Transfer pricing and COVID-19
Contributors: David Bond, Partner, Greenwoods & Herbert Smith Freehills
COVID-19 has disrupted business, including reduced profitability and disruption to supply chains. This creates risks and opportunities in terms of reviewing and adjusting transfer pricing policies to deal with:
- level of profits earned by low risk entities
- renegotiation of related party contracts
- changes in supply chains
- funding and parent guarantees
- intellectual property and royalties, and
- impact of government subsidies such as JobKeeper.
COVID-19 has disrupted business on an unprecedented scale but with the impact varying across different businesses. The impacts have included:
- significant reductions in third party revenue resulting in reduced profits or losses
- supply chains disruptions making it difficult to deliver goods or services to group companies
- adverse impacts on the creditworthiness of a group and individual group entities, increasing the cost of debt, and
- in response to breaches in debt covenants or requests for additional debt, external financiers requesting formal parent guarantees for third party financing.
Transfer pricing policies are often designed assuming overall group profits and therefore the impact of these economic changes can result in distortions in the allocations of profits and losses between group companies. This triggers a need to review and potentially amend transfer pricing policies and intra-group contracts to reflect the new economic conditions and ensure an appropriate allocation of profits or losses between group members.
Low risk entities
Low risk distributors, contract manufacturers or service providers, will generally be allocated routine profits based on either costs or revenue. Without adjustment, this results in low risk entities making profits even though the global group as a whole is making losses.
The COVID-19 crisis will also be impacting third parties operating low risk businesses. If these third parties are making losses, it provides evidence to support adjustments to transfer pricing policies for low risk related party entities. These adjustments may either reduce the profits of low risk related party entities or provide for them with a share of group losses, during the COVID-19 period.
Adjustments to transfer pricing policies to implement such outcomes will be much more convincing if they made at the time of the economic impact rather than after the event when tax outcomes are being assessed.
Renegotiation of contract terms
The arm’s length principal looks at how independent parties would transact and what contractual terms they would accept.
In assessing whether related party pricing can be adjusted in response to COVID-19, the starting point is the terms of the related party contract, and evidence of how independent entities are reacting to COVID-19.
Some related party contracts will include contract variation clauses or force majeure clauses which, if satisfied, allow a party to avoid performing its obligations under the contract. However, as we are seeing with third party contracts, in many cases force majeure clauses are not triggered by the COVID-19 crisis. In addition, there may be other legal remedies available such as frustration of contract.
Even where there are no contractual remedies, there are many circumstances in which third parties would be willing to renegotiate contracts in the face of unpredictable events such as COVID-19. Collecting this evidence on a contemporaneous basis and making timely adjustments to related party contracts diminishes the risk of the adjustments being successfully challenged by tax authorities.
Supply chain impacts
COVID-19 has created sudden and unexpected supply chain disruptions including shut downs (or reduced output) of manufacturing facilities, disruptions to transport, and restrictions on availability of labour.
Multinational groups are recalibrating their supply chains to manage these short term challenges, and some are seeking to diversify their supply chain to manage medium term risks. Resulting changes in functional profiles and levels of profit for related entities in the supply chain can impact on transfer pricing policies. Changes may be required to reduce the level of guaranteed profits for limited risk entities, and to address changes in the location of key decision makers and changes in workforces including redundancies. It will also be important to ensure that intercompany agreements are updated to reflect any supply chain restructures.
Funding of Australian entities
In the face of the COVID-19 crisis, many Australian entities will need additional funding to support cash flows during the period of reduced revenue. However, there are a number of challenges for external debt funding:
- the credit rating of the group and Australian group entities may be detrimentally affected by COVID-19
- financial markets have become more risk averse and interest rates have been increasing, particularly for lower credit rated companies, and
- thin capitalisation capacity is being reduced as cash balances are run down and assets are impaired.
As a result, many group entities will seek related party debt or additional equity. In this regard there is an opportunity to review existing debt terms and interest rates to optimise debt structures. In the current environment with higher interest rates and reduced thin capitalisation capacity, a smaller debt portfolio at a higher interest rate may maximise interest deductions.
There are various anti-avoidance measures which can apply when funding losses with debt, therefore the use of the optimal level of equity funding is also important. A review of intra-group dividend policies is also an important element in maintaining optimal levels of debt.
Group companies dealing with external financiers, either because of breaches of debt covenants or when seeking additional debt funding, may be asked by the external financier for a parent company guarantee.
If a parent guarantee is provided, the subsidiary should consider whether a guarantee fee is appropriate (noting that the ATO’s position on the deductibility of cross border intra-group guarantee fees remains somewhat unclear).
Intellectual property and royalties
If a group company is licensing intellectual property to related companies which are suffering losses, then it may be appropriate to provide a royalty holiday to assist the licensee to recover. In this regard, there are examples of third party licensors providing such royalty holidays when the licensee is facing difficult trading conditions.
Impact of government subsidies such as JobKeeper
JobKeeper payments and other government support may soften the impact of the COVID-19 crisis on profits. The OECD Transfer Pricing Guidelines provide that government interventions, which would include such interventions as the JobKeeper scheme, should normally be treated as part of market conditions, and therefore no adjustment should be made for JobKeeper payments when assessing whether related party dealing are arm’s length.
The JobKeeper scheme includes anti-avoidance provisions which empower the Commissioner of Taxation to reduce JobKeeper payments where an entity enters into a scheme with the sole or dominant purpose of accessing or increasing its entitlement to the government JobKeeper payments. However, Australian members of multinational groups also need to comply with transfer pricing rules. Therefore, it will be important to document the commercial basis and third party benchmarks supporting changes to transfer pricing positions which impact on JobKeeper entitlements.