FOREIGN COUNTRIES’ ANTICIPATION AND PRACTICES TOWARDS TRANSFER PRICING DURING COVID-19 PANDEMIC
The COVID-19 pandemic
The COVID-19 pandemic is an epidemic that is suffered simultaneously on a global scale in terms of health but also, economically. There was an impact on certain sectors and businesses, such as a significant decrease in income and expenses compared to the previous year.
Transfer Pricing is essential in ensuring normal and fair prices for transactions between international companies belonging to the same group as well as regulation of intra-group flows between companies located in different jurisdictions. Many of these international companies have adopted transfer pricing models that involve entities performing routine functions with low risk and guaranteed margin levels.
However, the pandemic has caused sudden declines in production, distribution, and even closure of sites in some jurisdictions, and creating complex repositioning problems.
According to De Gaulle Fleurance & Associés, there are several problems to anticipate regarding transfer pricing in this pandemic era :[1]
1. How can profit and loss be reallocated without incurring tax risk?
If there is a change in transfer pricing policy, it is necessary to observe the high tax risk that may occur. Instead of overhauling the existing transfer pricing policy, an alternative solution could be “playing” on the margins. However, the problem is that there is always a difference between the margin level used by the Company and the benchmark.
And what if the Company is forced to reduce its margin to zero? It is expected to be able to prove that in a relationship with a third party, the third party will give up all margin by agreeing to sell their assets - at cost.
The financial pressures caused by the pandemic may also affect transfer pricing, particularly regarding cash receipts. Since transfer prices are based on recognized prices, but not yet collected. This cause insufficient cash flow to meet the Company’s obligation, it can also cause distortion between the price recognized in the account and the reality of the cash flow.
2. Customs duties: a real collateral risk
If the margins that arise are varied and can be supported by comparisons, there may be a customs reassessment on the Company. This can happen because logically the price in transfer pricing may not in line with customs.
[1] https://www.degaullefleurance.com/en/covid-19-transfer-pricing-in-the-midst-of-change-when-the-supply-chain-causes-a-chain-reaction/
Import custom is calculated based on the actual asset value, then the transfer price includes the margin parameter in the selling price, which in results is a final selling price that is not correlated with the actual value, according to the customs.
This duality can then lead to a significant adjustment in customs, because the administration may consider that the price of the goods has been discounted excessively for the purpose of transfer price margins.
Thus, a significant decrease in the selling price of goods compared to the previous price, can be questioned by the government of customs base. Situation like this can lead to a series of adjustments.
3. Intra-group financing flows
International flows that are controlled by transfer prices often rises the problem of group funding needs. This is because the need for external loans is likely to be very high.
All companies, including manufactures, rely on cash flow to meet their needs and the ongoing maintenance of their manufacturing processes. Unfortunately, businesses that are growing are likely to become poor in cash as a result of this pandemic. This can be disastrous for manufacturers who need to buy raw materials to make their products.
The business group will have choices of alternative solutions such as intra-group loans, debt relief, external loans, etc.
4. Double Taxation
During this time of the pandemic, countries are experiencing financial difficulties and an increasing level of double tax risk on their Companies. As a result of this pandemic, there has been a problem in the procedures and mechanisms of agreement, exchanges and compromises that usually govern international relations, especially in the field of transfer pricing (for example MAP, APA, etc.).
Action must be taken now to anticipate trade-offs as financial betting can be very significant. This will require careful and precise audits, risk mapping, and adjustments. These steps should be taken on a case-by-case basis and require the support of a tax advisor.
Ultimately, measurable and strategic decisions must be taken to integrate the underlying risk and to ensure a conformity between the applied transfer pricing policies and the actual distribution of functions and risks within the group.
Other countries’ practice towards Pandemic
New problems will continue to emerge, especially regarding transfer pricing. So here are some of the practices that have been prepared by some other countries to deal with the issues that are being anticipated.
1. Singapore
INLAND REVENUE AUTHORITY OF SINGAPORE (IRAS)
TRANSFER PRICING DURING PANDEMIC
According to IRAS, the following is information that the Company needs to prepare regarding transfer pricing documentation that has been severely affected by COVID-19.
- Analysis of the industry that has been affected by COVID-19 and the impacts of COVID-19 on the Company.
- Documentation of how and who will manage the risks relating to COVID-19 within the group.
- The Functional Analysis of your Company and the related parties after COVID-19 in order to compare with the pre-COVID 19 analysis. (For example, if there’s any re-allocation of functions, assets and risks).
- The new contractual arrangements between the Company and its related parties, whether there’s any new conditions, amended or terminated during COVID-19.
- Budgeted (pre-COVID 19) and actual results of the profit and loss analysis of the Company, alongside with explanation and evidence to support any differences that may occur.
- Any specific government assistance or government regulations the Company has received which has any impact on the Company’s operations.
Applying term-testing for your Company’s related party transaction using a multiple-year period
According to Inland Revenue Authority of Singapore, under usual circumstances, the Company is required to consult IRAS before applying term testing.[2]
If the Company is facing an unstable result by using the annual testing due to the impact of COVID-19, the Company may apply term-testing (generally over three years) for the Tax Year of 2021. Evidence and explanations will be needed in your transfer pricing documentation to clearly implement that this is a once-off event. Apparently, this time as the term testing may be a once-off application for the Tax Year 2021, the Company does not need to consult IRAS.
Prior to performing the term-testing, make sure that the Company has already taken account of the impact of this approach on their related parties in other jurisdictions. Seeing if the term-testing is not allowed in the other jurisdictions, this may result in opposition.
The example of the application of term-testing is illustrated below[3] :
Company A is a distributor for the Group products. It buys the products from its parent Company for onward distribution to third party customers in Singapore. As the data for year 2018 is the latest available set of comparable data at the point of preparing the contemporaneous TP documentation for financial
[2]This example is adapted from page 99 of IRAS TPG (5th edition).
[3]Section 5.115 of the IRAS Transfer Pricing Guidelines (TPG) (5th edition).
year 2020, Company A uses the comparable data for 2016, 2017 and 2018 to establish the arm’s length range of the remuneration for its distribution function.
Based on the transfer pricing analyses and TP documentation, Company A is to be rewarded with an operating margin (i.e. operating profit over sales) between 3% and 5% for its distribution function.
Company A’s actual results for financial years 2018, 2019 and 2020 are as follows:
|
Actual Results
|
Financial Year 2018
SGD
|
Financial Year 2019
SGD
|
Financial Year 2020
SGD
|
Financial Year 2018 to 2020
SGD
|
|
Sales to third party customers
|
25,000,000
|
30,000,000
|
15,000,000
|
70,000,000
|
|
Less: Purchases from parent Company
|
(17,000,000)
|
(20,000,000)
|
(12,000,000)
|
(49,000,000)
|
|
Gross Profit
|
8,000,000
|
10,000,000
|
3,000,000
|
21,000,000
|
|
Less: Operating expenses
|
(7,000,000)
|
(8,500,000)
|
(4,000,000)
|
(19,500,000)
|
|
Actual operating profit
|
1,000,000
|
1,500,000
|
-1,000,000
|
1,500,000
|
|
Actual operating margin (B/A)
|
4 %
|
5 %
|
(6.67 %)
|
2.14 %
|
As Company A’s actual operating margin for financial year 2018 to 2020 is lower than the nearest edge of the arm’s length range of 3%, Company A makes year-end adjustments as follows:
|
Arm’s Length Result
|
Financial year 2018 to 2020
|
|
SGD
|
|
Sales to third party customers
|
70,000,000
|
|
Less: Purchases from parent Company
|
(48,400,000)
|
|
Gross profit
|
21,600,000
|
|
Less : Operating Expenses
|
(19,500,000)
|
|
Arm’s Length Operating Profit
|
2,100,000
|
|
Arm’s Length Operating Margin (Y/X)
|
3 %
|
Company A will make year-end adjustments to the actual results of financial year 2020 by reducing the purchases from parent Company by S$600,000 (i.e. S$49,000,000 – S$48,400,000). There will be a corresponding reduction in the parent Company’s accounts for the sales to Company A.
What about the APA process during the COVID-19 pandemic period?
First, Company has to find out if there are any transfer price implications arising from COVID-19 that could affect APA applications (for example, functional changes of entities). IRAS will need relevant details to be able to review the case and decide the appropriate next steps. If there is significant uncertainty, IRAS will run into difficulties which can stop the APA process.
The terms and conditions of an APA agreement include critical assumptions that provide no material changes throughout the relevant period, which means that the entities operate with functions performed, assets employed and risk assumed with respect to their transaction.
The Company must review and assess whether there is a violation of the terms and conditions of the existing APA agreement due to COVID-19. If so, the Company should notify IRAS as soon as possible, provide an analysis of the impact of COVID-19, explain why the terms and conditions were violated, and suggest further action. With this information, IRAS will evaluate the outcome by suspending or modifying the APA for the affected period.
In the case of bilateral / multilateral APA, the case needs to be discussed with the Competent Authority.
2. New Zealand
NEW ZEALAND INLAND REVENUE
TE TARI TAAKE
In documenting transfer pricing during COVID-19, businesses are encouraged to :
- Identify and compile evidence to document the level of material impact related to COVID-19 on the Business Group.
- Document the Group's response to a pandemic, including responses to any changes in business strategy, changes in the characteristics of product or service offerings and so on.
- Identify and describe changes in functional analysis during a pandemic period, including how those changes relate to business exposures or mitigation.
- Identify changes in intra-group transactions and contractual terms
- Document the changes of intra-group transfer prices and explanation why they are considered aligned with Arm’s Length Principle.
- Identify the impact of COVID-19 on the overall profitability of the Business Group whether it’s giving negative or positive impact.
Supporting evidences that can measure the financial consequences of the impact of COVID-19 is as follows:
- why local sales are lower than expected ?
- why local expenses are higher than expected ?
- any unusual on the financial report ?
- is there any government assistance received ?
- is there any impact of any amended intra-group transactions ?
- is there any adjustments made ?
3. Australia
AUSTRALIAN GOVERNMENT
AUSTRALIAN TAXATION OFFICE
How Australia assess the economic impacts of COVID-19 on transfer pricing arrangements?
Australia seek to understand the facts and circumstances by assessing:
- functional analysis of the Australian entity before and after COVID-19.
- The Analysis on how the industry has been affected in terms of economic circumstances
- The contractual agreements between the Australian entity and its related parties, whether it has been terminated, amended or renewed.
- Specific products and service offerings of the Australian entity during COVID-19 and how both products and services or either one of them has affected the financial results.
- Changes in business strategies caused by COVID-19 and the outcomes.
How Australian Taxation Office support the Arm’s Length Nature of the Transfer Pricing Outcomes
APA during COVID-19
To understand the impact of the breach on the APA and help to consider the appropriate outcomes. This could include:
- Usual business operations
- Renegotiating the APA while the impact is still demonstrable
- Modifying the APA
If Australian Company does not have an agreed APA, the Australian Taxation Office will still help with the APA application. But if the Australian Company is affected by COVID-19, the Australian Tax Office will need evidence to process the APA application.
Conclusion
COVID-19 has clearly disrupted the flow of international business other than causing health and safety problems. There are many problems that arise, especially for multinational companies on how they anticipate the profits and losses of the Company during the pandemic, customs issues especially in terms of imports, financing the business group and double taxation.
To conclude, we can consider taking other countries’ steps which more or less are needed to anticipate the preparation of the TP Documentation in 2020. The following is the information that Companies will need to prepare:
- The Functional Analysis of the Business Group after COVID-19 in order to compare with the pre-COVID 19 analysis. (For example, if there’s any re-allocation of functions, assets and risks).
- The new contractual arrangements of the Business Group, whether there’s any new conditions, amended or terminated during COVID-19.
- Budgeted (pre-COVID 19) and actual results of the profit and loss analysis of the Company, alongside with explanation and evidence to support any differences that may occur.
- Any specific government assistance or government regulations the Company has received which has any impact on the Company’s operations.
- Any new business strategy
- Any changes in the characteristics of product or service offerings and how both products and services or either one of them has affected the financial results.