The adverse impact of COVID-19 on a large number of businesses requires no introductory comment, as their focus turns to survival and cash preservation. Transfer pricing may not naturally be seen as an immediate concern for a number of multinational groups dealing with these key imperatives.transfer pricing

However, as other recessions have demonstrated, transfer pricing is inevitably a key issue that multinational groups will need to turn their minds to – and with proper application, it can be a legitimate tool that global groups can use to assist in dealing with the commercial imperatives of reducing costs, and relocating cash to where it is most needed. At the very least, in time, a reconsideration of transfer pricing policies may be necessary for many groups.

Potential TP considerations

We have published articles in connection with the impact of transfer pricing on financing, and the JobKeeper payment regime. This article sets out some of the key transfer pricing considerations more generally that are likely to emerge. 

Additional funding

Many groups will be needing to provide funding throughout the group where it is most needed. In the case of debt, questions arise as to whether the borrower would be able to borrow on an arm’s length basis, particularly if its asset values are impaired, and cash flows have diminished.

Interest deductions may have limited value if losses are arising but withholding tax would still be payable. Equity alleviates these issues but may have other adverse impacts. There may be a case for interest-free loans, which may not give rise to a transfer pricing benefit, as the ATO sets out in Taxation Determination TD 2019/10.

In appropriate cases, this would not lead to an interest withholding tax cost (which may be uncreditable in a loss-making lender). Further details are set out here.

Revision of transfer pricing policies

Existing transfer pricing policies may come under pressure from COVID-19 and may need to be reviewed because the economic environment in which groups operate is a key component of determining the arm’s length conditions. Transfer pricing policies have been established under a normal economic environment and generally seek to provide an appropriate risk/return trade-off for the parties involved.  However, for many groups, COVID-19 is expected to reduce not only the profitability of operating entities within the group but also the group as a whole.  Existing transfer pricing policies may not have envisaged such outcomes arising. transfer pricing

One area where existing transfer pricing policies may come under pressure is where an entity has been operating as a limited-risk entity.  Such arrangements ordinarily include a true up/down year-end adjustment having regard to the profit margins made by comparable companies. However, where losses arise throughout the value chain as a result of COVID-19, making a year-end adjustment may make a bad situation worse.  Furthermore, as discussed below, obtaining reliable profitability data to validate the actual impact of COVID-19 on comparables will not be available for some time.

In every case, however, before implementing a change in transfer pricing policy, it would be prudent for groups to:

  • Consider whether the financial impact of COVID-19 on the Australian business is anticipated to be short term or long term;
  • Evaluate whether any changes in the functional and/or risk profile of the Australian business as a consequence of COVID-19 are anticipated to be short term or long term; and
  • Consider whether a change in policy would increase or decrease transfer pricing risk.

Change of transfer pricing methodology

In some cases, COVID-19 may give rise to material changes in the functional profile of Australian businesses and/or the international related parties (IRPs) with which they deal which may warrant a review of existing transfer pricing methodologies.  In other cases, the impact of COVID-19 could result in certain eligibility criteria associated with the ATO’s Simplified Transfer Pricing Record-keeping (STPRK) options described in PCG 2017/2 no longer being satisfied such that other methodologies may need to be considered.  We briefly address such matters below.

A profit-sharing (loss-sharing) method may be supportable in some cases Transfer Pricing

Some groups may consider moving to a profit-sharing methodology – which by extension may also support loss-sharing. A change to a profit split methodology may be supportable where the impact of COVID-19 has resulted in business operations becoming highly integrated or where each party contributes valuable intangibles. 

A different benchmarking analysis may be preferable to changing methodology

Where the functional and/or risk profile of the Australian business has materially changed as a consequence of COVID-19, a review of the functional characterisation of the Australian business may indicate that the transfer pricing methodology should remain the same (eg TNMM) but that the supporting benchmarking analysis should be changed to better reflect the changed functional profile.  While using a different benchmarking analysis may better reflect the risks and returns of comparable entities, obtaining reliable profitability data to validate the actual impact of COVID-19 on the new comparables will not be available for some time.

Review eligibility/desirability to continue using a STPRK option

The impact of COVID-19 could result in certain eligibility criteria for the ATO’s STPRK options no longer being satisfied such that other methodologies may need to be used.  Two potential situations are discussed below:

  • Where the distributor option is relied upon: One of the eligibility requirements for the distributor option is a profit-before-tax (PBT) ratio of not less than 3% on a weighted average over 3 consecutive years, including the year for which the entity is considering applying the option.  Where COVID-19 has had a significant adverse impact on profitability, it may not be possible to satisfy the 3% PBT eligibility criterion. 
  • Have not undergone a restructure within the year:  Each of the ATO’s STPRK options includes an eligibility criterion that the Australian business has not undergone a restructure during the year. The definition of restructure is very broad and refers to “arrangements in which the assets, functions or risks of a business are transferred between you and your international related parties or your branch operations”.  Where the functional and/or risk profile of the Australian business has materially changed as a consequence of COVID-19, such that functions previously performed or risks previously assumed by the Australian business are now performed or assumed by IRPs, this eligibility criterion may not be satisfied.

Australian businesses that may no longer be eligible to use one of the ATO’s STPRK options due to the impact of COVID-19 should review the supporting transfer pricing documentation they have, identify the most appropriate transfer pricing methodology to use and also what supporting benchmarking analysis may be needed.

Hypothesising comparable data Comparable data

It is premature for groups to obtain profitability data to validate what the actual financial impact of COVID-19 might be on comparables - such data will not be available for some time and probably not before the first COVID-19 impacted tax return needs to be lodged.  In such circumstances, showing that transfer pricing outcomes are consistent with arm’s length conditions could become more difficult.  Nevertheless, there are steps that groups may be able to take to start developing such support:

  • Use multi-year data: The OECD’s Transfer Pricing Guidelines acknowledge that multi-year data should be used where it can add value to transfer pricing analyses and can also improve the understanding of long term arrangements.  As such, where the profitability outcome of an Australian business in an income year affected by COVID-19 continues to fall within an arm’s length range established from using multi-year data, such an outcome should lend support to the view that the entity’s transfer pricing outcomes continue to be consistent with arm’s length conditions.  Additional support would likely be needed where this was not the case.
  • Analyse gross margins: Where the gross profit margin of the Australian business in the income year affected by COVID-19 continues to fall within the arm’s length range of gross margins established by the comparables included in the historical benchmarking analysis, such an outcome may lend support to a view that a reduction in the net profit margin of the Australian business is not due to non-arm’s length transfer pricing but to other factors.
  • Review positions when profitability data becomes available: Once profitability data becomes available showing the actual financial impact of COVID-19 on comparables, a review should be undertaken of the position of the Australian business in an income year affected by COVID-19 to ascertain whether additional support may be needed in relation to transfer pricing outcomes.

Renegotiation of terms/reduction of pricing

There is ample evidence that arm’s length parties will seek to renegotiate arrangements in an environment such as the present – and therefore there is scope for related parties to do so as well. This could include providing more generous payment terms on outstanding accounts and/or temporarily reducing pricing.  Equally, a failure to renegotiate arrangements in circumstances where independent entites in comparable circumstances would do so could result in increased transfer pricing risk.

In relation to outbound arrangements, reductions in pricing of goods or services provided to IRPs, need to be managed with care in light of the ATO’s views in TD 2014/14 (capital support payments).

On a brighter note, reductions in the pricing of goods could also reduce costs from a customs perspective.

Impairment of assetsTransfer Pricing

A specific instance where a reduction of pricing may be appropriate is with intellectual property. Where the value of IP has reduced, this may indicate a reduced royalty should be charged – or potentially even paused – and therefore lower royalty withholding tax (which may be uncreditable in a loss-making IP owner). Note also that this may have an adverse impact on thin capitalisation positions – see the comments regarding “Additional funding” above.​

Revisiting management/group costs

Groups may wish to consider their existing cost base for management charges. To the extent that costs are being incurred in managing the risks arising from COVID-19 for the benefit of the group, there may be a basis to share these costs with group members.

The need for caution – and documentation of changes

Groups considering one or more of the above strategies will need to do so with care and will need to document their reasoning and obtain comfort that it is appropriate.

Furthermore, existing transfer pricing documentation will not have been prepared in light of COVID-19 and should, therefore, be reviewed and updated to reflect the following:

  • Any changes to the functions, assets and/or risks of the Australian entity and the IRPs with which it deals as a result of COVID-19; and
  • How the relevant industry has been affected, including how any government-imposed restrictions have impacted the industry.

The ATO’s guidance in Taxation Ruling TR 2014/8 affirms that taxpayers are required to update their documentation to reflect changes that are likely to have a material effect on their transfer pricing treatment.

Subsequent revenue office audit activity will be conducted with the benefit of hindsight, and history demonstrates that Governments will be equally enthusiastic about maximising their cash position in due course, in order to fund the commitments currently being made to keep economies afloat. Transfer pricing will remain a key risk area, and so consistency and sound judgment will be critical.

For more information

If you have any questions or require further information, please contact Liam Delahunty, director of international tax and transfer pricing today.