Transfer pricing opportunities in the coronavirus economy
The COVID-19 pandemic is delivering an unprecedented decline in the global economy. To many multinational taxpayers, this means less thought and worry about income taxes as revenues decline. To experienced and proactive taxpayers, this is exactly the time that tax planning tools and opportunities must be engaged as valuable investments in a down economy. Transfer pricing sits high on the list of global tax planning tools in difficult times to reduce global taxes, increase precious cash flows, and even reduce — rather than increase — overall global tax risks.
We see many companies making significant changes to their intercompany pricing for intangible property, tangible property, services, related-party financing, etc. For example, we see substantial drops in manufacturer pricing to related distributors to ensure distributor profitability levels remain balanced. Royalty payments are being suspended to ensure that related users of intangible property remain solvent. All of these transfer pricing modifications are harmonized with treasury activities to make sure they meet quickly moving cash flow objectives.
It is well understood that transfer pricing is a top priority as well as a risk area for multinational companies in any economic environment. It is less understood and under-publicized why it should be an even higher priority in this down economy that the entire world is now facing due to the COVID-19 pandemic. In fact, transfer pricing requires even more attention in these harsh economic times than it does when times are good, as it impacts the overall business more than ever.
There are a number of reasons why this is the case. The first and most obvious reason is the need for tax revenues by global taxing authorities in the post-pandemic environment. When this occurs, and it will, the most obvious targets to drive local country tax revenues will be those companies which are not locally based, as well as those based in high-tax jurisdictions. For companies fitting this profile, the time is now to initiate procedures to mitigate risk in both the subsidiary and parent company countries, but also to optimize transfer pricing positions to reduce current and future tax exposures at the same time.
Cash flow is tremendously important as well. Tough economic times make cash a precious commodity and transfer pricing is often the most effective tool to match cash reserves or generation with cash needs. Our transfer pricing practice has seen and remediated numerous instances of imbalanced global cash pools in difficult times where non-strategic transfer pricing is the root cause. Proactive transfer pricing changes can make dramatic and immediate positive cash flow changes, lessening the taxpayer’s reliance on expensive and condition-laden third-party financing.
Another, less-obvious, reason is that strong economic times carry with them a number of non-routine and time-consuming activities for a global tax group. These activities include mergers or acquisitions, global business expansion, and other tax planning activities. Sometimes lost in all of this is a proactive review of the company’s transfer pricing documentation to see if all of the changes in the typically fast-moving environment of today’s multinational company are reflected in the documents supporting the company’s transfer pricing policies. When economic times are down and tax department activity slows, it is a great time to review and refresh these documents.
Maintaining a paper trail
It is well settled in local country laws as well as OECD rules that a company must maintain contemporaneous transfer pricing documentation. Corporations that are publicly traded in the United States also have Sarbanes-Oxley 404 requirements for this same documentation. This documentation is generally accepted to include not only a factual description of the intercompany economic relationships but economic support for why the selected pricing is arm’s length. Maintaining this level of written support on a country-by-country basis and keeping it current is inherently difficult, and often impossible, when other seemingly more immediate tasks are demanding attention from limited resources.
The first step is to make sure that the intercompany relationships are understood and up to date. Transfer pricing rules cover myriad relationships, ranging from intercompany sales of goods to cash pooling arrangements. Included in this spectrum are some overlooked items such as loan guarantees, foreign exchange risk management activities, and captive insurance arrangements. It is important that everything be captured.
Reaching out to colleagues in operations, who may also be a bit less busy due to a decline in business activity, is often the only way to understand exactly how the legal entities in various jurisdictions are interacting. Business may have changed since facts were last gathered, and functions and risks may have shifted due to acquisitions, consolidations, or divestitures. It is also a good time to educate those outside of tax on the importance of transfer pricing and why the tax department should be made aware of changes to how business is being conducted.
This fact-gathering process may be time-consuming but it is necessary and it is critical that it be performed in a thoughtful manner so that no intercompany activity is missed. After all, the result will never be positive if a tax authority uncovers an activity during an audit that was overlooked during an internal transfer pricing review. This is especially true if it is material and undermines the factual and economic support for a selected pricing method.
Once facts are gathered and documented, the economic support must be updated and also documented. The methods of doing this are outside the scope of this article, but two of the most popular are directly accessing economic databases or using outside consultants to perform this task. Whatever method is chosen, it is important that it be diligently performed in order to be considered arm’s-length by a tax authority.
The rules and requirements that I have discussed here are well-known. The complexity lies in capturing all the facts and making sure they are all considered and supported in the written economic analysis. However, this is where the opportunities reside.
It is critically important, and legally required, that entities be compensated for the economic activities that they perform and the economic risks that they take. When facts and businesses change, these functions change as well. It is often the case, especially in business environments constantly moving toward centralized business activities, that these shifts are not accounted for in current transfer pricing documents. Because activities are typically centralized in lower-tax jurisdictions, the failure to reflect these centralized activities in global transfer pricing policies is often a missed opportunity.
Intercompany contracts which support various activities, including services, royalties, loans, etc., must be updated to reflect the current activities. If, for example, R&D is being performed in new jurisdictions, then intercompany R&D agreements should reflect that. If they don’t, the economic support for intercompany royalty structures could be at risk.
After all facts are gathered and documented, it is important to review the supporting economics. This includes looking at comparables very closely. Do the comparables still factually match up with the tested party? Are others a better match? In tough and trying economic times, as well as good times with significant merger and acquisition activity, there can be significant changes in both the composition and profitability of comparables. Cash flow problems and incorrect pricing can result if those changes are not reflected in your economics.
It is very important that multinational tax departments be prepared to move quickly to make year-end adjustments. This may require a significant amount of detailed work but the results will be worth it. The primary issue here is the difficulty in many jurisdictions of making taxpayer-favorable transfer pricing adjustments once the original return has been filed.
The bottom line is that there are a number of transfer pricing tools that can be used to both lower a company’s overall risk profile and obtain tax savings, and improve cash flows at the same time. Some are rather easy and high-level, and some require more sophisticated methodology. With an increased risk environment and a need to save cash taxes and improve global cash flow wherever possible, this downward economic cycle is the best time to act.