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Dealing at Arm’s Length in Times of Social Distance: A Case Study

Posted on Sep. 21, 2020
Raffaele Petruzzi
Raffaele Petruzzi

Raffaele Petruzzi is the managing director of the WU Transfer Pricing Center at the Institute for Austrian and International Tax Law at WU (Vienna University of Economics and Business) and is an international tax adviser specializing in international corporate taxation and transfer pricing with L&P Global in Vienna and Ludovici Piccone & Partners in Milan. Email: raffaele.petruzzi@wu.ac.at

In this article, the author considers the potential impact of the pandemic on transfer pricing analyses and other cross-border tax matters.

COVID-19 has radically changed the lives of people all around the world. Terms like “social distancing,” “lockdown,” and “quarantine” have permeated our daily conversations. The severe health crisis has led to one of history’s worst crises with a dramatic increase in unemployment, skyrocketing government debts, and unprecedented uncertainty regarding the future.

The pandemic has also significantly changed the way companies do business. Multinational enterprises have been forced to restructure their supply chains. Many employees are now working remotely. Investment in innovations and patenting has decreased while debt and risk levels have risen significantly.

All these changes will have far-reaching effects, including having an impact on transfer pricing analyses for fiscal 2020 and for the years to come. In many cases, the application of the arm’s-length principle will be significantly affected by these new circumstances.1 While many experts have considered how the COVID-19 pandemic will affect the profitability of group members (especially those group members characterized by a limited functional profile), the true impact will reach much further.

Indeed, the pandemic will not affect only the last step of a transfer pricing analysis — that is, the application of the most appropriate pricing method. Rather, it will affect the entire analysis, including each of the following steps2:

  1. identification of the commercial or financial relationships;

  2. recognition of the accurately delineated transaction;

  3. selection of the most appropriate method; and

  4. application of the most appropriate method.

This article shows how the COVID-19 pandemic might affect MNEs’ transfer pricing analyses using an illustrative case study. All the issues raised and solutions provided are specific to the hypothetical facts and circumstances represented in the case study.

The Hypothetical Facts

DELHIciousPizza is an Indian subsidiary of Pizzageddon Group, an Italian MNE that produces and sells pizza all over the world. The group is famous for its unique-tasting dough, and it employs 10,000 pizzamakers in 50 countries.

Before India’s COVID-19 lockdown in March, DELHIciousPizza employed 500 pizzamakers. This included 20 Italian pizzamakers specifically hired for DELHIciousPizza’s local research and development department to customize the taste of the pizza for the local market.

According to the 2019 transfer pricing documentation, DELHIciousPizza was functionally characterized as a full-fledged manufacturer and distributor. It paid royalties to its Italian parent company for its famous original recipe. Based on a development, enhancement, maintenance, protection, and exploitation (DEMPE) analysis, DELHIciousPizza was entitled to a portion of the R&D-related returns from Indian sales because its 20 pizzamakers contributed significantly to improving the recipes to fit the local market. The comparable uncontrolled price method was selected as the most appropriate method to price those royalties and the transactional profit-split method (TPSM) was used as a corroborative method. The application of these methods resulted in DELHIciousPizza paying a yearly 10 percent royalty fee to the Italian parent company.

When India announced its COVID-19 lockdown, DELHIciousPizza had to close all its branches. All 20 pizzamakers flew back to Italy to stay with their families until the lockdown was over. During this period, they kept working for DELHIciousPizza from Italy. Some of the pizzamakers worked from their homes, while some others worked from the R&D department at Pizzageddon headquarters. Obviously, closing the branches resulted in a significant decrease in sales in India (and, for the MNE, throughout the world) and led to significant losses for DELHIciousPizza (and also for other group entities).

In June after a few months of lockdown, the Pizzageddon Group decided that the Italian HQ R&D department should reemploy the 20 pizzamakers. There were various reasons for this decision, including Italian labor law issues and the desire to avoid creating a permanent establishment. From a transfer pricing perspective, Pizzageddon Group concluded that for the rest of the year DELHIciousPizza would not perform any DEMPE functions, and therefore all R&D-related returns from the Indian sales would be attributed to the Italian HQ, resulting in increased royalty payments.3

The changes will remain in place for the rest of 2020, but 2021 remains uncertain.

The figure illustrates the facts described above.

COVID-19’s Impact on the Pizzageddon Structure

Transfer Pricing After COVID-19

Step 1: Identifying Commercial Relations

The first step of the transfer pricing analysis involves identifying the relevant commercial or financial relations, which allows one to accurately delineate the actual transactions. All the economically relevant characteristics — that is, contractual terms, functional analysis, characteristics of properties and services, economic circumstances, and business strategies — should be analyzed for each intragroup transaction.

For the royalty payments from DELHIciousPizza to Pizzageddon HQ, it is important to highlight any economically relevant characteristics that may have changed between the transactions that the group accurately delineated in its 2019 transfer pricing analysis and those that actually occurred in 2020.

To this end, one of the key questions will be how the changes stemming from the lockdown affect the DEMPE analysis and the related royalty payments in the 2020 transfer pricing documentation.

When the pizzamakers remain employed by DELHIciousPizza but they are working from their homes in Italy, there should be no change to the DEMPE analysis — and, hence, no change in the accurate delineation of the actual transaction. The pizzamakers still work for DELHIciousPizza. The fact that they are working from a different location (that is, their homes in Italy) should not make any difference. The relevant DEMPE functions, assets, and risks are still (respectively) performed, employed, and assumed by DELHIciousPizza. For the same reasons, the situation should not change when the pizzamakers work for DELHIciousPizza from the Pizzageddon HQ R&D department. In both cases, however, and especially in the second scenario, DELHIciousPizza may risk creating a PE in Italy if the conditions set forth in both the Italian tax legislation and the relevant double tax treaty between Italy and India are met.

These conclusions will change when the Pizzageddon Group decides that the Italian HQ R&D department should employ the 20 pizzamakers and institutes that change. In this situation, the relevant DEMPE functions, assets, and risks would be performed, employed, and assumed by the Italian parent company, and the accurate delineation of the actual transaction would change.

Another relevant question will be how the changes to the economic circumstances affect the accurate delineation of the royalty payments in the 2020 transfer pricing documentation.4 Indeed, closing the branches resulted in a significant decrease of sales in India — and in the rest of the world — and, consequently, in significant losses for DELHIciousPizza — and for the rest of the group. Hence, DELHIciousPizza (and the Pizzageddon Group) should define how those economic changes affect the accurate delineation of the intragroup royalties and whether the contractual terms and the related allocation of functions, assets, and risks identified in 2019 still reflect the economic circumstances and the conduct of the parties in 2020.

Step 2: Recognizing the Delineated Transaction

The second step of the analysis focuses on the recognition of the accurately delineated transaction. To this end, the commercial rationality of the relevant transactions will need to be assessed. If it is assumed that the accurate delineation of the transaction under step 1 above does not change while the 20 pizzamakers continue to be employed by DELHIciousPizza, then it might also be reasonable to conclude that the recognition of the accurately delineated transaction will not change.

However, these conclusions will change considerably once Pizzageddon Group decides that the 20 pizzamakers should be employed by the Italian HQ R&D department. Indeed, in the hypothetical, Pizzageddon Group concludes that from a transfer pricing perspective DELHIciousPizza will no longer perform any DEMPE functions for the rest of 2020. Consequently, all the R&D-related returns coming from the Indian sales will be attributed to the Italian HQ by means of increased royalty payments.

These changes may raise several questions, including:

  • Should the changes in the transfer pricing policy be recognized as delineated by DELHIciousPizza?

  • Do the changes have commercial rationality?

  • Should the Indian tax administration disregard the changes?

  • Should the changes be considered a business restructuring?

To answer those questions, a thorough analysis should be performed of the following issues:

  • Are there contractual clauses that would prevent the changes? If not, is this circumstance occurring at arm’s length?

  • Are there provisions of Indian commercial law that would prevent the changes?

  • Are the changes supported by commercial rationality? Is it commercially rational to move the experts to Italy considering, among other things, the higher labor costs and the diminished connection to the Indian market?

  • Is there a shift of profit potential from India to Italy?

  • What if the changes are only temporary? If so, how long would they need to last before they raise issues?

Needless to say, all these issues will need to be analyzed on a case-by-case basis. Possible outcomes of the analysis include:

  • The Indian tax administration recognizes the transactions as delineated by DELHIciousPizza and does not consider the changes as business restructurings. The position of DELHIciousPizza will not be challenged.

  • The Indian tax administration recognizes the transactions as delineated by DELHIciousPizza, but it considers the changes to amount to business restructuring. The position of DELHIciousPizza will not be challenged, but some exit taxes might be levied by the Indian tax administration.

  • The Indian tax administration does not recognize the transactions as delineated by DELHIciousPizza and disregards the changes from a transfer pricing perspective. The position of DELHIciousPizza will be challenged.

Step 3: Selecting the Transfer Pricing Method

After delineating and recognizing the actual transaction, the most appropriate method must be selected. In the 2019 transfer pricing documentation the company found that the CUP method was the most appropriate for pricing the royalties, and it used the TPSM as a corroborative method. Therefore, the question becomes whether this choice should be reconsidered based on the changes in 2020.

While the accurate delineation of the actual transaction under step 1 above does not change — that is, while DELHIciousPizza remains the employer of the 20 pizzamakers — the most appropriate method should not change either.

However, when the accurate delineation of the actual transaction changes, the most appropriate method might change too. In this case, the CUP method might still be the most appropriate method, but the corroborative method might change from TPSM to transactional net margin method, depending on the specific changes that occurred. The transactional net margin method might work better than the TPSM if, as a result of the changes that occurred, DELHIciousPizza’s functional profile has also changed and it is not a full-fledged manufacturer.

Step 4: Applying the Transfer Pricing Method

The final step is applying the most appropriate transfer pricing method to price the royalty payments from India to Italy. Based on the 2019 transfer pricing documentation, DELHIciousPizza paid a 10 percent yearly royalty fee to its Italian parent company.

However, in 2020, decreased sales in India have resulted in significant losses for DELHIciousPizza, with group companies in other markets experiencing similar declines. This raises the question of whether, considering the changes to the accurate delineation of the actual transaction — including the Italian HQ’s employment of the 20 pizzamakers and the consequent amendments to the DEMPE analysis — the royalty fee should be redetermined. The answer to this question will probably be yes.

However, the more difficult question will be how these changes should be quantified. The new royalty fee should certainly take into consideration the fact that, based on the accurately delineated transaction, it appears that DELHIciousPizza has not been performing any DEMPE functions since June.

To quantify the changes in the economic circumstances, some ideas that have been developed in practice include:

  • selecting different target ranges;

  • selecting different years; or

  • performing comparability adjustments, either to the tested parties or to the comparable set of data.5

As far as adjustments are concerned, the following solutions might be considered:

  • using information from the financial crisis 2007-2009;

  • using 2020 public company data;

  • using microeconomic data; or

  • using macroeconomic data.6

Finally, when it’s available in 2021 it will be important to consider whether data from 2020 can still be used based on the legal framework of individual countries.7

Conclusions

As the illustrative example shows, the COVID-19 pandemic may have a significant impact on the transfer pricing analyses of many MNEs. This impact will not be confined to the transactions identified in the case study; it will extend to all relevant intragroup transactions, involving services, financing, intangibles, and business restructurings. However, temporary changes should not lead to permanent amendments to transfer pricing analyses.

Moreover, the impact of COVID-19 will extend to other parts of the international tax framework. For example, it will present challenges for the OECD’s ongoing work on the digitalization of the economy and its pillar 1 proposal. As far as amount A is concerned, the pandemic has revealed that not all “highly digitalized businesses” are the same; some have seen gains as a result of the crisis, others have incurred losses. In terms of amount B, the impact of the crisis has shown how difficult it is to conceive of and rely upon predetermined and fixed profitability margins, even for entities with limited functions, assets, and risks. Finally, turning to amount C, it will most probably be more difficult to reach a consensus agreement about binding dispute resolution mechanisms in times of governmental crisis.

There will also be questions about the impact of crisis-related measures on the potential existence of PEs, an issue the OECD discussed in early April,8 as well as on customs and indirect taxes.

Last but not least, tax administrations will face the dilemma of whether to be more lenient with their taxpayers in light of the economic situation or be more aggressive with them considering the need to finance countries’ costly responses to the pandemic and its aftermath. In general, tax authorities should pay close attention when analyzing transfer pricing documentation and, in particular, focus on significant changes to organizational charts and any secondment of personnel.

A key part of the solution to all the problems identified in this article is an improvement in the dialogue between taxpayers and tax administrations. Social distancing may actually have the potential to bring the relevant parties closer together to consider solutions that might have been unthinkable in the old world.

FOOTNOTES

1 Sayee Prasanna and Gabriela Capristano Cardoso, “Developing a Transfer Pricing Policy Framework for the Current Economic Crisis and Beyond,” 27(5) Int’l Transfer Pricing J. 3 (July 2020).

2 See Raffaele Petruzzi et al., “Introduction to Transfer Pricing,” in Fundamentals of Transfer Pricing: A Practical Guide (2018).

3 For the sake of simplicity, this case study will not consider the impact of the timing difference between R&D activities and changes to the products on the market.

4 To simplify the case study, assume that the other economically relevant characteristics (that is, contractual terms, characteristics of properties and services, and business strategies) related to the intragroup royalty transaction remain the same.

5 Brian Cody, Gianni De Robertis, and Werner Rosar, “Determining Arm’s Length Ranges During Economic Downturns: Challenges and Possible Solutions,” WU Transfer Pricing Workshop (July 8, 2020).

6 Id.

7 Paolo Ludovici, Marco Orlandi, and Marco Striato, “Dealing at Arm’s Length in Times of Social Distancing,” WU Transfer Pricing Workshop (May 28, 2020).

END FOOTNOTES

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