The impact of COVID-19 on transfer pricing

As the novel coronavirus continues to spread, national and international reactions, with increasing restrictions on the movement of people and goods, will leave unmistakable traces. This could have a significant impact on group earnings, as well as results at country and individual company level. What actions can we take now to mitigate the effects and improve transfer pricing models for the future?

Position of the group after COVID-19 and remuneration of functions

Classical value chains are based on the idea of strong, often historically grown, entrepreneurs who make decisive strategic decisions and combine the intangible assets that are essential for the success of the company in their hands.

The basic rules are:

• Entrepreneurial risks should be borne by the company, deciding whether to take these risks and performing the associated risk management function.
• The agreement of the transaction partners regarding pricing should reflect the above-mentioned risk allocation.
• Profit expectations increase with the functions performed, assets used and risks borne.
• Entities performing routine functions should be entitled to a stable routine return.

The COVID-19 crisis creates a rare situation for multinational groups that could affect internal transfer pricing policies as well. In this respect, a few scenarios that could occur within a multinational group from a transfer pricing perspective should be considered.

Transfer pricing policies within a multinational group

Cost-plus remuneration

Production company in country A produces for pPrincipal in country B. Production company is currently remunerated on a cost-plus basis. Production company is impacted by COVID-19 because the purchase of raw materials is more difficult/impossible or because employees of the production company are impacted by COVID-19.

Questions to consider concerning your group:

1. Which entity within the group bears the risk concerning the procurement function?
2. Do entities in the group that are remunerated on a cost-plus basis still perform activities or are all functions performed temporarily stopped?
3. Which entity is liable if products cannot be delivered due to COVID-19?
4. Based on the outcome of question 1, is a cost-plus remuneration still an at arm’s length method to remunerate the production company?

Transaction based net margin method

A routine distribution company in country A is responsible for distributing principal company’s (country B) products in the local market. Distribution company in country A is usually remunerated based on a routine return and risks lie with the principal. Actual turnover falls significantly short to budgets due to COVID-19.

Questions to consider concerning your group:

1. Does the actual turnover fall significantly short to the budgets you prepared beforehand due to COVID-19?
2. Does the routine remuneration for the distribution company in country A lead to significant losses at the level of the principal company in country B and does this affect the liquidity of your group?
3. Should the budgets that were prepared before the COVID-19 outbreak be adjusted to reflect COVID-19 impact and to prevent liquidity issues for your group?

Resale price method

Distribution company in country A sources products from production company in country B for resale purposes in its region. The turnover either falls short or there is a significant increase (based on the industry in which the multinational group operates).

Questions to consider concerning your group:

1. Does the actual turnover fall significantly short to the budgets you prepared beforehand due to COVID-19?
2. Does the routine remuneration for the distribution company in country A lead to significant losses at the level of the production company in country B and does this affect the liquidity of your group?
3. Should the budgets that were prepared before the COVID-19 outbreak be adjusted to reflect COVID-19 impact and to prevent liquidity issues for your group?
4. In case of a turnover increase, should a transfer pricing adjustment be made, even if prices are affected by the market and not by a specific value-adding functions performed by the entity?

Management fees

As COVID-19 affects the whole world, multinational groups are currently considering their options. In a normal situation, your group can either be considered as a decentralized group (some strategic decisions by group HQ, but most local companies perform their own management) or as a centralized group (management is located at group HQ and performs management services to other group entities). Due to the outbreak of COVID-19, involvement by top management could increase, in the decentralized group as well as in the centralized group.

Questions to consider concerning your group:

1. Can your group be considered as centralized or decentralized concerning management functions?
2. How are management costs currently charged through, are there management fees paid within the group?
3. What is the allocation key of the management functions that are performed in the pre-COVID-19 situation?
4. Is there an increase of management functions performed?
5. Should the costs and management fees be reconsidered to be in line with the at arm’s length principle?

Permanent establishment risks

Certain employees that live in country A work for company B in nearby country B. Because the borders are closed due to COVID-19, the employees start to work from home.

Questions to consider concerning your group:

1. Which role do the employees have within your group?
2. Do the employees make strategic decisions for company B and do they have signing authority?
3. Does the situation trigger a place of management or another PE in country A?

Project reallocations

Several employees of production entity in country A tested positive for COVID-19, and, therefore, all production and business operations are temporarily suspended. Production entity in country B temporarily takes over the production function from production entity in country A and subsequently sells products to customers from production entity B.

Questions to consider concerning your group:

1. How is production entity in country A normally remunerated?
2. Does the production entity in country B have to spend significant extra costs concerning marketing and sales because of the sales to customers from production entity in country A or does only the production function move to country B?
3. Who is responsible for liability claims before and after moving the production function?

Hard to value intangibles

Some countries have enacted obligatory price adjustment clauses for hard to value intangibles. These may apply directly or only in case taxpayers have not agreed upon individual price adjustment clauses. The impact of COVID-19 on budgeted profits may trigger the execution of such clauses.

Questions to consider concerning your group:

1. Have hard to value intangibles or functions been transferred within your group in recent years?
2. Does a price adjustment clause apply?
3. Is the price adjustment clause to be executed?
4. How should the revaluation exactly be executed?

Intercompany financing

As a result of COVID-19, entities within the group could require additional financing to ensure the liquidity of these local entities. If intercompany financing is already provided in previous years, the interest payments could be a burden on the liquidity of local entities. Providing additional intercompany financing or delaying interest payments could be a way to temporarily solve these issues.

Furthermore, if there is a cash pool structure within the group, there could be consequences if certain entities within the group have contributed cash before the crisis that is of more benefit during the crisis and the remuneration for those entities.

Questions to consider concerning your group:

1. How are intercompany loans currently documented?
2. Is there an internal policy for determining interest on intercompany loans?
3. Is there a cash pool within the group and what is the current underlying remuneration for providing cash to the cash pool?
4. Does COVID-19 affect your intercompany financing transactions or cash pool structure?

Conclusion

Is your group significantly affected by COVID-19? Do you want to address local profitability aspects proactively and timely? .