COVID-19: The health crisis may affect the analysis, pricing and documentation of controlled transactions
COVID-19: The health crisis may affect the analysis, pricing and documentation of controlled transactions
Spain Tax Commentary
The current international health emergency is having a huge impact in every area, including tax, and will foreseeably have lasting effects. Transfer pricing is not immune to this situation and its consequences are being felt in elements such as intra-group financing, how controlled transactions are carried out, priced and documented, or the advance pricing agreements concluded with the tax authorities.
For this reason, the OECD has already announced the preparation of guidance on the transfer pricing aspects coming out of this crisis (which is expected to be ready at the end of this year), with the goal of it being able to be used by multinational groups and tax authorities for reference in relation to more complex or problematic points.
Described below are the currently most relevant issues in relation to controlled transactions, although detailed analysis will be needed of the individual situation of every group.
1. Liquidity needs and financing transactions
The current situation is going to create, to a greater or lesser extent, cash flow pressures caused by lower revenues or by delayed collection of debts, which may lead to decisions being made at groups of companies with an impact on controlled transactions or on their pricing.
Examples of this may be found in: (i) additional financing needs (particularly at companies with losses); (ii) revision of terms and conditions in facility agreements and cash pooling systems; (iii) increase in factoring agreements; (iv) requirement for, implicit or explicit, guarantees, for access to financing; or (v) delayed payment for purchases or other intra-group transactions (i.e. management fees, royalties, etc.).
These will have an associated finance charge, which must be valued at arm’s length, or even involve the writing off of some of those payments, if possible, on the basis of any clauses stipulated in the agreements.
Moreover, the number and amount of new transactions (or of changes to existing ones) will depend on how intensely the crisis impacts some subsidiaries as opposed to others (depending on where they are located), or some businesses as opposed to others, which may mean that cash flow needs are not always symmetrical within groups.
The comparability analysis that will be needed as a prior step to determining the interest rate on these transactions will have to include elements such as the new solvency of borrowers, their future repayment capacity and the various existing alternatives, all of this in light of the new guidance published by the OECD on transfer pricing in February 2020.
Those same liquidity pressures may also have an impact on any financing coming from outside the group such as, for example, failure to meet covenants or lower creditworthiness (making it more difficult to access to lending), or the need to provide greater guarantees to obtain financing, which may increase the use of intra-group financing.
The policies adopted by central banks or financial and credit institutions also have important implications for determining the arm’s length pricing of financial transactions (both new transactions and any needing to be refinanced, similarly to what happened in the last crisis), and the effects of the various tax rules (limits on indebtedness, deduction of interest, or withholding taxes).
Lastly, a few multinational groups will receive financial support from their respective governments, which will have financial consequences within their respective groups that will need to be studied carefully (not only on the applicable rates, but much more importantly, on the correct definition of the type and characteristics of the transaction).
2. Intra-group transactions: adjustments to transfer pricing policies
The value chain and previously habitual transactions of the various businesses may be impacted in a multiple range of ways, because they were not designed in almost any case to cover the effects of a crisis of this type.
So, whereas in a few phases of these elements a centralization of functions may take place (to optimize costs mainly), in others, decentralization may improve the ability to react and adapt to specific markets. Some sales channels (i.e. online sales for example) or business divisions may perform better than others.
This will be require revision of the contributions that the various entities in a multinational group make to the generation of value of the business (and to risk monitoring), and therefore, it may be necessary to adjust transfer pricing policies to secure a better fit, by adapting them to the new functional and risk profile of every entity and of every group.
Situations may also arise that require a decision as to whether a given profit split method may be used, with or without any additional adjustments, for the allocation of losses accumulated globally among the various entities in a group.
Particular attention is needed to the possible effect on the analysis of controlled transactions of any temporary measures or events that emerged as a result of the crisis: interruptions/delays in supplies, temporary layoff procedures and temporary shutdowns of operations, inability to absorb fixed costs with shrinking operations, or sudden falls in sales and their impacts on results and inventory management.
Also needing to be considered are the possible “exceptions” that may be needed to habitual transfer pricing policies, which must be supported by the conduct of third parties as a result of the crisis.
In the area of operations, a few examples of this may be: (i) goods or services transferred at cost (or even at a loss) to reduce inventories at the seller or losses at the purchaser; (ii) the effects that the temporary stalling of production and sales activities may have on the prices charged or on the margins obtained; (iii) temporary suspension of the payment of certain recurring items such as management fees or royalties; (iv) potential changes to accounting principles/methods of allocating extraordinary costs; (v) the effect of state aid on the calculation of results; (vi) compensation for loss of profit; etc.
On the flip side, the chance may arise for synergies or for new types of controlled transactions between entities in a same group, resulting mainly from provisions of services or the subcontracting of activities.
In the most extreme cases, the current crisis may even give way to a complete change of the operational and business model of a given multinational group (potentially through an irreversible move to digitization), which will involve the reconfiguration of its value chain, together with the restructuring of its controlled transactions, which must be identified and receive the correct treatment in transfer pricing matters.
Lastly, and although at this stage it is hard to gauge the scope of this question, the impact of the crisis will also have to be monitored in (the many) cases where satisfaction of the arm's length principle is measured on the basis of the annual return that is obtained in relation to a specific indicator (costs or sales, normally), together with any potential adjustments that may be needed in this respect and the timing for making those adjustments (the projected short-term revenues and costs must be studied for these purposes).
The most illustrative example of this question is probably that of entities operating under limited risk and remuneration arrangements (contractor manufacturers, low risk distributors, limited risk service providers, etc.), that had traditionally been remunerated with a reduced margin (on costs or on sales), by reference to the small amount of risk they assume in the conduct of their daily activities.
In a scenario where these companies will have to meet high structural fixed costs or inventory losses, the question that will need to be asked is how far these entities may see their remuneration reduced or may not receive any even, if the losses also obtained globally by the group to which they belong (and, in particular, any companies operating as the principal in the structure with respect to those entities).
This may be a particularly delicate question in Spain, where these arrangements have more than a few times been questioned through transfer pricing reasoning or arguing the existence of a permanent establishment.
3. Preparation of the compulsory documentation: pricing of controlled transactions
Obvious though it may seem, it must be borne in mind that the documentation for this year must be prepared contemporaneously (over next year, in most jurisdictions) whereas it will not be reviewed by the tax authorities until a few years later, and the available elements of judgment will be greater then.
It is therefore crucial for that documentation to reflect clearly the decision-making process and the reasons that were behind changes made to transfer pricing policies as a result of the crisis at every level (value and supply chain, functions, risks and assets employed, functional characterization of the parties, prices or margins, comparables used in support of arm´s length conditions, etc.).
Particular attention will also be needed to the information contained in the masterfile and in the country-by-country report, and it must be ensured that any changes that occur are properly reported and consistent with the contents of every entity’s documentation. Now more than ever, it will be necessary to adopt a joint approach to preparing the transfer pricing documentation.
It will need to be seen how much information is available to substantiate the arm's length basis of the valuations resulting from this crisis (remember that the databases normally used for these purposes are updated with a time lag of approximately a year).
As happened in the 2008 crisis, a high degree of instability may be expected due to the little usefulness (in terms of showing the current arm's length conditions) that the benchmark studies performed or updated with previous years’ data may have, under radically different economic and business circumstances.
In this context, potential measures will have to be studied that could serve to reduce these comparability deficiencies as far as possible.
Those measures could involve, for example, a re-evaluation of the comparability of specific companies used as such in prior years, the timeframe that is taken into account, use of entities recording losses, discrimination by reference to economic sectors or countries depending on their level of exposure to the crisis, or the addition of certain adjustments (to working capital or inventory level, for example, or in the ranges originally obtained, in light of the losses recorded on the income statement of the tested company in 2020).
It must not be forgotten either that measures of this type will only be needed where they are sufficiently reasonable and contribute to improving the reliability of the sample.
4. Advance pricing agreements (APAs)
Where transfer pricing policies are supported by advance pricing agreements with one or more tax authorities, individual monitoring of each of these will be needed, particularly, their critical (quantitative or qualitative) assumptions.
Namely, depending on the impact that the crisis will have on the various agreements, it may be useful to contact the authorities concerned to inform them and evaluate together the need to add variations, or maybe assess the need to request for them not to apply, temporarily at least.
Moreover, any circumstance that may affect strict compliance with their terms needs to be suitably reported in the annual compliance reports that are filed with corporate income tax returns.
For any agreements that are currently under negotiation, the impact of the current situation will need to be considered to the required extent.
In view of the uncertainty that is going to remain with us over a long period of time, however, it is particularly recommendable to seek agreements of this type with the tax authorities for transactions which, due to their size in quantitative terms or their technical complexity, are difficult to value from a transfer pricing standpoint.
Additionally, attention is also needed to the current circumstances on the future negotiation of mutual agreement procedures affecting this fiscal year.
5. Other items of interest
Although the OECD Secretariat has now clarified in the notice it published on April 3 (view here) that the exceptional nature of temporary change of residence of workers as a result of this crisis should not create (in principle and if a tax treaty applies) a new permanent establishments, the confinement measures and working remotely may give rise to scenarios where a few key functions move to another jurisdiction.
This may also increase the importance of certain members of staff to the detriment of others when analyzing the value chain, affect the functional characterization of certain entities or have an impact on how certain services are provided (which were previously carried out through staff members sent abroad to work), and on staff incentives.
5.2 Contractual terms
In the current circumstances, it is going to be crucial to revise in depth the clauses contained in contracts signed by entities, both in relationships with third parties and with related parties, to evaluate the existing options for supporting changes to transactions and their consistency with terms that would have been agreed between independent third parties in similar conditions (i.e. volumes, prices, delivery terms, payment terms, etc.).
This will require an analysis of the terms and conditions agreed by contract, of any agreements that third parties are concluding in comparable situations and the provisions in the laws of the jurisdiction applicable to the agreement: adjustment clauses, force majeure, rebus sic stantibus, unforeseen circumstances, adverse material changes, or reasonableness and good faith criteria.
In relation to the introduction of new contractual clauses, a question that needs to be asked is which terms and conditions are consistent with exceptional situations of the type being experienced, and a range of variables (i.e. GDP, inflation, sales, etc.) may be added that with allow the contractual terms and conditions to be adapted to sudden changes in the market.
6. General recommendations
To conclude, and from an eminently practical standpoint, summarized below are a number of general transfer pricing aspects, mentioned throughout this piece, which will have to be followed very closely over the coming months to achieve a correct adaptation to the changes that the current situation may require, and avoid, as far as possible, questions potentially being asked in the future over the adjustments made now.
Firstly, it will be recommendable to monitor any changes that occur in the course of business activities, in the value and supply chains and in operational and financial needs, together with the impact on the carrying out of controlled transactions within multinational groups.
Therefore, attention is needed, among other factors, to changes to the functional and risk profiles of the parties participating in the transactions and to the potential comparables, to their impact on the benchmark analyses needed to evidence their arm's length nature, to the contractual clauses and to the options realistically available to the parties.
It needs to be remembered that any audit examining all these circumstances in future years will (predictably) take place in a more serene context and with a broader perspective and more information will be available (as we experienced in the past concerning the 2009 - 2012 crisis).
In that context, the tax authorities will examine the economic impact of this crisis on the tax bases of companies and will most probably attempt to establish a relationship between the outcome of the transfer pricing policies before and after the restructuring which will most likely give rise to questions regarding transfer pricing matters.
For this reason, it is crucially important at this time to develop and document in as much detail as possible the business and economic arguments that support and will be able to evidence in the future the reasonableness of the changes made to the transfer pricing policy and the impact of this policy on the various remuneration models.
Finally, and for the most important cases (in quantitative or operational terms), it will be necessary to consider the advantages of validating or comparing the changes made through advance pricing agreements with the tax authorities, for the purpose of obtaining a sufficient degree of certainty.