In December 2019, the world was taken by surprise with the emergence of a new disease known as SARS-CoV-2 (Covid-19), originating in Wuhan, China. By mid-2020, the virus had evolved into a full-blown pandemic, spreading rapidly and uncontrollably, resulting in a tragic loss of human lives and a significant deterioration of economic conditions worldwide. This situation will inevitably have a negative impact on the profit margins of a substantial sector of the economy and will put the transfer pricing policies of both national and multinational groups to the test.
The Moment Calls for Timely Decision-Making
One of the key variables companies must manage during the pandemic is taxation. For taxpayers who are part of a corporate group and engage in transactions with related parties, it is critical to immediately assess whether their documentation aligns with the economic reality of their business. Failing to do so could lead to an overestimation of the taxable base, causing an immediate negative impact on the company’s financial situation. Several key issues must be considered, including the following:
My Business is Losing Money—Are the Comparables Too?
A fundamental requirement of the transfer pricing regime is to demonstrate the arm’s length value (market value) of each transaction carried out with related parties. The current challenging economic environment, characterized by demand shocks, disruptions in production chains, renegotiation of contractual terms, and a lack of economic support, may, under certain circumstances, lead to negative margins in intercompany transactions or even across an entire business.
In this scenario, and given the frequent use of transfer pricing methods based on profitability analysis, it is essential to ensure that the reference parameters (ranges) used in these methods are composed of truly comparable transactions or, at the very least, companies that share similar industry, distribution channels, strategy, business model, risks, etc. Otherwise, taxpayers may face an unjustified tax burden at an already difficult time.
The situation is even more complex for companies that have recently undergone a restructuring process, migrating functions, assets, and risks, or those that commercialize their excess production capacity and currently operate as contract manufacturers or limited-risk distributors—business models that are presumed to shield them from risks beyond those inherent to their activities. It is crucial to monitor the performance of comparable entities to justify any decline in profitability and, where applicable, support a reduction in the taxable base.
Additionally, with the halt in business operations, companies must carefully document any disruptions or changes in intercompany services to comply with the benefit test required by OECD transfer pricing guidelines. Another critical issue relates to hard-to-value intangibles, which may require adjustments in compensation in the short term due to the significant deviation in valuation estimates under current conditions.
How Can I Renegotiate with Related Parties?
In the current situation, which has led to unprecedented disruptions beyond human control, governments worldwide have implemented emergency health measures. Given these circumstances, taxpayers may consider the materialization of force majeure events, which, by altering contractual equilibrium, could open the door for renegotiating intercompany transactions.
When considering these renegotiations, it is essential to evaluate how the taxpayer itself is restructuring its agreements with customers and suppliers or, alternatively, how the entire industry is adjusting critical variables. Proper documentation of these contractual modifications will be key in justifying any changes to intercompany agreements and avoiding future tax disputes.
What if Additional Resources Are Needed?
A pressing need for many companies will be securing financial resources. In this regard, taxpayers must be aware of the new regulatory framework on transfer pricing for financial transactions issued by the OECD in February 2020. These new provisions coexist with existing anti-abuse rules, which limit the deductibility of interest when debt levels exceed predefined debt-to-equity ratios or adjusted taxable income thresholds (EBITDA).
In any case, identifying how the pandemic affects the group’s capital structure and financing needs, determining appropriate financing mechanisms, and assessing intercompany loan interest rates based on the credit risk of each entity are immediate priorities. Companies should also consider the potential benefits of group synergies, such as cash pooling arrangements, or the impact of parent company guarantees or other entities on loan interest rates.
Business Will Not Be the Same
The pandemic will have lasting effects on many economic sectors. Numerous organizations will need to reassess and restructure their value chains, shifting functions to optimize competitive advantages and mitigate risks. Process automation and the rise of disruptive business models are ongoing trends that will likely accelerate.
In this context, evaluating the transfer pricing implications of upcoming corporate restructurings is a top priority to avoid potential tax contingencies related to the remuneration of displaced business units or functions. Additionally, with the increasing digitalization of the economy, the outcome of the OECD-led negotiations, reflected in the “Unified Approach” proposal, is highly anticipated. This initiative aims to impose taxation on digital economy companies through two key mechanisms:
- Remunerating routine activities performed by multinational groups at market value in the jurisdictions where they operate.
- Imposing a global minimum tax (GloBE) on the residual profits of multinational groups, allocating taxable income among jurisdictions based on their contribution to the group’s revenue.
The immediate future is uncertain and will require careful navigation to avoid disputes with increasingly aggressive tax authorities and to mitigate risks associated with poor transfer pricing planning. We invite you to contact us to discuss this matter further and develop a specific action plan that will allow you to make informed decisions in the short, medium, and long term for the benefit of your company.
