This article offers guidance for multinational groups to help your thinking process as you navigate necessary changes for your transfer pricing model in the wake of the coronavirus.
We suggest key areas to focus on and describe a number of tools multinational groups may find helpful while reviewing your transfer pricing policies to ensure they are appropriate and effective.
The majority of multinationals’ transfer pricing policies have been impacted by measures taken to protect people during the pandemic.
Key points of impact may include:
Decentralized operational and transfer pricing models will be able to better spread the impact of the exceptional cost incurred. Residual profit split or full profit split models should enable the proper repartition of losses over the supply chain.
It can be questioned whether, in the application of the residual profit split method, the level of initial routine remuneration to be allocated should not be revised downwards, as will be further discussed below. This is particularly the case if the same level of residual profit would be earned by the different parties involved, and adjustment would only have a minimal or no impact.
The methodology applied to split the profits between the related parties might also have to be reviewed taking into account possible changes in functionality / contribution. Strong operational arguments should be in place before modifying the profit allocation key used historically.
Groups applying the internal Comparable Uncontrolled Pricing (“CUP”) method on certain types of transactions, will most likely also have a robust model in place for such transactions1. Indeed, the impact of the Covid-19 crisis is supposed to be fairly rapidly reflected in the pricing towards third parties. It’s important to make sure that the crisis did not impact the functional profile of the related parties, and analyze whether the CUP can still be applied as is, or whether additional comparability adjustments should be performed.
The robustness of methodologies based on external CUPs can be more questionable. External comparables, which can for instance be identified in licensing agreement databases, are often not very recent, and are slow to take into account the impact of the crisis. It should be noted that in a number of such third party licensing agreements, parties did already implement a royalty payment methodology where the royalty fee varies according to the EBIT level of the licensee. Depending on the type of technology or trade name a multinational group is licensing to its related parties, the renegotiation of the intercompany agreements and the introduction of an equivalent pricing clause might be opportune. Although the licensor may earn zero, or reduced, royalty income over one or two years, the licensor will be able to give oxygen to the licensee to survive, thereby ensuring its future revenue / royalty streams.
In the context of intercompany financing, we observe that the external CUP method is often being used, with reference to Bloomberg or Thomson Reuters data. Although such data is being updated on a constant basis and should therefore accurately reflect market evolutions, care should be given to correct allocation of the credit rating to the borrowing entity. The crisis might have an impact on the credit rating of the group and the credit rating allocated to individual group companies. The implied credit rating of the borrowing entity is one of the key factors in determining an arm’s length interest rate. The available options at the level of the borrower and the lender might also have changed, and will have to be reviewed. The importance of the latter element has been stressed in the OECD report dated February 11, 2020 “Transfer Pricing Guidance on Financial Transactions”, and will certainly be applied by tax administrations.
Transfer pricing implementation models which have historically always applied accurate budgeted costs, without having applied year-end adjustments based on actuals, might be better equipped to argue that excess costs will have to be kept locally. However, in practice we see that having a budgeted cost based pricing model which would be as accurate as the one observed between third parties is difficult / rarely observed, and that most multinational groups have historically applied targeted return based on actual costs.
A number of remedies are available to help multinational groups recover, adapt, and move forward, including:
In assessing which modified model to implement or temporary measures to take, there are also potentially undesirable outcomes to take into account, including:
The Principal is often not only performing the ‘significant people functions’, but is also the economic7 and legal owner of the Intangible Property (“IP”). In practice, we see that such Principals, or the group companies owning the IP, are applying tax friendly8 IP-Box regimes. In Belgium, there is the attractive IP-Box regime called “Innovation Income Deduction”, which is exempting 85% of the net income related to patents or copyrighted software. Many other European countries have similar regimes. The IP used by groups is considered to generate non-routine profits and transfer pricing methodologies are therefore often allocating part of the residual profit to the IP. In envisioning the conversion of a Principal model to a profit split model, it’s important to be aware of the fact that in the future, once the economy picks up again, less income might be allocated to the IP-Box. However, transfer pricing methods allocating a fixed royalty rate based on an external or internal CUP analysis might be less vulnerable to such side effects.
As has always been the case, the customs impact of transfer pricing policies to be implemented should not be overseen. Adjustments to the transfer pricing methods will result in changes in the future product pricing and the application of potential year-end adjustments. This will trigger the attention of the customs authorities, and might therefore result in a customs audit. The customs impacts of the changed pricing model in the short and long term should therefore be carefully considered.
Another side effect, although manageable, is the potential impact of a revised transfer pricing model on the remuneration of individuals. Past experience has shown that this is often a very sensitive point for organizations. KPIs might therefore have to be revisited / adjusted to avoid adverse effects.
Multinationals might also have a number of Advanced Pricing Agreements (“APAs”) or unilateral rulings in place which are covering the targeted returns of a number of tested parties. When deciding on a lower positioning within the range for transactions not covered by an APA / ruling, the question can be raised as to whether APAs / rulings need to be reopened, considering the changed economic environment.
Loans concluded prior to June 17, 2016 are not to be included into the 30% fiscal EBITDA thin cap rule (based on the EU Anti-Tax Avoidance Directive (“ATAD”), as implemented in Belgian Law), unless significant changes are subsequently made to the terms & conditions of these loans.
Where group entities are renegotiating certain terms and conditions of such older loans in the context of the Covid-19 crisis, start by estimating the potential impact thereof in terms of interest deductibility.
Of course it is not only the multinational groups that are brainstorming and simulating the impact of the Covid-19 crisis on the taxable basis and the transfer pricing policies. Tax authorities are also creating workgroups to align viewpoints as to what will be acceptable or not. The Belgian tax authorities involved in transfer pricing matters have also created a Covid-19 workgroup, composed of the same parties which have been working together on the recently published Belgian transfer pricing Circular9.
In this respect, we already know some of the viewpoints taken by tax authorities in the context of the 2008 economic downturn. For instance, we recall Mr. P. Chiau, formerly active within the Belgian transfer pricing audit department and now active within the Belgian special investigation squad, saying: “In times of economic growth, I never observe any Belgian routine entity earning a margin above the median of the arm’s length range. However, in times of economic downturn, everybody is arguing that a positioning below the interquartile or full range should be acceptable for the tested party”.
The Force Majeure element which is the basis of the current crisis might however be an important differentiator compared to the 2008 crisis. Although it might be a differentiator for the lock-down period, this type of discussion will be inevitable in relation to the period after the lock-down, which will most likely take at least one year.
We understand in this respect that the OECD is also working on further guidance in this respect, to be issued before year-end.
Today, we see that Belgian transfer pricing audits are initiated, based on information included in the Local File Forms which are submitted together with the corporate income / branch tax returns. In such forms, one also has to indicate whether a ‘Business Restructuring’ took place, as described under Chapter IX of the OECD Transfer Pricing Guidelines. A clear correlation could be observed this year between the selected companies and the ones who ticked the restructuring box. Covid-19 impacts will certainly lead to business restructurings and such boxes will also have to be ticked in this context. We can therefore assume that any substantial change to the methodology will be audited in the near future. This trend is probably not different in other countries around the world.
Cash is king. Many groups are struggling to overcome liquidity problems. Between third parties, delays of payment are being applied, be it for account payables, rental, or interest payments. There is no reason that such payment delays could not be introduced in an intercompany context.
However, it’s important to be able to demonstrate the real need for such payment delays for the entities concerned and define precisely the modalities around it, as would occur between third parties. A detailed and quantifiable repayment schedule would be expected, which takes into account the facts and circumstances surrounding the transactions and related entities.
Waiver of debt, potentially subject to revival, could also be observed between third parties. Such types of waivers were already observed in the context of the 2008 crisis. Consistency between the intercompany financing policy implemented and the credit rating model applied therein will be crucial.
It will also be necessary to review the terms and conditions of the intercompany loans. Are the borrowing companies still able to service the loans? Should interest be capitalized? Banks might also require additional guarantees in order to keep on providing liquidity to a local operating group entity. It will have to be reviewed, based on the guidance provided in the latest OECD paper on intercompany financing, whether or not such formal guarantees will require the payment of guarantee fees. Tax authorities could try to proportionally refuse the deductibility of intercompany interest charges, insofar as the borrowing entity would only have been able to borrow a lower amount in the event that no formal group guarantee is provided.
Not only will groups have to handle the impact of the crisis on their transfer pricing model, they might also be tracked following the implementation of restructuring related to Covid-19.
Under the Mandatory Disclose Requirement introduced under DAC 6, multinational groups will have to report, amongst others, any transfers of hard to value intangibles or transfer of functions, risks or assets where a reduction of more than 50 percent of the EBIT is expected in the coming 3 years.
Depending on the changed transfer pricing model to be introduced, one could rapidly be confronted with this “E3” transfer pricing hallmark, as from the moment that some functions, risks assets are moved. This makes it even more difficult to estimate the budgeted impact of the transfer on the EBIT result for the coming three years. The decision as to whether to report such a transfer or not will therefore not be an evident one.
Although the regulations and reporting requirements will remain in place in most of the European countries, the reporting deadlines may yet be postponed at country and EU level.
In adjusting the current transfer pricing policy based on the above recommendations, it is important not to forget to stress-test the desired model for future expected ‘best case’ and ‘worst case’ scenarios.
Although operational and economic evolutions might be difficult to predict, some trends in relation to future regulatory restrictions have already been disclosed by authorities. One of those elements is the impact of the work being performed by the OECD around BEPS 2.0.
The OECD itself will however have to reflect as well on the impact of the current crisis on the robustness of the ‘Unified Approach’ model proposed under Pillar One.
Without wanting to address the impact in the present article, the question remains as to how willing countries would be to absorb residual losses which would be available at the level of the so-called ‘Amount A’10. However, the current version of the OECD papers mention that the new allocation rules would also apply to losses. The design of the loss rules is still pending.
While BEPS 2.0 might have felt like a storm, we did not see the Covid-19 tornado coming. This pandemic is yet another reminder of the unpredictability of the international business environment. We have known a long period of delocalization of production to Asian countries and tried to mitigate exit tax issues related to such transfers. It appears now that some of those transfers might have to be reversed, as we face the limits of globalization.
The world is constantly changing and it becomes more and more difficult to implement a transfer pricing model which is immune to all new challenges. Adapting policies to operational needs, economic circumstances, regulatory environment and the latest tax / compliance requirements will be an ongoing task on our ‘to-do’ lists in the years to come.