Tax Planning in the Wake of COVID-19: Transfer Pricing in a New Economic Reality

Transfer Pricing Practice Leader

The economic impact of the COVID-19 pandemic is having serious implications for multinational groups’ transfer prices, analyses, and documentation. In this unprecedented environment, businesses must reexamine the fundamental principles underlying their transfer pricing policies and take proactive steps to develop and ensure defensible comparable companies and benchmarks are guiding transfer pricing now, in 2020, and as the global economy ultimately recovers from the COVID-19 outbreak.

Disruption hits transfer pricing methodologies

Transfer pricing benchmarking, valuation, compliance, planning studies and accepted methodologies, such as CUPs, CPM/TNMM and even the residual profit split, hinge on applying reasonable comparable companies and these companies’ financial results to determine defensible transfer prices among and between controlled legal affiliates located across international or US state borders. Currently, COVID19 is an unexpected global market supply and also a demand shock that is impacting the balance sheets and overall profitability of comparable companies applied in transfer pricing analyses.

Most multinational and US domestic multistate firms establish their current year FY2020 transfer pricing policies and profitability metrics (gross margins, cost plus mark ups, interest rates, etc.) based on best comparable company financial data available in the most recent prior year (2019) or prior three years (2017 – 2019). This approach is the basis for OECD and UN transfer pricing guidelines, as well as US Section 482 and local country transfer pricing regulations. The key assumption underpinning these comparability analyses, most relevant in establishing current FY2020 transfer pricing policies, is that the underlying macro economy will largely remain stable and unchanged year to year.

However, the first calendar quarter of 2020 is directly challenging this underlying assumption. In the first calendar quarter of 2020, especially since March 2020, nations around the world are being challenged with “stay at home” policies, severely limited or suspended business operations, and severe reductions in their workforce to prevent the spread of COVID-19 among their communities.

COVID-19 has few historical precedents

The major difference between this unexpected COVID-19 pandemic economic supply shock and the sharp downturn in 2008-2009, is that the COVID-19 pandemic shock is being felt widely across multiple industry sectors. In comparison, the 2008-2009 shock was largely limited to the financial services and banking industries. Lehman Brothers went bankrupt and US unemployment rose to a high of 10.2% in 2009, but for the most part, the US and global workforce still had jobs and continued to work.

This is not the case in the current COVID-19 environment, which has caused severe dislocation and disruption in global supply chains and workforce. US unemployment is expected to exceed 2009 levels by May 2020.

When economic assumptions fail

COVID-19 has triggered the validity of the underlying macro-economic stability assumption behind currently-active FY2020 transfer pricing policies and operations. As a result, the actual, current 2020 financial results of comparable companies that underpin FY2019 and FY2017-FY2019 transfer pricing benchmark analyses, which are actively being applied to drive and manage multinational companies’ FY2020 transfer pricing policies in Q1-Q2/2020 -- and likely for the rest of this fiscal year and into fiscal 2021 -- are sorely out of step with actual business operations and depressed financial returns that the multinational firms’ tested party affiliates may currently be facing.

The comparable companies’ actual 2020 financial results may be able to inform FY2021 transfer pricing policies, but they are currently not available contemporaneously to determine the arm’s length profitability or valuation required to determine firms’ FY2020 transfer pricing policies and support operations to settle accruals and book journal entries on a quarterly or monthly basis.

What businesses can do

There are a number of available options to address this disruption, depending on how your company is being impacted by COVID-19.

Option 1: For companies experiencing or expected to experience sharp contraction in their business operations during this supply shock and into 2021:

1. MGO can provide a ‘look-back’ benchmark analysis to review comparability of a companies’ profitability margins during the 2008-2011 financial downturn and analyze how these comparable companies were impacted financially during that earlier period. Each industry will be impacted differently; however, one can assume that comparable companies’ profitability (or lack thereof) during the 2008-2009 recessionary period could at least provide a ceiling for an expected range of returns among comparable companies now facing an unexpected global economic supply shock in fiscal 2020.
2. MGO can review the national COVID-19 guarantees and company support payments and assess whether affiliate financials need to be adjusted to account for these subsidy measures. Inter-company markups and profit margins may trend downward as a result.
3. MGO can re-examine industry competitors and assess overall comparable company impacts in the specific industries due to COVID-19. For example, we can determine whether your firm’s global sales and marketing affiliates should continue earning positive or break even returns depending on peer and industry performance.
4. MGO can review and make recommendations for revising inter-company agreements that ensure optimal tax and transfer pricing risk-taking positions for controlled affiliates.

Option 2: For companies facing increased or expanded business opportunities during this supply shock (like Amazon, Costco, Medical suppliers and Pharmaceutical companies among others):

1. The Commensurate with Income (“CWI”) standard could provide additional audit defense support ex-post for active FY2020 transfer pricing policies currently being applied.
2. Negative economic supply shocks can be optimal opportunities to implement tax restructuring and associated shifts in IP ownership. MGO can assess international restructuring opportunities and conduct IP and business enterprise valuations for private and publicly traded firms.

Option 3: For companies in a zero or negative interest rate environment:

1. The cost of accruing Payables and Receives and other working capital becomes near zero. Some of these assets and liabilities may be written off entirely, materially written down or recharacterized as debt or equity.
2. Adjustments and revisions to comparable company balance sheets in fiscal 2020 and 2021 are thereby worth reviewing to ensure similar tax treatment and COVID-19-related adjustments are obtained for transactions among and between related parties.

The MGO Transfer Pricing Practice is ready to assist and provide ‘look-back’ benchmarks, revised Valuations and new Commensurate with Income Analyses. We can help ensure you have an audit-defensible position for your company’s US and global transfer pricing policies and operations, at the close of fiscal 2020 and looking ahead into fiscal 2021, that consider the economic impact of COVID-19 on your industry and firm.

To schedule a consultation, contact us today.