How to maintain the arm’s length during a pandemic?

Material of Kambourov and Partners.

Markets functioning on the basis of free movement of goods, services, persons and capital flows, are currently facing one of the biggest challenges since 1930s. Assessing the full impact of this shockwave would require historical distancing. However, now is a good moment to understand the implications that could arise in the field of transfer pricing, adapt to the consequences and seize the opportunities through a comprehensive and practical approach.

In the past weeks, governments around the world took different emergency measures, aimed at combating the social and economic consequences of the pandemic, as well as at providing stimulus for businesses and individuals. Ultimately, such stimulus measures create gaps in the state budget. In the long run, this would result in pressure on tax administrations to generate state revenue through tax audits. Therefore, it is expected that Multinational enterprises (“MNEs”) would be subject to an increased post-pandemic scrutiny by the tax authorities.

Prior to the pandemic, companies maintained transfer pricing (“TP”) policies designed on the basis of economic growth, given the global tendency until recently. Depending on the group structure and the business model, TP policies can involve subsidiaries having limited risks and functions, implemented from a perspective of profit-sharing. In light of the current circumstances, however, such arrangements can prove obsolete for the allocation of losses arising from the COVID-19 pandemic. Concretely, groups with limited risk subsidiaries would need to determine how limited their risks actually are. This boils down to the question whether a limited risk distributor has thecapacity to bear a portion of the losses arising from the impact of COVID-19 on the market it operates, given the low risks inherent to its functional profile?

Having a pre-agreed fixed compensation for a limited risk profile might become an unfeasible option given the current market volatility. Insufficient capacity use due to shut downs and carrying costs will only deepen the stemming issues. Acknowledging such challenges early on, therefore, is necessary for transfer pricing purposes.

Here are a few recommendations that could serve as a starting point for managing the risks of your transfer pricing policies:

  1. Assessment of group agreements: If the terms and conditions of your inter-company agreements do not provide for pricing adjustments in force majeure situations, consider whether post factum amendments are an option. Taxpayers should be prepared to address and defend potential challenges raised by tax authorities as a result of such amendments. We emphasise that any change in the policy should be accompanied by a proper TP study.
  2. Value added functions assessment: Take a look at the added-value functions that bear the greatest impact from the pandemic and consider actions accordingly.
  3. Key decision makers: Note and consider where key risk management decisions regarding COVID-19 responses are taken. Businesses should keep an archive of any emails or other similar evidence to indicate who were the decision-makers in terms of COVID-19.
  4. Government aid: Assess whether government COVID-19 measures impact your current transfer pricing policies and internal compensation structure.

A crucial point in a potential post-pandemic tax audit would be distinguishing between the economic effects triggered by COVID-19 and those arising from ordinary market circumstances. Тhe key to a successful transfer pricing policy would be demonstrating that all related party arrangements were at arm’s length during the pandemic, accompanied by a thorough analysis of the adverse COVID-19 factors beyond the group’s control.

Kambourov & Partners – Tax Consulting continues to monitor the potential impact of COVID-19 on transfer pricing during this unpredictable period.

Reach out to Nikol Nikolova, [email protected] and Dennitsa Dimitrova, [email protected] to discuss any potential implications that may affect your organisation.