging times, additional complexities might be faced when performing benchmarking analyses. This since, beyond the common practice of using information related to previous fiscal years to the one to be tested (e.g. weighted average results of the previous 3-year period), which would not permit to identify the actual crisis effects on the tested fiscal year, the companies’ financial data available in the commercial databases are affected by a delay that does not allow to detect the crisis effects on the fiscal year to be tested.
Hence, it is necessary to ascertain if OECD Guidelines provide for methodologies to be used for the aim of adjusting transfer prices to arm’s length values based on benchmarking analyses performed by using financial data referred to fiscal years not impacted by the current crisis and, should the latter be the case, how they should be implemented.
Moreover, regarding Advance Pricing Agreement (so called “APA”) it is necessary to ascertain if the requirements for submitting a request for changing the agreement, or just for evaluating such possibility, exist and, should this be the case, which adjustments should be made to introduce flexibility for both preserving its validity and taking into account the significant changes in the “economic circumstances”.
Intercompany agreements and transfer pricing documentation
It is also necessary to ensure consistency between the rights and obligations of the parties involved as per the legal agreement in place and their actual conduct, especially if the Group operates in jurisdictions in which the so called “contemporaneous documentation” requirement exists.
More in detail, multinational enterprises should: (i) renegotiateexisting intercompany agreements, by taking into account how independent third parties would behave in dealing with such an extraordinary crisis; (ii) update transfer pricing documentation , in order to explain how and to what extent the sudden economic circumstances change impacted on the TP Policy and the related Group choices. Such agreements and transfer pricing documentation (including any other supporting document or analysis) will have a main role in future tax audits performed.
Potential Business Restructuring implications
COVID-19 may also have impacts on medium-long term Group strategies, aimed at preserving profitability or reducing losses, through the adoption of structural actions for: containing structural costs; centralizing business activities to take advantage from economies of scale or decentralizing them to benefit from a more flexible supply chain; focusing resources in more profitable markets; automating processes and investing in e-commerce.
Such medium-long term solutions, potentially resulting in changes in business models, impacts on the Group worldwide supply chain, closing of some Group local companies, transfer of risks, functions and assets, require an accurate analysis of restructuring profiles, based on Chapter IX of OECD Guidelines. In conclusion, the issues highlighted above represent only some of the matters that multinational Groups should deal with for managing COVID-19 effects. Furthermore, an intervention by the OECD, standard setter on transfer pricing matters, is desirable for the purpose of preventing conflicts among Countries, otherwise unlikely to be avoided. In this regard, it is worth mentioning that, on April 4, 2020, OECD published a first draft document referred to COVID-19 impacts on cross-border businesses by providing some indications as for permanent establishment, residency (of both legal and physical persons) and cross-border workers.
Such document is publicly available.
Let’s Talk
For a deeper discussion, please contact:
PwC TLS Avvocati e Commercialisti
Partner
PwC TLS Avvocati e Commercialisti
Partner
PwC TLS Avvocati e Commercialisti
Partner
PwC TLS Avvocati e Commercialisti
Associate Partner
PwC TLS Avvocati e Commercialisti
Director
PwC TLS Avvocati e Commercialisti
Director
PwC TLS Avvocati e Commercialisti
Director
PwC TLS Avvocati e Commercialisti
Senior Manager
PwC TLS Avvocati e Commercialisti
Senior Manager
PwC TLS Avvocati e Commercialisti – sede di Roma
Partner
PwC TLS Avvocati e Commercialisti – sede di Roma
Director
PwC TLS Avvocati e Commercialisti – sede di Firenze
Director
PwC TLS Avvocati e Commercialisti – sede di Novara
Director