The rapid onset of the COVID-19 pandemic has reduced or shut down many manufacturing and distribution operations globally and negatively affected demand for many types of goods. As a result, manufacturers are reassessing their operations and developing short- and long-term plans to combat the adverse operational and financial impacts of the pandemic. As they do so, they need to be mindful of the potential impact or consequences these changes could have from an international taxation perspective in order to avoid unintended negative tax consequences.
Transfer pricing in a nutshell
Manufacturers compete in a truly global marketplace and operate complex supply chains that cross country borders and continents. This landscape, which complicates potential COVID-19 responses for manufacturers (such as switching raw materials suppliers), also presents increasingly challenging taxation issues for both multinational enterprises (MNEs) and tax administrations. In particular, significant issues arise when determining the appropriate pricing of cross-border transactions among members of an MNE (for instance, in sales of inventory from manufacturer parent company to subsidiary distributor). According to a commonly subscribed to international tax framework, transactions among members of an MNE must be priced at arm’s length, meaning that the price charged should be the same as would be charged to an unrelated party. Otherwise, MNEs could knowingly or inadvertently price intercompany transactions to shift profits between taxing jurisdictions, which, in turn, would affect the amount of taxes paid in those jurisdictions.
This concept, transfer pricing, has gained importance given the growing number of cross-border transactions (such as inventory sales, license of intangible property (IP), or the provision of services) required to operate in today’s global economy. As such, transfer pricing has been a focus for tax authorities for some time, and given forecasted budget shortfalls for governments as a result of the pandemic, scrutiny over an MNE’s transfer pricing arrangements likely will intensify in the coming years. The operational or financial changes MNEs are considering, especially as they relate to cross-border activity within MNEs, likely have transfer pricing implications that need to be thoughtfully considered. Otherwise, MNEs might forgo potential financial or tax opportunities and expose themselves to future audit adjustments by tax authorities, which often have significant penalties.
Manufacturers’ COVID-19 responses and transfer pricing
To continue operations and meet customer demand, some MNEs are modifying subsidiaries’ functions, either permanently or temporarily. Such changes could alter the characterization of the entity for transfer pricing purposes. A shuttered manufacturing entity, for example, might start purchasing finished goods from an affiliate and reselling the goods in its local market, therefore functioning as a distributor. Alternatively, the manufacturing entity could outsource its production to another related manufacturing entity, in essence making the entity a contract manufacturer (with respect to that specific production).
To the extent that functional profiles for entities change (for example, from manufacturer to distributor), MNEs need to re-evaluate profit (or loss) levels for each party in the supply chain and analyze the allocation of income associated with decisions being made. Relocating or ceasing certain functions could have unintended consequences if IP (such as production know-how) or other value is migrated from one location to another. For example, if production of a certain good is moved from one manufacturer in the MNE group to another, there might be a transfer of IP, which could create a royalty or other payment obligation from the new user to the IP owner within the MNE.
Regardless of whether functional entity characterizations change, MNEs will need to determine how to allocate consolidated losses, if any, among the group, and they should be modeling what financial results might look like as a result of the pandemic. Depending on these results, companies can reassess or revise their existing transfer pricing approaches. Entities characterized as limited-risk entities, such as contract manufacturers or distributors, normally have a limited level of operating profitability while the entrepreneur (the entity that owns the relevant IP) normally recognizes the excess loss or profitability in the supply chain. Economically speaking, profitability for distributors and contract manufacturers is not guaranteed, but, historically, tax authorities generally have expected that these entities should consistently have at least some level of operating profitability. Therefore, if losses ultimately are recognized by these limited-risk entities, they need to be thoroughly documented and supported by a transfer pricing analysis.
Given the current need for liquidity, MNEs might need to move cash assets among members. Assuming a cash transfer from one entity to another is not characterized as a capital contribution or distribution, the transfer likely will be characterized as an intercompany loan, and, accordingly, intercompany agreements will need to document the terms of the transfer. MNEs also will need to determine an appropriate arm’s-length interest rate for the loan. Furthermore, if a related-party borrower is delaying payment, MNEs should review existing intercompany financing arrangements to determine whether the financing arrangement can be restructured or renegotiated.
MNEs that make transfer pricing changes in response to the pandemic must update intercompany agreements and documentation to reflect the new financial and commercial conditions to support their decisions and any resulting changes in entity-level profitability. MNEs also need to consider whether newly implemented intercompany charges, such as royalties, service fees, or buy-outs for IP, reflect such changes. To effectively defend against challenges by tax authorities related to profitability (or lack thereof), MNEs should examine and document the impact the pandemic is having on their business while considering the need for contemporaneous transfer pricing documentation reports.
Numerous transfer pricing implications exist as a result of this pandemic. To manage the disruption, MNEs need to re-evaluate their supply chains to ensure both short- and long-term sustainability and monitor and document changes they make to defend against tax and transfer pricing challenges.