How COVID-19 is changing transfer pricing

The COVID-19 pandemic has altered the landscape of international business so significantly that any business with intercompany pricing policies should review its transfer pricing practices to make sure that they still align with today’s economic realities. Changes in demand and supply chain disruptions can play havoc with the facts on which transfer prices are based. Affected businesses should reexamine some of the most fundamental building blocks of their intercompany pricing policies to determine what amendments are necessary to reflect today’s newest version of normal.

Transfer pricing documentation will be key

Perhaps the most important thing to remember when modifying your transfer pricing policy is that you must be able to support the changes that you make. Taxing authorities will certainly be aware of the global impact that COVID-19 is having on businesses and individuals, but that doesn’t mean they will accept everyone’s worst-case scenarios on faith. The benchmarks, standards, and indices that many businesses use to set intercompany prices and margins are without a doubt going through extraordinary change during this period, but businesses need to make sure that their responses to these changes are proportional and fully supported.

Perhaps the most important thing to remember when modifying your transfer pricing policy is that you must be able to support the changes that you make.

Where are the tax attributes located?

Intercompany pricing models are typically built on the assumption that a business will earn a profit. It’s not unusual for the process to concentrate income in certain jurisdictions, such as those with tax advantages for certain kinds of production, or those where a company is headquartered.

The pandemic has turned that assumption on its ear for the short term. For many businesses, the goal has become to minimize the inevitable losses during the downturn in order to survive until the global economy begins to recover. Taxing authorities are inherently suspicious of operating losses that reside within their borders. Such a loss in operations could be the norm for the pandemic’s duration. Affected businesses should focus on documenting and justifying the losses throughout the global organization, planning within policies to concentrate losses in jurisdictions where they are more favorably treated. Affected businesses should be such asking questions as:

• Are there ways to decrease profits where returns are guaranteed and certain to cover losses or cash shortages in areas that are being hit harder by the effects of COVID-19?
• Does the current transfer pricing structure adequately defend losses in a particular jurisdiction?

For those jurisdictions where limited-risk distribution subsidiaries reside, the current circumstances may have fundamentally altered the limits of those risks. If the global revenues of a conglomerate have shrunk by a third in light of the current circumstances, it’s not out of the question to say that the limited-risk groups would see similar proportional decreases. For that matter, some industries have seen such changes that even limited risk subsidiaries may not be operating at a profit during the downturn.

Royalty payments represent another area where COVID-19 has challenged the basic assumptions of transfer pricing policies. Under normal circumstances when a business is operating at a 30% margin, a 25% payment into a jurisdiction where the intangible resides could make perfect sense. With margins today falling well short of long-established projections, a 25% royalty could drive the entity into a loss. The “commensurate with income” standard holds that percentages like these should align with the overall profits in the system and would suggest that some renegotiation of the royalty rate would be appropriate under these circumstances.

COVID-19-driven changes

On top of the economics of international operations, the COVID-19 crisis has driven some logistical changes that may need to be reflected in transfer pricing strategies, including:

• Geographic redistribution of workers: Many multinationals have called their overseas employees back home in order to protect their safety during the pandemic. As operations stabilize, those people may stay in their home countries and reduce their employers’ footprint in foreign countries.
• Supply chain disruptions: Foreign government responses to a crisis like COVID-19 may cause businesses to rethink where they produce or acquire goods in the future.
• Changes in assumptions to advanced pricing agreements (APAs): Companies that have taken the additional step of negotiating an APA with a tax jurisdiction may want to consider renegotiation based on changes to the fundamental assumptions of the agreement.

On top of the economics of international operations, the COVID-19 crisis has driven some logistical changes that may need to be reflected in transfer pricing strategies.

We can help

Any of these changing circumstances could warrant a reexamination of a business’s transfer pricing policies. Whether your business may have losses that could be redistributed into more favorable jurisdictions, potential benefits by registering goods that may need to be price-adjusted under the Customs and Border Patrol’s reconciliation program, or possible new strategies to consider such as a “first-sale” valuation, the changing circumstances of the COVID-19 economy definitely warrant a closer review of intercompany pricing.

For more information, please contact your Plante Moran advisor.