COVID-19 and transfer pricing

Due to the economic downturn caused by COVID-19, some of the common transfer-pricing positions should be reassessed.

By JONATHAN LUBICK LIOR HADDAD, LEON HARRIS
An electronic board displaying market data is seen at the entrance of the Tel Aviv Stock Exchange, in Tel Aviv, Israel (photo credit: REUTERS)
An electronic board displaying market data is seen at the entrance of the Tel Aviv Stock Exchange, in Tel Aviv, Israel
(photo credit: REUTERS)
Transfer pricing refers to pricing between related companies around the world. Much international trade is done via multinational groups.
Due to the economic downturn caused by COVID-19, some of the common transfer-pricing positions should be reassessed. One popular position that appears to have become a globally accepted axiom is the term low-risk distributor (LRD) or low-risk service provider (LRSP). This specific axiom states that LRDs and LRSPs cannot ever lose money
In a standard transfer-pricing comparable profits method (CPM) or transactional net margin method (TNMM) analysis, the main risks are adjusted through the use of working capital adjustments, i.e. adjustments for differences in the level of accounts receivable, inventory and accounts payable between the taxpayer and the comparable firm. Once these risks are adjusted for, a transfer-pricing practitioner needs to determine if there are other risks that can be quantified. In theory, one other quantifiable risk would be the difference in market risk between the comparable firms and the taxpayer (or tested party).
As the LRDs/LRSPs bear some market risk, then there is validation for a LRD or LRSP to lose money or earn zero profits during an economic downturn, subject to the points we raise below.
The following aspects need to be considered where appropriate:
1. Determine which entity is requesting the transfer-pricing change. Is it the parent company or is it the subsidiary or both. Highlight this fact and the reasons for the change.
2. Determine and measure quantitatively the factors which are causing the pricing change. Factors could be:
a) a decline in sales or in sales forecasts,
b) costs associated with releasing or firing workers, and/or
c) costs related to unused office space or others. Note that the cost elements noted herein will not be part of the transfer-pricing analysis when determining the appropriate arm’s-length return. These costs may be classified as temporary expenses so long as the pandemic continues, and be recorded after the transfer-pricing benchmark is established.
3. If one is relying on a net cost plus analysis, and stock options are included in the cost base, they likely ought to be repriced in the transfer-pricing analysis based on the present conditions in the appropriate stock market or the economy at large. The difference between the previous price and the present price would be an expense that would not be incorporated into the cost base for the cost plus markup.
4. With respect to the three bullet points above, external benchmarks pertaining to industry metrics or market information ought to be documented. For example, declines in industry metrics (revenues, sales, values, etc.) or in specific companies that are deemed competitors, should be highlighted to provide validation of the above analytics;
5. Assess whether the intercompany contract allows for renegotiation of pricing terms. If so, assess the ability for the LRD or LRSP to earn a zero profit or lose money.
6. If possible, redo the intercompany contract. In redoing the legal contract, consider including a force majeure clause.
7. In the COVID-19 era, e-commerce is increasing rapidly, so are the tax rules in many countries. Do you have an optimal e-commerce tax strategy?
Note that an aggressive tax examiner (e.g. at the Israel Tax Authority) could argue that the above changes represent a change or transfer of risks, as such, a “business restructuring” in which intangibles or risks have been transferred. While the risks presently are “negative” risks, they will in the future potentially be “positive risks” with a value.
Strong and timely documentation may negate this argument together with additional quantitative work not pertinent to a standard transfer-pricing study.
On a related note, the OECD is proposing a major international tax reform. Under “Pillar One” of these proposals, multinationals may be taxed using a formula on the revenues generated in a given local country, even if the multinational has no nexus in that country!
An important question now arises: can a multinational be taxed if a profit split analysis shows a loss in a local country or globally, e.g. due to COVID-19 economic circumstances? And even worse, multiple taxation on losses! These issues need attention.
COVID-19 highlights the weakness of the formulary approaches in the OECD’s Pillar One, and “deemed” formulary approaches such as the LRD/LRSP concept. Solutions exist. Whether you are large or small, make sure you have the right international strategy.
Jonathan Lubick and Lior Haddad are transfer-pricing specialists at Jonathan Lubick Consulting. Leon Harris is a tax specialist at Harris Horoviz Consulting & Tax Ltd. The views expressed herein are those of the authors only. As always, consult experienced advisers in each country at an early stage in specific cases. jonathan@jlc-intl.com, lior@jlc-intl.com,  leon@h2cat.com