COVID-19 AND TRANSFER PRICING – TOP 5 IMPACT AREAS

Starting December, 2019, the
world has witnessed the once-in-a-generation pandemic. Multinational
Enterprises will have to consider the effect of COVID 19 on their transfer
pricing policies due to large scale economic disruption. It will be imperative,
especially in this economic environment, to adhere to and demonstrate arms
length behaviour. Many MNEs have started revisiting transfer pricing policies,
inter company agreements, and documentation standards.

This article highlights the top
five transfer pricing impact areas arising out of Covid-19:

• Supply chain restructuring

• Renegotiation of pricing and other terms

• Cash optimisation

• Balancing business uncertainty with tax
  certainty

• Benchmarking

Towards the end of the article,
some recommendations have also been outlined for consideration of the
government authorities to make it easier for taxpayers to demonstrate
compliance with arm’s length principles.

1.  Supply chain restructuring

MNE groups with geographically
diverse supply chains are affected severely due to the pandemic. Any disruption
to any part of the supply chain tends to impact the entire group, though the
extent of the impact depends on the importance of the part of the supply chain
which has been disrupted and the availability of alternatives.

Many MNE groups have discovered
the fragility in their value chains as a result of the disruption caused by the
pandemic. They are faced with one or more of the following situations:

• Longer than needed supply chain involving
  various countries

• Overdependence on a particular supplier /
  set of suppliers / region / country for materials / services / manufacturing /
  market

• Affiliate(s) finding it difficult to sustain
  their businesses owing to disruption caused by the pandemic

• Unviable non-core businesses.

MNE groups could consider this as
an opportunity to revisit their existing supply chains and also potentially
restructure the supply chain to achieve one or more of the following:

• Shorter supply chains involving lesser
  number of geographical locations

• Creation of alternate sourcing destinations
  for materials and services

• Setting up of manufacturing / service
  facilities in alternate destinations

• Closure and / or monetisation of non-core
  businesses / entities.

These restructuring transactions
could raise multiple transfer pricing issues, including:

• Exit charges for that affiliate which will
  be eliminated from the supply chain / will get reduced business because of
  creation of an alternate destination

• New transfer pricing agreements, policies
  and benchmarks to be developed in case of setting up of affiliates in new /
  alternate jurisdictions

• Valuation issues in case non-core assets are
  transferred to affiliates

• Issues relating to bearing of closure costs
  in case some group entities or part of their businesses face insolvency /
  closure

• Issues around identification and valuation
  of intangibles involved in the restructuring exercise

• Appropriate articulation of restructuring
  transactions in the local files of the entities concerned and the Master File
  of the group.

2.  Renegotiation of pricing and other terms

In arm’s length dealings,
businesses are in fact renegotiating prices as well as other terms, mainly with
their vendors.

In the case
of many MNEs it would be perfectly arm’s length behaviour for different
entities within the group to start discussions and re-negotiations regarding
prices and other terms of their inter-company transactions. In fact, in many
cases it might be non-arm’s length for companies to not renegotiate with their
affiliates. In almost all cases, it would be arm’s length behaviour to have
inter-company agreements which mirror agreements that would have been entered
into between third parties.

Renegotiations of existing
arrangements / agreements could be of at least the following types:

2.1. Compensation for limited
risk entities in the group

Many MNEs
have entities which operate as limited risk entities, such as captive service
providers, contract manufacturers, limited risk distributors, etc. As a general
rule, these limited risk entities are eligible for a stable income, all
residual profits or losses being attributed to the Principal affiliate.
However, in today’s dynamic business environment, no-risk entities do not exist
and limited risk entities also bear some risks. For example, limited risks
captive service providers or contract manufacturers have a significant single
customer risk; therefore any adverse disruption to that single customer will
adversely impact the captive as well.

In times of disruption like this,
exceptions to the general rule may be warranted and compensation for limited
risk activities may need to be revisited, depending, inter alia, on the
type of activity performed, type of disruption faced and the control and decision-making
capabilities of each of the parties involved.

In third party situations the
service provider would be better off to agree to reduced income (or even losses
in the short term) from the Principal, especially if the Principal itself is
facing challenges relating to its own survival. Accordingly, on a case-to-case
basis, certain MNEs may have the ability / necessity to revisit their
arrangements with their captive entities for the short to medium term. The
revision in the inter-company agreements could take several forms. For
instance, such revised agreements may provide for compensation for only costs
(without a mark-up), reduced mark-up, compensation for only ‘normal’ costs
(with or without mark-up), etc.

2.2.  Renegotiations of other terms

It is common for entities in an
MNE group to negotiate prices of their inter-company transactions from time to
time in line with the prevailing business dynamics. However, in emergencies
like these certain other terms of the agreements between affiliates may also
need to be renegotiated. For example, the commitment relating to quantities
which a manufacturer will purchase from the related raw material supplier may
undergo a significant renegotiation. Given the non-recovery of fixed costs due
to the resulting idle capacity, the raw material cost per unit may increase
which the supplier may want to pass on to the manufacturer. A higher per unit
cost, on the other hand, may make the related supplier uneconomical for the
manufacturer. In the interest of the long-term commercial relationship, the
parties may agree to an in-between pricing mechanism, as is likely to be the
case in third-party dealings. Which party would bear which types of costs would
depend on the characterisation of the parties, the decision-making evidenced
through capabilities of the persons involved, and the options realistically
available to the parties involved.

3. Cash optimisation

Cash optimisation is currently
one of the most important considerations of businesses across the world.

Many MNE groups facing a cash
crunch have started looking at the cash position with different group entities
and trying to optimise the cash available with them. This could lead to some
new funding-related transactions and benchmarking issues such as those relating
to interest and guarantee fees transactions between affiliates.

In some situations, taxpayers
that have borrowed funds from their affiliates and are not in a position to
honour their interest / principal repayment commitments could approach their
affiliate lenders to negotiate for a reduction in interest rate / interest
waiver / moratorium at least for some period of time. On the other hand, the
lender affiliate may want to balance the moratorium with a revision in the
interest rate. Significant movements in exchange rates of currencies primarily
attributable to the pandemic could make this negotiation even more dynamic. Any
kind of negotiation should take into account the perspectives of both parties
and options realistically available to them.

Similarly, payment terms for
goods or services purchased from or sold to AEs or other inter-company
transactions, such as royalties, could also be renegotiated at least for the
short term, to enable different entities within the MNE group to manage their
working capital cycle more efficiently.

4. Balancing business uncertainty with tax certainty

4.1. Advance Pricing Agreements (APAs)

Globally, APAs have been an
effective tool for taxpayers and tax authorities to achieve tax certainty.
However, in times like these businesses go through unprecedented levels of
uncertainty. Therefore, many taxpayers may find it against their interest to be
bound by the terms of the APAs, especially where these provide for a minimum
level of tax profits to be reported by the taxpayer.

If their circumstances warrant
it, taxpayers who have already entered into an APA may consider applying for
revision of the same. The law provides that an APA may be revised if, inter
alia, there is a change in the underlying critical assumptions¹.  Most Indian APAs have a critical assumption
of the business environment being normal through the term of the APA. In times
like these, a request for revision may be warranted if the business environment
for the taxpayer is considered to be abnormal based on the specific facts and
circumstances of its case and the impact of the uncertainty on the transaction
under consideration.

If the taxpayer and the
authorities do not agree to the revision, the taxpayer may potentially also
request for cancellation of the agreement². On the other hand, in
case the tax authorities believe that cancellation of the agreement is
warranted due to failure on the part of the taxpayer to comply with its terms,
the taxpayer should utilise the opportunity provided to it to explain the
pandemic-related impact on the APA and the related reason for its failure to
comply with the terms of the agreement.

For taxpayers who are in the
process of negotiating for their APAs, and for whom the business impact is very
uncertain right now, it may be prudent to wait to get some more clarity
regarding the full impact of the pandemic on their business before actually
concluding the APA.

Alternatively,
taxpayers should request for an APA for a shorter term, say a period of up to
Financial Year (F.Y.) 2019-20, even if it means entering into the APA for, say
three or four years. Another APA could then be applied for, starting F.Y.
2021-22, based on the scenario prevailing then.

4.2. Safe harbours

The government has not yet
pronounced the safe harbours for the F.Y. 2019-20. Once these are pronounced,
depending on their industry, extent of business disruption, expected loss of
business / margins and the safe harbours provided for F.Y. 2019-20 and onwards,
taxpayers should evaluate whether or not to opt for safe harbours at least for
the F.Y.s 2019-20 and 2020-21.

5. Benchmarking

The current economic situation is
likely to create some unique benchmarking issues which should be borne in mind.
While some of these issues are common to taxpayers globally, a few issues are
specific to India given the specific language of the Indian transfer pricing
regulations.

5.1. Justification of losses / low margins

Taxpayers are facing several
business challenges including cost escalations / revenue reductions which are
not related to their transactions with affiliates. Taxpayers in several sectors
have recorded sharp declines in revenues due to lockdowns in various parts of
the world, including India. Some taxpayers are faced with the double whammy of
escalated costs even in times of reduced revenues. Escalated costs could
include, for example, additional costs relating to factory personnel who are
provided daily meals and other essentials, additional transportation costs
incurred to arrange special transport for essentials owing to most fleet
operators not plying, etc.

It is pertinent for taxpayers to
identify and record these expenses separately from the expenses incurred in the
regular course of business (preferably using separate accounting codes in the
accounting system). Depending on the transfer pricing method and comparables
selected, taxpayers should explore the possibility of presenting their
profitability statements excluding the impact of these additional costs /
reduced revenues.

Another alternative available to
taxpayers is to justify their transfer prices considering alternative profit
level indicators (PLIs).

In any case, given the fact that
a lot of information about comparable benchmarks is not available in the public
domain currently, business plans, industry reports, business estimates, etc.,
prepared / approved by the management of the organisation should be maintained in
the documentation file and presented to the transfer pricing authorities if
called for.

5.2.  Loss-Making Comparables

During times of emergency like
these, for many businesses the focus shifts from growth / profitability to
survival. Therefore, many businesses could try operating at marginal costing
levels to recover committed costs / utilise idle capacity. Therefore, businesses
operating at net operating losses could be a normal event at least in times
like these. Secondly, even the taxpayer could have been pushed into losses
because of completely commercial reasons and even such losses could be arm’s
length and commercially justifiable.

From the
perspective of transfer pricing benchmarking, persistently loss-making
companies are typically rejected as comparables mainly because they do not
represent the normal economic assumption that businesses operate to make
profits. However, in times when business losses are normal events, benchmarking
a loss-making taxpayer with only profit-making comparables would lead to
artificial benchmarks and, potentially, unwarranted transfer pricing additions
in the hands of taxpayers.

In case loss-making comparables
are indeed rejected, it could be more prudent to reject companies making losses
at a gross level.

5.3.  Unintended comparables

The current
focus of many businesses is survival. Businesses which have created capacities
to cater to their affiliates may find it difficult to sustain if the impact of
the pandemic lasts longer than a few months. For example, consider the case of
an Indian manufacturer whose manufacturing capacities are created based on
demand projections and confirmed orders from its affiliates. Since the
capacities are completely used up in catering to demand from its affiliates,
the manufacturer does not cater to unrelated parties. In case there is a
disruption in the demand from such affiliates expected in the medium term, in
order to sustain in the short to medium term, the Indian manufacturer could
start using its manufacturing set-up for other potential (unrelated) customers
also. While this appears to be a purely rational business decision by the
Indian manufacturer, a question arises whether such third-party dealings will
be considered as comparable transactions for dealings with affiliates. The
Indian manufacturer in this case would need to be able to document the business
justification for entering into these transactions with unrelated parties and
whether these are economically and commercially different from the routine
related party transactions. Similar issues could arise in respect of other
transactions such as temporary local procurement, local funding, etc.

5.4.  Mismatch in years and adjustments

The Indian transfer pricing
regulations provide for the use of three years’ data of comparables to iron out
the impact of cyclical events from the benchmarking analysis. However, data of
the last two years may not be representative of the conditions prevailing in
the current year (in this context, current year could be F.Y. 2019-20 as well
as 2020-21, both years being impacted to different extents due to the
pandemic).

Since the financial data of a lot
of comparables is not available up to the due date of transfer pricing
compliance, this mismatch may lead to a situation where normal business years
of comparables are compared with the pandemic-affected years of taxpayers – a
situation which is very likely to give skewed results.

Adjustments are regularly made to
minimise the impact of certain differences between a tested party (say,
taxpayer) and the comparable benchmarks. Depending on the industry in which the
taxpayer operates and the manner in which its affiliates are impacted,
taxpayers may need to make adjustments, including some unique adjustments, to
more aptly reflect the arm’s length nature of inter-company prices.

However, in the Indian context
the law does not provide for the making 
of adjustments to the tested party and the adjustments are to be
necessarily made to comparable data³. Given the lack of reliable
data for making adjustments, the reliability of the adjustments themselves may
be questioned.

It must be borne in mind that the
principle which necessitates downward adjustments to comparables’ margins
currently being made to normal years will also require upward adjustments to
comparables’ margins in respect of pandemic-affected years going forward. This
situation is simplistically illustrated in Table 1 below. For the purpose of
the illustration, it is assumed that:

• F.Y. 2017-18 and 2018-19 are considered as
  normal business years

• F.Y. 2019-20 is impacted by the pandemic,
  but to a lesser degree

• F.Y. 2020-21 is impacted severely by the
  pandemic

• F.Y. 2021-22 is a normal business year

• At the time of conducting the benchmarking
  analysis, comparables’ data is available for only the last two years.

Table 1 – Year-wise comparability⁴
and adjustments⁵

6.  Recommendations to government authorities

Government authorities could
consider the following recommendations by way of amendments to the law to relax
adherence to transfer pricing regulations for taxpayers, especially for F.Y.s
2019-20 and 2020-21, i.e., the impacted years:

• Expansion of arm’s length range –
  Since different industries and different companies in the same industry will
  respond to the pandemic in different ways, the margins of comparables over the
  next two years could be extremely varied. Therefore, for the impacted years the
  arm’s length range may be expanded from the current 35^th to 65^th
  percentile to a full range, or inter-quartile range (25^th to 75^th
  percentile), as is used globally. Similarly, the applicable tolerance band
  could be appropriately increased from the current 1% / 3%.

• Extending compliance deadline – In
  case the deadline for companies to file their financial statements for F.Y.
  2019-20 with the Registrar of Companies (RoC) is extended, the deadline for
  transfer pricing compliance should also be extended, to give the taxpayers
  their best chance to use comparable data for F.Y. 2019-20.

• Extending deadlines for Master File
  compliance – It is expected that companies will take time to be able to
  fully assess the impact of the pandemic on their business models, value chains,
  profit drivers, etc., and then appropriately document the same in their Master
  File. Therefore, the due date for Master File compliances may be extended at
  least for F.Y. 2019-20.

• Adjustment to taxpayer data – At
  least for the impacted years, the law could be amended to provide an option to
  the taxpayer to adjust its own financial data since the taxpayer will have a
  better level of information regarding its own financial indicators.

• Multiple year tested party data – As
  discussed earlier, the Indian transfer pricing regulations currently provide
  for using multiple year data of the comparables as benchmarks for current year
  data of the tested party. For F.Y.s 2019-20 and 2020-21, use of multiple year
  data could be allowed even for the tested party to average out the impact of
  the pandemic to a certain extent.

• Safe harbours relaxation – Safe
  harbours for F.Y. starting 2019-20 are currently pending announcement. The
  authorities could use this opportunity to rationalise these safe harbours to
  levels representative of the current business realities and reduce the safe
  harbour margins expected of Indian taxpayers. Safe harbours which are
  representative of the current business scenario will be very helpful to
  taxpayers potentially facing benchmarking issues discussed earlier in the
  article.

• Relaxation in time period for
  repatriation of excess money (secondary adjustment) – Given the cash crunch
  being faced by MNEs worldwide, the time period for repatriation of excess money⁶  could be extended from the current period of
  only 90 days⁷.

CLOSING REMARKS

While the pandemic has impacted
almost every business in some way or the other in the short term and in many
inconceivable ways in the long term, just this claim alone will not be enough
from a transfer pricing perspective. Taxpayers will need to analyse the exact
impact of the pandemic on their entire supply chain and to the extent possible
also quantify the impact for their specific business. The impact of the
pandemic, steps taken by the management to mitigate the adverse impact,
negotiations / renegotiation (with third parties as well as affiliates),
business plans and business strategies, government policies and interventions
are some of the key factors which will together determine the transfer pricing
impact of the pandemic on the taxpayer.

The pandemic has brought to the
fore the importance of having robust agreements. While the current discussion
revolves mostly around force majeure clauses in third-party agreements,
inter-company agreements are equally important in the context of transfer
prices between the entities of an MNE group. Going forward, for new
transactions with affiliates or at the time of renewal of agreements relating
to existing transactions, care should be taken to draft / revise inter-company
agreements specifically outlining emergency-like situations and the
relationship between the parties in such times. Which party will be responsible
for which functions and would bear what type of risks and costs should be
clarified in detail. Agreements could potentially also include appropriate
price adjustment clauses. MNEs could consider entering into shorter term
agreements till the time the impact of the pandemic is reasonably clear. Having
said that, even if the agreement permits price adjustments, any pricing / price
adjustment decisions taken should also consider the economic situation and the
implication of such decisions under other applicable laws, including transfer
pricing laws of the other country/ies impacted by such decisions.

These times require businesses to
act fast and address several aspects of their business, and often, to keep the
business floating in the near term. Needless to say, taxpayers should
adequately document the commercial considerations dictating these decisions on
a real time basis and be able to present the same to transfer pricing
authorities in case of a transfer pricing scrutiny. Further, in the Master File
taxpayers should include a detailed industry analysis and a description of
business strategies as well as the corporate philosophy in combating the
financial impact of Covid-19, including the relationships with employees,
suppliers, customers / clients and lenders.

Governments and
inter-governmental organisations around the world are closely monitoring the
economic situation caused by the pandemic. Organisations such as OECD are also
monitoring various tax and non-tax measures taken by government authorities to
combat the impact of Covid-19⁸. Taxpayers would do well to
continuously monitor the developments (including issuance of specific transfer
pricing guidelines relevant to this pandemic) at the level of organisations
such as OECD and UN, and also look out for guidance from the government
authorities.  

____________________________________________________________

1   Refer Rule 10Q of Income Tax Rules, 1962

2   Refer Rule 10Q of
Income Tax Rules, 1962

3   Refer Rule 10B of Income Tax Rules, 1962

4   Refer Rule 10CA of Income Tax Rules, 1962

5   Refer Rule 10B of
Income Tax Rules, 1962

6   Refer section 92CE of Income-tax Act, 1961

7   Refer Rule 10CB of Income-tax Rules, 1962

8   For instance, the OECD has recently published a report on tax and
fiscal policy in response to the coronavirus crisis. The OECD has also compiled
and published data relating to country-wise tax policy measures. Both, the
report as well as the country-wise data, can be accessed at www.oecd.org/tax