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Without doubt, no one could have predicted the impact of the COVID-19 pandemic to every human being, thus impacting businesses and governments in an enormous way. We are in extremely uncertain times, predicting new norms and managing how businesses are run as supply chains are disrupted, businesses moving rapidly into digital integration, fast action business continuity plans and seizing opportunities, and above all, keeping safe and healthy.

There is no doubt that we will all survive this pandemic and our lives and businesses will slowly but surely revert to normal, albeit a new normal.  Thus, whilst managing the challenges of COVID-19, we must not forget to deal with our tax and transfer pricing (“TP”) obligations.  In terms of TP compliance in Malaysia, we are not short of relevant legislations, rules and guidelines to ensure taxpayers comply in the area of transfer pricing.  Tax audits will continue and may not slow down post the movement control order (“MCO”) period.  Companies should continue to manage tax risks by preparing transfer pricing documentation to support their related party transactions and implement them well to defend their transfer pricing positions. 

Limited risk entities

It is common for multinational companies operating in Malaysia to set up as limited risk distributors, service providers or contract manufacturers. These companies are typically remunerated with a routine profit margin and hence, expected to earn a stable and reasonable profit margin under normal business conditions.  In order to substantiate its characterization, companies would typically carry out a functional analysis as part of their transfer pricing documentation, which describes the functions performed, assets used or people employed, and risks assumed by the company as a way to demonstrate that the outcome is consistent with the arm’s length standard.

During the COVID-19 crisis, we would expect such companies to record results which could differ significantly from normal business conditions or possibly, incur operating losses. Whilst tax authorities appreciate that losses can be incurred in independent situations due to unfavourable economic conditions or other legitimate business factors, it remains to be seen how these factors can be identified and quantified for transfer pricing purposes. Some of the factors that come to mind are the impact of social distancing and work from home arrangements, productivity, disruptive supply chain as well as lock down affecting movement of goods and employees, which are not easily quantifiable or measurable.  Would tax authorities still expect such limited risk entities to record the routine profit? Can this view be sustainable given the far-reaching impact of COVID-19 to businesses and what extent of information would be required to satisfy tax authority challenges? For instance, a contract manufacturer would typically earn a cost plus 5% margin but in 2020, due to COVID-19, there may be a drastic reduction in orders.  This could translate into potential losses for the contract manufacturer.  Would the tax authority still expect a similar remuneration for the contract manufacturer given the limited risk profile?  Would the tax authority expect that the contract manufacturer be protected by its principal against the economic downturn caused by COVID-19? There is a need to think through such transfer pricing arrangements and develop defense strategies to address these future challenges. 

Meeting the substance test

Due to the global implementation of travel or movement restrictions as well as lock downs, people are now grounded in their respective homes and countries, providing virtual advice and information. As a result of increasing use of technology and online meetings, signed documents and reports, evidence of troubleshooting, amongst others, may not be so clearly visible during this period of crisis. Question is whether mere email correspondences would be sufficient to meet tax authority requirements as evidence of beneficial and value added services.  Would this undermine the substance test that tax authorities expect to verify under ‘business as usual’ circumstances?

These temporary changes need to be articulated and appropriately documented to ensure that the companies can continue to justify its transfer pricing positions.

Cash flow pressures

When COVID-19 became widespread, the stock markets and financial markets were first to experience the hit. The financial system will be greatly stressed as a result of bleak forecasts and cash flow pressures albeit economic stimulus packages, people’s aid as well as rate cuts and implementation of moratorium on financing payments. 

Cash flow pressures will impact existing financing arrangements, altering terms of payment or create new financial support and guarantees between related parties. For instance, where companies enter into renegotiation of financing facilities, these may come with additional costs or requirements such as parent company having to provide guarantees. Thus, it is necessary for companies to determine whether such guarantees are chargeable.

Whilst not all hope is lost, it is timely to review whether current transfer pricing arrangements ought to be adjusted considering disruptive events as they unfold. As priority is probably not at the top to prepare documentation now, companies should consider keeping evidences to justify decisions that are made in times of crisis and document them thoroughly.

My wish is to have active dialogues with tax authorities to encourage them to have some relaxation or consideration for taxpayers during this difficult period as the financial effects of COVID-19 will soon be established when financial accounts are drawn and tax returns to be filed at a later date.