There is no modern precedent for dealing with a world pandemic and its impact on our global businesses. Companies need to consider all aspects of their operations to strategize and to take decisive action to minimize their losses, as well as to take advantage of the strategic planning opportunities that this downtime may bring.
As if global transfer pricing considerations were not complicated enough, they become infinitely more so in this environment. We recommend that multinational firms review their existing global transfer pricing strategies today, assess them for suitability in this environment and reconfigure them if needed to make their companies stronger in both the short- and long-term.
The economic impact of this pandemic will run deep and transfer pricing strategy will be impacted. As companies deal with reduced sales and profits, they may fall out of their respective profitability ranges against benchmarked firms. This will impact customs declarations and the cash flow needs of affiliates may be significantly different, depending on the timing and severity of impact. The IRS may not provide taxpayers with concrete guidance on how to adjust to the current realities. We may start hearing informal whispers from tax authorities such as “not an extraordinary event”, “normal course of business” and “typical risks” for companies. As multinationals receive the message that tax authorities still expect them to earn profit within the normal targeted range of their existing comparable firms, taxpayers and advisers need to proactively build the case for change.
Let’s be clear, world pandemics are indeed extraordinary events. Companies can neither predict nor control these events and thus there is no way they could have anticipated the risks and hedged against their impact. Companies can’t rally quickly enough to mitigate the damages, with supply channels in place and production tough to shift, plus declining sales due to inevitable increased pricing or consumers’ inability to leave their homes to physically purchase the product.
Transfer pricing regulations are meant to prevent multinational firms from manipulating their internal pricing for goods, services, royalties, or financing based solely on differences in tax rates. Current world events have nothing to do with transfer pricing and tax manipulation. This point is clear for many reasons, but primarily because companies did not initiate these events, nor do they benefit from them uniquely, nor in a way that universally favors their global tax position. Every country in which the multinational operates, regardless of the tax rate, is negatively impacted by these unprecedented events. Every operating segment of the multinational, regardless of its location, will be disrupted. Any resulting changes in transfer pricing are not proactive attempts to manipulate taxes, but a reactive way, after the fact, to mitigate the operational damages to these one-off, extraordinary events.
Multinationals and their advisors should work together to consider these 4 practical transfer pricing action items. Taken today, these assessments will allow for a smoother transfer pricing documentation process for fiscal year 2020.
Practical Action Items for Transfer Pricing Strategy
#1: Capture the New Story of Your Business:
Quantify + Make Adjustments for Extraordinary Events
It’s critical to capture the details today while they are happening in real-time. Documenting the story of the business and how current events are impacting operations today is essential when attempting to quantify and adjust for those impacts during FY2020 transfer pricing documentation. Depending on the industry and impact on the business, there are opportunities to claim extraordinary events, to quantify the additional cost or the loss of revenue, and to adjust for them. For example, a severe drop in sales could be attributable to supply channel deficits or lack of customers due to manufacturing shutdowns or sheltering-in-place. We can see the trajectory in actual against budget for the year (or multiple years) and quantify and adjust for the COVID-19 impact.
Another example, if bottom-line profits are down due to layoffs, the severance costs can be considered one-off, extraordinary costs that were neither predictable nor recurring. We would argue that these costs should be removed from the operating margin calculation before comparing to benchmarked comparable firms.
If the business decline is excessive, there is also an opportunity to change the transfer pricing strategy based on a new categorization of entities. A new FAR (functions, assets and risks) analysis is critical to understand the new dynamics of the global operation and to recategorize the various companies. For example, can the limited function/risk distributors still be considered low risk in this unprecedented environment? How can affiliated companies share the impact of this extraordinary burden to their business? Global transfer pricing strategies may need to be revisited in light of this unprecedented and unpredictable economic impact. A reassessment of risks will allow for quantifying the financial impact and making adjustments to mitigate. If a change in transfer pricing strategy is necessary to account for the present-day business, it’s best to make the change before the end of the 2020 fiscal year. This way, changes are incorporated into the accounting when it’s time to prepare the 2020 contemporaneous documentation in 2021, and transfer pricing is supportable because it’s the optimal one for the facts and circumstances of the current business.
#2: Review Product Pricing + Customs Declarations to Ensure Optimal Approach
It’s critical for distributors which import products from cross-border, affiliated manufacturers to understand their current customs position and to revisit their strategy if needed. This allows for flexibility in changing product pricing among affiliated manufacturers and distributors (or third parties). These world events present an opportunity to be more strategic about customs declarations and attempt to minimize customs duty. There are several considerations related to a customs strategy, including source of origin (as the regulations are rather ambiguous on this) and timing of liquidation in terms of the customs declaration and product pricing/customs duty paid.
In particular, there is a customs reconciliation program that allows importers of record to leave declarations open for an extended period of time before declaring the actual cost of the product and resulting customs duty based on that declared value. This provides the flexibility taxpayers may need right now to make changes to the transfer pricing related to product purchases so that they are within targeted transfer pricing ranges. It will reduce the need for a more burdensome scenario where a drop in the product price triggers the need to claim future refunds on the duty already paid. While many multinational enterprises currently use this strategy, smaller international companies and importers may want to consider the benefits in this new environment.
contact a member of the International Tax Team
#3: Develop New + Improved Cashflow Management Strategies and Repatriation Planning
Not all companies have coordinated global financing mechanisms between affiliates, such as a treasury function, cash pooling, cashflow management and repatriation strategies. Regardless of size, all companies operating globally should give consideration to the methods in which they handle financing across affiliates as current events may expose some weaknesses and provide opportunities to improve them.
Cash shortfalls may appear in unexpected markets in which the global company operates, depending on the timing and severity of the current crisis and its impacts on the business. With a global approach to cash management, the company is in the optimal position to divert funds where needed as quickly as possible for these operational shifts.
Intercompany loans could take longer than normal to settle as affiliates are faced with revenue shortages and increased costs. This is true for third-party loans as well. Since we are seeing concessions made in the marketplace for third-party lenders, related parties should consider similar concessions. The regulations do allow for delayed intercompany loans repayments and clauses in legal agreements may do the same. It is important to review and reconsider language in case the legal agreements (both intercompany and third-party) do not provide for changes based on extraordinary events.
Current events will test the strength of multinationals’ cashflow management systems and repatriation strategies. Affiliated companies could be subjected to governmental decisions that restrict their ability to move cash out of their market. The implications of this could be instantaneous, with multinationals unable to repatriate funds as needed. The inability to move funds between locations where they are due and required for normal business operations could dramatically impact transfer pricing targets and international tax positions.
To prepare for a world where certain entities need more cash than others, depending on how much the business was impacted, multinationals should understand and revisit their financing/treasury strategies to be certain they are efficient.
#4: Understand New Levels of Tax Uncertainties + Transfer Pricing Risks
Transfer pricing is the biggest tax uncertainty for multinationals and efforts should be made to minimize risk. Companies work hard to understand and mitigate risk, primarily through annual documentation contemporaneous to their tax return filings. The most certainty around transfer pricing risk is a bilateral or multilateral Advance Pricing Agreement (“APA”) because it is a Competent Authority negotiation and agreement by all tax authorities to the company’s global transfer pricing. There is, of course, the standard clause that the signed APA is only valid if there are no significant changes to the facts and circumstances of the taxpayer’s business. Whether or not current events can be categorized as a significant change in the business must be determined on a case-by-case basis. The IRS Advance Pricing and Mutual Agreement Program (“APMA”) issued modified procedures this week to assist taxpayers amidst the turmoil of COVID-19.
Companies that have worked hard (and allocated significant budgets) to manage and lower transfer pricing risk now face uncertain times. Current events require them to revisit transfer pricing strategies, APAs and other Competent Authority agreements. APMA is suggesting that a change in business results would not necessarily materially change the terms of the APA, assuming facts and circumstances of the initial APA filing request remain the same. Taxpayers should seek guidance from past recessions or economic turmoil where certain adjustments were proposed to handle APA impact.
Multinational companies are already dealing with significant operational changes with their supply chains at risk, manufacturing plants shutting down, customers drying up, employees being furloughed or terminated and now they have the added complexity of dealing with higher transfer pricing and tax uncertainty. The sooner companies assess and understand their new risk position, the better they can mitigate the risks and be prepared for any upcoming transfer pricing audits. It stands to reason that the current events may trigger increased scrutiny and transfer pricing audits by the IRS and other tax authorities to confirm taxpayers are still complying with arm’s length, or market-rate, pricing, as well as to make up for government revenue disruptions that are currently taking place for the same extraordinary reasons.
Multinational companies should consider improved transfer pricing strategies and streamlined contemporaneous documentation for the fiscal year 2020. For additional information, including a review of global transfer pricing strategies and recommendations for minimizing any negative financial impact, contact Marina Gentile, Lead of Global Transfer Pricing Strategies at Withum.
International Services Tax