Compared to most industries, financial services companies have until now seen relatively less disruption from COVID-19. Responses to measures to contain the virus’s spread have led to significant operational change and unexpected costs, but the sector’s focus on managing and mitigating risk since the 2008 financial crisis has helped many banks, insurers and asset managers weather the situation we find ourselves in today.
As intermediaries, however, the indirect impacts on the sector are profound. Shocks to supply and demand have shaken other industries, with knock-on effects for many financial services businesses and their intercompany transactions. These effects may be observed indifferent forms (such as credit losses in banks, reduced AUM in asset management, or higher claims for insurance. These effects, in turn, may impact the allocation of profits across legal entities in a financial institution, possibly impacting the returns they achieve and whether those impacts are properly captured by the existing TP policies, or whether those policies need to be reassessed.
Based on our conversations with our firms’ financial services clients, many of them are not immediately changing their transfer pricing arrangements. Following 2008, many financial services companies have greatly improved their understanding of the potential transfer pricing impacts of severe volatility or market shocks. This gives them confidence that their existing transfer pricing policies are set up appropriately to account for the volatility that we’ve seen to date.
While transfer pricing models are generally holding steady for now, many banks and other financial institutions we work with are thinking through the transfer pricing implications of a number of important COVID-19 related issues.
Short-term crisis-management costs: Many financial services companies have set up dedicated teams, often involving top executives, to manage COVID-19’s impacts globally, and these teams can result in significant short-term costs. For transfer pricing, taxpayers need to decide how to deal with these unexpected expenses. Do the services of these teams provide a benefit that should be charged out through management fees? If so, on what basis should the costs be allocated, and is a mark-up appropriate? Or are they performed for the benefit of the shareholder and therefore should be held at the head office?
Given that the expenses may be significant, companies may want to avoid sweeping these costs into their existing head office charge-out processes and instead give some thought on how to treat them under transfer pricing guidelines.
Remote employees: Lockdowns, border closings and other movement restrictions have caused widespread disruptions in employee locations, whether by choice or circumstance. Many financial services companies are keeping an eye on whether or when these employees could give rise to permanent establishments, and whether employee movement or changes in activities, functions or risk management could lead to a change in transfer pricing results or to the attribution of profits to a permanent establishment. It’s important to monitor and document these changes in real time. Questions to consider include:
Monitoring operational results: Now that many businesses are approaching the end of their second full quarter with COVID-19, it’s important that they check that their transfer pricing calculations are correctly following their policies, for example, in allocating any losses among group companies. There may also be opportunities within those policies to benefit from adjustments within the arm’s length range.
Monitoring intercompany contracts: As businesses adapt to quickly changing circumstances, monitoring intercompany contracts from a tax and transfer pricing perspective may be overlooked or set aside until things are more settled. However, as companies rearrange transactions, introduce services or change financing instruments in response to COVID-19, it’s a good practice to check whether the relevant contracts allow such moves.
Sometimes, an intercompany contract may include a force majeure clause that related companies can rely on. But many internal contracts do not address a pandemic situation, so companies may need to analyze their arrangements with external parties in the current context. From simple services transactions to complex financing transactions, group contracts should be reviewed to determine whether adjustments, break-out clauses or other unusual considerations can be defended as something that the company would agree to in their dealings with unrelated parties.
Managing liquidity needs: COVID-19 is straining liquidity for many financial services companies, and we’re seeing much attention devoted to forecasting cash needs for the short, medium and long term — no easy task with volatility and uncertainty expected to linger for some time to come. Once companies have determined when and where they may need cash in the organization, they can then examine options such as external borrowing, intercompany loans, repatriating funds from offshore entities, and restructuring cash pooling arrangements.
Looking ahead, intercompany financing is expected to be in the spotlight, making transfer pricing analysis and benchmarking crucial as companies move forward with new arrangements. New guidance from the Organisation for Economic Co-operation and Development released in February 2020 on the transfer pricing aspects of financial transactions imposes strict standards on the analysis and documentation of financing arrangements. These analyses are complicated by market volatility, which is reducing debt issuances and affecting debt pricing and credit spreads. All this uncertainty in debt markets makes it difficult to price and justify intercompany financing as bona fide debt. Tax authorities will have the benefit of hindsight by the time these transactions come up for audit.
Managing digitalization’s impacts: Advancing technology has been disrupting the financial services sector for some time now, and, like other industries, COVID-19 is accelerating the digitalization of financial services business models, from routine back office functions to more value-adding applications to attract and retain customers. As technology becomes ever more embedded across financial services companies, it can blur the lines between different functions in the value chain. Does a newly deployed technology simply enable operations in a market or is it truly a market differentiator that generates additional profits in the form of increased revenues or reduced costs.
Historically, many financial services companies have considered technology to be an operational requirement and, as a result, cost-plus transfer pricing policies have been regularly applied. To the extent technology drives real value, however, other methods such as cost-sharing, profit splits or residual profit contributions may be more appropriate.
Before introducing any associated transfer pricing changes, companies should consider how the technology fits within their existing transfer pricing structure and strategy, and whether they need to build a bridge between historical and future practices. This involves carefully assessing where any development, enhancement, maintenance, protection and exploitation (DEMPE) functions are taking place. It also involves analyzing the role technology plays as a value driver on its own or as an enabler of functions performed by people in the business. We expect this type of analysis to become more important in the coming years, especially in light of the OECD’s project to establish global principles for taxing businesses in the digital domain.
As we emerge from the pandemic, many governments will seek to restore their depleted finances. Tax authorities may be encouraged to aggressively boost collections, and transfer pricing adjustments are likely to increase as a result. For financial services companies, carefully documenting the conditions and reasons for any transfer pricing decisions taken now will be key to managing potential tax controversy in a post-COVID world.