6 minute read 25 Aug 2020
The Impact of COVID-19 on Transfer Pricing

What transfer pricing may look like in a world disrupted by COVID-19

By

Ashwin Vishwanathan

EY India International Tax & Transaction Services- Transfer Pricing, Partner

Experienced transfer pricing professional advising companies on intercompany pricing and working with tax administration on tax policy issues.

6 minute read 25 Aug 2020
Related topics Tax COVID-19

While transfer pricing policies (TP) are crafted considering normal economic risks, the current pandemic and the economic downturn it has sparked cannot be treated in a business as usual manner and requires a differential approach. 

COVID-19 is a tragedy at many levels. The Congressional Research Service in their report on the Global Economic Effects of COVID-19 (updated August 7, 2020)[1], writes, “Estimates so far indicate the virus could trim global economic growth by 3.0% to 6.0% in 2020, with a partial recovery in 2021, assuming there is not a second wave of infections. The economic fallout from the pandemic raises the risks of a global economic recession with levels of unemployment not experienced since the Great Depression of the 1930s. The human costs in terms of lives lost will permanently affect global economic growth in addition to the cost of rising levels of poverty, lives upended, careers derailed, and increased social unrest. Global trade could also fall by 13% to 32%, depending on the depth and extent of the global economic downturn, exacting an especially heavy economic toll on trade-dependent developing and emerging economies.”  

This is straining cross border intra-group transactions within multinational enterprises (MNEs). The transfer pricing environment is becoming more uncertain. What do we see in the market and how should companies view this?

The story so far

Restrictions on economic activity and lockdowns have resulted in disrupted supply chains. Businesses are faced with falling demand as income levels are diminished. Manufacturing and distribution functions requiring physical labor, movement of people, transportation and logistics have been more severely hit. Some industry sectors like aviation, travel, hospitality and luxury retail have seen deeper declines compared to others. Many companies have pivoted to digital means of product and service delivery and implemented work from home measures as they adapt to operating in a COVID world. Some operating costs like travel costs within the organizations are decreasing and could help preserve margins in view of reduced toplines. Companies are focused on conserving cash and ensuring liquidity in their operations. At a time like this, transfer pricing policies which guarantee entities within the group – contract manufacturers, limited risk distributors, captive service providers – a minimum assured profit are becoming very difficult to implement. Simultaneously, risk bearing entities like licensed manufacturers and regional distributors are not earning sufficient profits in local operations to afford committed intra-group royalty or distribution rights payments. Consequently, the financial outcomes of the group and particularly the headquarter company is under stress.

While transfer pricing policies are crafted considering normal economic risks, it is clear that the current pandemic and the economic downturn it has sparked cannot be treated in a business as usual manner and requires a differential approach. Governments and tax administrations also recognize COVID-19 as an unprecedented shock and some of them like Australia[2] and Singapore[3] have released guidance how transfer pricing would be viewed in the current context.

How to approach the future

Every organization must assess how this pandemic has not only impacted its business currently but implications over the longer term. Based on this, clear business objectives have to be identified and a transfer pricing policy to support these objectives could be accordingly fashioned.

What should companies do?

Now (immediate term)

As the impact of the pandemic is not uniform, every company may want to examine and understand the effects on its business relative to the industry in which they operate and the overall economy and record it appropriately. This includes steps like:

  • Identifying how contractual arrangements have been altered
  • Comparing own impact with impact on the industry
  • Recording all abnormal or exceptional costs in a separate ledger for tracking
  • Describing changes to business strategies, decisions made and implemented
  • Preparing a profit and loss statement showing impact on revenues and costs vis-à-vis a normalized situation (in the absence of the pandemic)

These could help build evidence and documentation to support the rationale for change and present it to the tax authorities during an audit.

Next (medium term)

An MNE group may have to evolve a view of the pandemic’s effect over a slightly longer time horizon to determine liquidity needs for the business. The focus could be on revisiting transfer pricing policies based on:

  • Analysis of comparable data culled from most recent quarterly results of public companies
  • Simulated models of historical crises and its effect on comparable benchmarks
  • Determination of whether royalty payments and management fee charges could be forgiven, debt obligations reset, and loss splits introduced
  • Ideation around additional policies required to address current needs

Existing Advance Pricing Agreements could be renegotiated to take into account changes to critical assumptions. Given the value of cash, companies pursuing protracted litigation could consider settlement if it helps close long standing disputes. In the Indian context, the government’s Vivad-se-Vishwas (VsV) scheme might be an attractive option to settle income tax and transfer pricing cases and requires examination.

Beyond (long term)

Given the uncertainty of when the pandemic will end, it is reasonable to assume that companies may not want to or be able to take a long-term view. However, the current crisis is a good wake up call for the need to build supply chain resilience. The pandemic is changing the way everyone, and everything works. Vulnerabilities in cross-border supply chains have emerged and would motivate companies to rethink their global operations. Remote workforces may alter the way executive decision making is undertaken and impact distribution of value generating activities beyond the centralized models we are familiar with today. Business models may need to be reimagined given the digital surge and companies might increasingly pivot to online, mobile-first or contactless technologies and automate processes. This impetus would require long term supply chain restructuring and a futuristic transfer pricing policy reflecting the principles of digital economy taxation and a more equitable distribution of the global tax pie. These are being debated and discussed at the Organization for Economic Cooperation & Development (OECD)’s pillar one and pillar two consultations and are expected to have far reaching implications.

Concluding thoughts

In his analysis of whether COVID-19 rises to the level of a black swan event[4], Glenn McGillivray writes, “Since the “black swan” metaphor was coined in the 2007 book[5] of the same name, it has become fashionable to label virtually all low probability-high impact events black swans. But the danger of making an occurrence like COVID-19 appear to be astronomically rare is we will treat it as such and fail to prepare for the next pandemic.” He goes on to say, “Indeed Taleb recently weighed in on the question of whether COVID-19 is or isn’t a black swan. Spoiler alert: it isn’t.”

The critical point is many so-called unthinkable scenarios may not necessarily be beyond the realm of the plausible and companies need to plan and prepare for these. Flexibility and adaptability will be key.

Summary

Given the interconnected nature of the global economy, transfer pricing will continue to be a significant factor in the business equation and companies will do well to shape what they want their transfer pricing to look like now, next and beyond.

About this article

By

Ashwin Vishwanathan

EY India International Tax & Transaction Services- Transfer Pricing, Partner

Experienced transfer pricing professional advising companies on intercompany pricing and working with tax administration on tax policy issues.

Related topics Tax COVID-19