Menu
Tax Notes logo

Three Transfer Pricing Strategies for the COVID-19 Recession

Posted on June 1, 2020
Andrew Hughes
Andrew Hughes

Andrew Hughes is an economist specializing in transfer pricing, valuation, and risk management. He is based in Brussels.

In this article, the author develops several practical arguments and strategies that transfer pricing and international tax practitioners can use in today’s economic environment to optimize their tax strategies and reduce risk regarding intercompany pricing in the face of what will likely be a prolonged global economic recession.

The COVID-19 pandemic has led economists to call today’s economic situation the “Great Lockdown.” As businesses have been shutting down in compliance with government requirements, global supply chains have been disrupted, leading to operational losses and misses on earnings expectations for many multinational enterprises. This has also led companies to draw down on credit lines — either from third-party lenders or from governments themselves in the form of a bailout.

The IMF recently declared today’s COVID-19 recession the “worst recession since the Great Depression, and far worse than the Global Financial Crisis.”1 During the global financial crisis of 2008, the global economy experienced -0.1 percent year-over-year real GDP growth. In comparison, the IMF has revised their 2020 year-over-year GDP growth forecast down from 3.3 percent to -3 percent. In the United States, GDP has fallen by 4.8 percent on an annual basis in the first quarter of 2020, with economists not expecting a return to pre-pandemic levels until 2022 at the earliest. Also, U.S. consumer spending fell 7.6 percent, with travel, hotels, restaurants, and automobiles hit the hardest.2 Lastly, structural changes have rapidly started to take place across the globe with unemployment soaring. In the United States alone, 26.5 million jobs have been lost, in comparison to 15.3 million lost during the financial crisis of 2008, making today’s unemployment rate the highest since the Great Depression.3

All these facts create a challenging context for MNEs, many of which find themselves in the thick of the crisis with losses forecast through at least the next several quarters, if not years. Fortunately, the OECD transfer pricing guidelines provide very clear leeway to adjust intercompany pricing during recessionary times:

Associated enterprises, like independent enterprises, can sustain genuine losses, whether due to heavy start-up costs, unfavorable economic conditions, inefficiencies, or other legitimate business reasons.4

Although IRC section 482 regs are less explicit than those found in the OECD guidelines, chapter 1 of section 482 discusses comparability requirements in the analysis of arm’s-length transactions. One of the factors taken into account is economic conditions, or more specifically, “the economic condition of the particular industry, including whether the market is in contraction or expansion.”5

In summary, both the OECD transfer pricing guidelines and the section 482 regs leave room for taxpayers to maneuver during economic downturns. The following sections describe strategies that a practitioner might enact to optimize intercompany pricing.

Decreasing Returns for Routine Entities

In many international supply chains, MNEs may segment the performance of specific routine functions in single legal entities to drive economic efficiencies within the organization. Some examples of this include limited risk distributors, contract manufacturers, or contract service providers that perform functions under the general direction and responsibility of another group entity.

The OECD transfer pricing guidelines recognize that although “an independent enterprise would not be prepared to tolerate losses that continue indefinitely . . . an associated enterprise that realizes losses may remain in business if the business is beneficial to the MNE group as a whole.”6 This opens the door to potentially having loss-making entities in a multinational supply chain. However, the question should still be asked whether such routine function entities actually should bear the risk of an economic downturn to the point of being in a loss-making position. Rather, perhaps a downward adjustment of current returns is more sustainable if warranted at all by the facts and circumstances.

Guidance can be best derived with reference to the performance of the set of comparable companies used to benchmark returns for the routine function entity pre-crisis. For example, statistical analysis can be performed to see if an adjustment to pricing is warranted in an economic downturn. To provide a concrete example, I pulled the operating margins of a set of routine food distributor companies around the time of the global financial crisis.7 The bulk of the last recession took place during 2007 and 2008, when the majority of bankruptcies, economic stimulus, and monetary policy changes took place. As we can see in the table, there is a clear decline in 2007 and 2008 in the average operating margin of a set of routine food distributors.

Average Operating Margin for North American Routine Food Distributors During Last Recession

Operating Margins

2006

2007

2008

2009

2010

2011

Upper Quartile

3.6%

3.1%

3.3%

5.6%

4.7%

5.6%

Average

2.3%

1.9%

0.9%

4%

3.1%

3.8%

Lower Quartile

0.8%

0.8%

0.7%

2.7%

1.6%

1.8%

A practitioner who observes a similar pattern among their set of comparable companies can perform one of two actions. The simplest is to adjust intercompany pricing downward based on past margin evidence and statistical adjustment of their most recent returns. For example, observation of a 50 percent decrease in margins over the prior economic depression could merit a similar downward adjustment in intercompany remuneration for the economic recession. Certainly, such a “high-level” adjustment should be corroborated by using the latest industry and analyst estimates available. Projected earnings and forecasts of the comparable companies should be heavily scrutinized to make sure that the practitioner has taken into consideration all possible information before an adjustment is made. Practitioners should also err on the side of caution to ensure that any eventual adjustments will not be too drastic, potentially falling outside the range of comparables’ actual results and requiring end-of-year adjustments.

A more complex analysis would entail an actual econometric regression to determine what percentage change in operating margin would occur given a percentage change in GDP. If a strong correlation can be found between industry average remuneration for routine function and GDP, forecasted projections in GDP can help practitioners more accurately determine if a corresponding adjustment is warranted to intercompany pricing and, if so, how much.

Decreasing Returns for Principal Entities

The second strategy that tax practitioners can enact is in reference to the intercompany returns for principal entities. Whether your organization is a large multinational group with many legal entities or a single entity, it is likely that it will be affected by the Great Lockdown recession. Principal entities could find themselves in loss-making positions lasting several quarters or years, which could be further exacerbated if routine return entities are still in a profit-making position. In such a case, defense files should be prepared to justify these principal losses, or companies should seek advance pricing agreements from their governments so that the losses will be accepted and deductible.

I reiterate that when possible, an econometric regression analysis could correlate changes in GDP to changes in overall company profitability. To provide a concrete example, I pulled the publicly available financials of a privately held European passenger railway company and regressed its revenues against GDP of the OECD countries. The figure visually showed a strong relationship between GDP growth and sales growth.

Railway Passenger Sales vs OECD GDP

After running the regression, 95 percent of variation in this company’s sales was found to be explained by GDP movements. Although this is one very specific example, it shows that applying economic studies to a company’s response to economic recession can help explain historical and future losses caused by a recession. Performing a similar regression within your organization, by region or by segment, is likely to provide compelling results of decreasing revenue or profit for the overall company or a principal entity.

Companies able to draw similar links could use this analysis to build an audit defense file against a tax authority’s interrogations over losses built up during a recession, or as a bargaining tool in negotiating future intercompany pricing or APAs. Prudent practitioners will realize that these analyses are straightforward to perform and can even be included in negotiations with tax authorities during “normal economic times” over pre-agreed adjustments in the case of future economic downturns.

Building Documentary Evidence

Tax practitioners should also be taking advantage of the unique situation presented under these economic conditions either to support complex transfer pricing strategies or to think about how to optimize tax structures going forward under nontraditional arrangements. Large government bailouts are taking place across a variety of industries, providing a multitude of third-party transactions that could support complex intercompany transactions.

United Airlines will receive $1.5 billion in funding from the U.S. government while paying a 1 percent interest rate for the first five years. The cheapest collateral-backed debt before the COVID-19 pandemic for airline companies carried interest rates of 2 to 3 percent, with unsecured debt commanding an interest rate of between 4 and 6 percent. In return, Treasury will receive warrants to buy shares in return for the funds.8 Also, Delta, American, Southwest, and Alaska Airlines are expected to pull from the government-provided funding that provides a mix of grants and loans at lower-than-market rates.

Many other publicly traded companies have taken loans from the U.S. government under the Coronavirus Aid, Relief, and Economic Security Act (P.L. 116-136). Publicly traded companies — including, inter alia, MiMedx Group Inc., Digimarc Corp., and ZAGG Inc. — all have accessed funding under the Paycheck Protection Program as part of the act.9 This funding carries with it a 1 percent interest rate and criteria for potential forgiveness. The U.S. government is not the only government to provide fully guaranteed loans or loans with below-market interest rates.

What is clear is that we are seeing many extraordinary third-party transactions. Governments are showing a sensitivity to protecting businesses, strategic supply chains, and jobs, and doing so by propping up MNEs with financial support that may not have been available in a fully capitalistic free market. Transactions supported on the market today can create compelling precedent for international organizations that are looking to implement business strategies that may result in local losses. Tax practitioners that need to justify more complex intercompany strategies such as market support payments, market penetration payments, or subsidies payments to loss-making entities will have more market comparables and reference to transactions during this crisis that could provide solid rationale in an intercompany context. MNEs looking to finance “below-investment-grade” entities or entities through hybrid arrangements (for example, lower interest rates in exchange for issuance of warrants) will also find precedence in today’s economic context.

Diligent tax practitioners should closely monitor and document the facts and circumstances of today’s economic environment. Transactions seen on the market can provide ideas and strategies for implementation in a future intercompany context and allow an organization more flexibility to implement “nontraditional” intercompany strategies in the future.

Conclusions

The Great Lockdown is a recession like we have not seen before. Tax practitioners will likely need to reexamine their intercompany strategies and pricing arrangements, especially as MNEs enter downturns and potentially loss-making positions. Multinational groups can leverage data from past crises to proactively adjust their transfer prices for 2020 and beyond. For loss-making entities, companies should start considering defending loss positions in their documentation and leveraging facts and data to consider future negotiations with tax authorities. Future APAs can include statistical analyses that provide flexibility for the taxpayer for downward adjustments to their intercompany pricing. Lastly, taxpayers should closely follow up on and document the nontraditional transactions occurring in the third-party marketplace today. Such transactions can provide precedence for future transfer pricing planning opportunities and be used to potentially defend complex intercompany positions.

FOOTNOTES

1 IMF, “The Great Lockdown: Worst Economic Downturn Since the Great Depression” (Apr. 2020).

2 Ben Casselman, “Worst Economy in a Decade. What’s Next? Worst in Our Lifetime,” The New York Times, Apr. 29, 2020.

3 Lance Lambert, “Real Unemployment Rate Soars Past 20% — and the U.S. Has Now Lost 26.5 Million Jobs,” Fortune, Apr. 23, 2020.

4 OECD, “Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations,” at para. 1.129 (July 2017).

5 Section 482-1(d)(3)(iv)(G).

6 OECD transfer pricing guidelines, at para. 1.129.

7 I selected Amcon Distributing Co., Chef’s Warehouse, Core Mark Holding Co. Inc, Innovative Food Holdings, Sysco Corp., and United Natural Foods Inc. as the set of routine food distributors in North America that were active during the previous recession.

8 Claire Bushey, “Bailout Interest Rate for US Airlines Is as Low as 1%,” Financial Times, Apr. 20, 2020.

9 Hilary Russ and Joshua Franklin, “Some U.S. Companies Will Keep Small Business Loans, Defying Backlash,” Reuters, Apr. 24, 2020.

END FOOTNOTES

Copy RID