The COVID-19 pandemic has brought unforeseen and unprecedented circumstances to the fore and has seriously impacted the global economy. Governments across the world are providing stimulus packages to support the economy and companies are considering various avenues to generate cashflow and stay afloat.
The Australian Taxation Office (ATO), along with other tax authorities, is playing its part and has introduced measures to support businesses. While it is likely the ATO will accept a reduction in profitability during this period, they may scrutinise related party arrangements to understand the adverse impact of such provisions on reduced profitability.
Transfer Pricing (TP) may not be at the forefront of this scrutiny but, to manage cashflow, some companies may need to restructure their related party transactions. These decisions are likely to have tax and TP implications.
Foreign owned distributors or service providers typically earn a fixed profit margin in Australia but COVID-19 could result in a group incurring overall global losses. In this scenario, it may be unfair to expect only the parent company to bear the losses and groups may consider transferring some of the losses to their subsidiaries.
In contrast, the ATO may expect a similar position to be taken when the group earns super profits. Transfer of losses may not be justified in all cases and companies will need to revisit their functional profile to support such a position.
It is highly likely the ATO will scrutinise these positions so it is important for appropriate TP documentation to be maintained to support them, and in the case of an audit by the ATO, to be eligible for penalty protection. Lack of documentation could lead to higher shortfall penalties (up to 50 percent of the shortfall amount).
In these challenging times, companies are under pressure to effectively manage their cashflow requirements and entities are likely to borrow from their affiliates to meet their working capital needs. They may also consider entering into cash pooling arrangements to easily transfer funds from cash-rich affiliates to cash-poor entities. Alternatively, parent companies may provide guarantees in cases where subsidiaries look to borrow from third party lenders.
Financing transactions is one of the key focus areas of the ATO. Once the environment stabilises, the ATO may review these financing arrangements to ensure they are arm’s length in nature. The ATO expects intercompany loans to be priced as they would be from third party lenders and to comply with the recent OECD (Organisation for Economic Co-operation and Development) guidance on financial transactions. To ensure the terms and conditions of the intercompany agreement are in line with market practices, seek assistance when pricing these related party debt arrangements.
In the instance of existing debt arrangements with affiliates, there could be potential for interest deferrals or relaxed payment terms to allow the Australian entity to manage their cashflow. Before COVID-19 took hold, such changes may not have been considered arm’s length in nature. However, in these extraordinary times, tax authorities are likely to be more accepting but it is imperative that any changes to related party arrangements are supported by documentation to prove that independent lenders would also permit them.
As interest rates fall, the ATO will likely expect entities to renegotiate their existing loans from related parties. This is consistent with the practice of independent entities renegotiating the terms of the loans from external lenders and reducing their cash outflow.
While most companies would understandably oppose incurring additional compliance costs, it may be necessary to seek assistance to ensure that the amended intercompany loan terms are supported with TP documentation. The ATO has the benefit of hindsight at the time of audit and it is necessary for all changes to be contemporaneously documented.
The ATO acknowledges entities may no longer be able to rely on safe harbour or worldwide gearing tests to determine their maximum allowable debt for thin capitalisation purposes, due to balance sheet impacts stemming from COVID-19. It has suggested taxpayers explore alternative valuation measurement periods that may allow a degree of smoothing of values in situations where wide variations have occurred throughout the income year.
Taxpayers who are required to rely on the Arm’s Length Debt Test (ALDT) as a direct consequence of COVID-19, can expect the ATO to not review their application of ALDT, subject to certain conditions being satisfied. The ATO has noted it will take a balanced approach to matters such as record keeping and timing of the creation of records for the purposes of the ALDT. We recommend reviewing your thin capitalisation position if it is likely you will rely on the ALDT for the ongoing year.
One of the key learnings from this pandemic is not to rely on just one geographical area for the supply of goods and services. As groups begin to revisit and optimise their existing supply chain, it may result in shifting of certain operations or functions from one jurisdiction to another.
It’s important to ensure the jurisdiction that was previously performing a function is appropriately remunerated for “transferring” its business operations, and the TP documentation to support the transaction is in place.
Offshore affiliates usually provide centralised management services. Travel restrictions due to COVID-19 may have resulted in a reduction of services from these entities. The ATO may expect a reduction in the quantum of management service charges paid by Australian entities and scrutinise cases where the arrangement is not consistent with the services being received.
Some centralised services may not meet the benefit test and may be considered “shareholder services”, which may not be admissible as a tax return deduction.
For centralised management services, groups typically enter into an agreement to reimburse costs plus a mark-up for these services. From a TP perspective, these mark-ups are supported by a benchmarking analysis, where independent companies are identified. With COVID-19 impacting all companies, these mark-ups may no longer be supportable by existing benchmarking analysis (further discussed below).
Under these challenging circumstances, we can expect groups to suspend royalty payments. With some businesses temporarily closed and potential tax losses in overseas jurisdictions, subsidiaries may no longer find it viable to pay royalties to their parent companies. We recommend you seek assistance if you are considering suspending royalty payments to manage cashflow and reduce losses.
The arm’s length nature of existing TP policies of an Australian entity may have been supported by benchmarking analysis where independent companies were identified. The analysis would be based on the profit margin of these independent companies.
The results of these independent companies may be impacted by COVID-19, which will skew the benchmarking analysis of the Australian entity. The updated results of these independent companies may not be available by the time the Australian entity lodges its tax return. However, tax authorities may question the outcome of such pricing models in the event of significant market downturn. Therefore, your benchmarking analysis needs to be appropriately updated to reflect the downturn in the economy.
As you overcome these challenging times and rearrange your current business arrangements, please remember that changes to related party arrangements will have TP implications. If you need any advice relating to transfer pricing, please submit this form or get in touch directly with these members of our Tax Advisory team.
Keerthiga Sharma, Manager, Tax Advisory (Sydney)
Anthony Patrk, Partner, Tax Advisory (Sydney)
John Baillie, Senior Partner, Tax Advisory (Melbourne)
Trevor Pascall, Senior Partner, Tax Advisory (Brisbane)