Aimée Dushime is a senior tax adviser and Chidinma Onukogu is an experienced analyst with KPMG’s global transfer pricing services in Lagos, Nigeria.
In this article, the authors discuss adjustments that companies might make in light of the coronavirus pandemic, as well as their related transfer pricing implications.
The COVID-19 pandemic has disrupted business in various sectors, and many organizations have been forced to significantly modify their operations to address its short- and long-term effects. In the short term, some groups may resort to decentralizing intragroup activities if local companies can better handle those disruptions, while others will either centralize most operations for better control or introduce new cross-border services to cope with the pandemic.
Those operational modifications have transfer pricing implications.
Amending Contracts
Some intragroup contracts finalized under normal circumstances might no longer be favorable to some parties, which could necessitate renegotiation. Contracting parties must critically evaluate whether a renegotiation or termination of these intercompany contracts is necessary in the current economic circumstances, as well as how independent parties would likely treat those arrangements. Some contracts might allow for amendment, such as in their terms and conditions or force majeure clauses. Companies should document all changes made to contracts and maintain those supporting documents so they can justify any amendments in the event of a transfer pricing audit.
Should the contract be renegotiated, the terms must be similar to the outcome of renegotiations conducted by independent parties in similar circumstances. In any contract renegotiation or modification, it is important to refer to the conduct of independent parties under similar market conditions because that is the most reliable basis for justifying any action.
Intragroup Cash Pooling Arrangements
To resolve their liquidity problems and manage working capital needs, companies might opt for intragroup cash pooling arrangements, which must be managed efficiently to control demand and manage group liquidity. Therefore, there might be a need to review credit limits or include additional compensation in cash pool drawings. That could be in the form of a fixed rate or premium to the group member providing additional funding to the pool or to any funds drawn from the cash pool. The applicable fee or premium will serve as an emergency liquidity buffer for the group.
Loans and Guarantees
The profitability of most companies has been harmed, which translates into a low credit risk profile. Thus, it is highly likely that subsidiaries will rely on their parent companies to provide loans or to act as guarantors when seeking loans because independent lenders may request such guarantees. A guarantor should evaluate a loan’s associated benefits (that is, interest cost reduction or increase in debt capacity) and risks because the loan might be seen as partly lent to the guarantor if the borrower would ordinarily be unable to obtain the loan, given its credit risk profile. That might lead to a recharacterization of the guarantor’s role for transfer pricing purposes and could require compensation.
It might also be more difficult to justify intercompany loans and their terms if market benchmarks do not reflect today’s extraordinary circumstances.
There could be many loan restructurings now because of possible modifications to old intercompany loan terms, such as allowing borrowers to skip interest payments, extending the loan’s tenure, converting outstanding loan debt to equity, and rolling forward interest and capital repayment. In restructuring intercompany loans, the treatment of similar third-party loans under current circumstances should be considered, and any adjustments should be documented and in line with what would be obtainable in the market.
Identifying Comparable Companies
In benchmarking transactions following a crisis, comparable companies tend to be unreliable in reflecting recessionary times. A standard benchmark search strategy will exclude loss-makers, so the available comparable companies will exclude those severely affected by the crisis. That will result in understating the pandemic’s actual impact because the companies most affected might be out of business or loss-makers. Thus, the available companies will be only those that were able to survive the recession.
Another factor to consider is the lack of real-time data because financials of comparable companies for the current year will not be available until late next year. That will pose a challenge for companies that want to identify arm’s-length prices because the benchmarking results will not reflect the true nature of the economy in the year under review. While companies might consider making adjustments to the tested parties and set of comparables in trying to accommodate today’s circumstances, they should first consult their revenue authorities to gain certainty on the acceptability of such an adjustment.
Management Support Services
Related entities may incur crisis management costs, so it is important to evaluate how those activities interact with the company’s supply chain. To determine the appropriate treatment of those costs, businesses must consider whether they benefit group members and affiliated companies — that is, they pass the benefit test; whether they are duplicative or result in major long-term benefits for the company; as well as the functions and risks incurred by the crisis management teams, how those costs are charged out, and whether they constitute shareholder activity or low-value-adding services. It is also important to document the facts and circumstances of those transactions because the costs could trigger an audit — especially if they are significant.
Other Tax and Transfer Pricing Considerations
Advance Pricing Agreements
Advance pricing agreements are based on fulfilling assumptions, such as that the taxpayer’s business activities, functions, risks, and assets remain materially the same as those described in its APA request. Therefore, taxpayers with APAs should consider evaluating the pandemic’s effect on these agreements. APAs in progress should be reviewed to determine the current relevance of data and information already presented to a tax authority and the ability of both the taxpayer and tax authority to proceed with agreed timetables should data need to be resubmitted or transactions change during the negotiation period.
Permanent Establishments
Article 5 of the 2017 OECD model tax convention defines a permanent establishment as:
A fixed place of business through which the business of an enterprise is wholly or partly carried . . . a place of management, a branch, an office, a factory, a workshop, a mine, an oil or gas well, a quarry or any other place of extraction of natural resources, a building site or construction or installation project constitutes a permanent establishment only if it lasts more than twelve months.
Given that movement has been restricted during the pandemic, some taxpayers might be forced to work away from their place of residence, and employers might be required to pay employees who are stuck in different jurisdictions. Whether those circumstances will give rise to a PE depends on the laws of the jurisdictions in question. Taxpayers should consult with their revenue authorities to avoid unforeseen tax liabilities and penalties.
Functions, Assets, and Risk Analysis
Some functions previously undertaken by related entities have been halted, while others have significantly increased. Taxpayers should reassess the functions performed, assets used, and risks borne by any particular group entity, as well as how that should be rewarded. Changes in functions performed could affect the functional analysis used to appraise arm’s-length pricing.
Transfer Pricing Methods
In benchmarking related-party transactions, the OECD has recommended the comparable uncontrolled transaction method as the most preferred when reliable data is available. Current conditions might make reliable comparables unavailable, especially for transactions that result in a loss for the service provider. Related parties might be forced to reevaluate the suitability of their transfer pricing method, given the economic climate and substantive changes to the related parties’ functional profiles.
The OECD has also provided guidelines on determining the arm’s-length price for routine functions, saying companies that provide those functions should not make long-term losses under normal circumstances. However, whether those routine companies will make a profit right now will be determined by market conditions.
In testing for routine functions, the method already in use might have to be applied with a slight adjustment to account for the economic circumstances. If the method and terms of compensation are not especially apt in today’s conditions, the long-term implications of a change in method should be considered. Companies should also consider how third parties are remunerating similar transactions to determine the arm’s-length price.
Digital Economy
It is safe to say that COVID-19 has sped up the digitalization of the economy by causing business owners to think creatively and find innovative ways of providing services. During this period, services such as e-commerce, entertainment, online streaming, and finance and medicine have become more digitalized. Digital platforms are playing a major role in helping reduce disruptions to daily life. For instance, distance learning and cross-border educational services have become the norm, adopted for levels from kindergarten to postgraduate. Most notably, there has been a shift from physical interactions to classes being prerecorded and assignments being submitted at the click of a button.
The expansion of the digital economy has enlarged digital tax footprints and will enable revenue authorities to expand their tax nets. Nigeria and other countries have introduced significant economic presence guidelines in their income tax legislation. Tax administrations will be keen on obtaining their fair share of revenue generated from digital transactions that create PEs in their jurisdictions.
Conclusion
Tax audits will continue, so taxpayers should reevaluate their transfer pricing policies as a matter of priority. While companies are expected to respond differently in order to survive challenges or take advantage of opportunities created by COVID-19, the modifications to their related-party transactions and transfer pricing policies must be consistent with the arm’s-length principle. Documentation of adjustments to agreements and transfer pricing policies must be justifiable to ensure that tax authorities do not misconstrue them as opportunistic.