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Covid Brings Transfer Pricing Issues
Compliance
Covid Brings Transfer Pricing Issues
By Paul Sutton
As multinational groups respond to the challenges and opportunities presented by the coronavirus outbreak, many of them need to update their transfer pricing policies and internal supply chains, as well as their outwardfacing business operations. General counsel have a key role to play in ensuring that the legal aspects of these transitions are managed appropriately.
This article provides a brief recap on the essential role of inter-company agreements in transfer pricing compliance.
Transfer pricing relates to the charges made between associated entities such as companies within a group. Tax authorities may challenge the amounts of those charges, and this may give rise to a risk of double or multiple taxation of the same profits. Legal agreements between those entities — often referred to as intercompany agreements (ICAs) or transfer pricing agreements — form an essential part of the documentation required for transfer pricing compliance. If intercompany agreements are missing, or don’t match the group’s stated transfer pricing policies, then the group can be exposed to time-consuming and costly tax audits, fines, and penalties in multiple jurisdictions.
A key concept in transfer pricing is the “arm’s length principle.” In essence, this requires transfer prices to be determined based on conditions (including with respect to risk allocation) that would be made between independent or unrelated enterprises. In order for a group’s transfer pricing policies to be actually implemented, as opposed to being a theoretical statement of intent, the allocation of risk and reward described in the transfer pricing policies must be reflected in the legal terms of appropriate inter-company agreements. The Organization for Economic Cooperation and Development’s (OECD’s) Transfer Pricing Guidelines are very clear that contractual allocation of risk cannot be backdated.
Therefore, agreements should be put in place in advance, or as contemporaneously as possible, and kept up to date so that they reflect the group’s actual operations and corporate structure.
ADAPTING IN RESPONSE TO THE PANDEMIC
As has been extensively documented elsewhere, the disruption caused by the coronavirus outbreak is causing many multinational groups to adapt their business models and revise their transfer pricing policies. The following is a simplified case study for a group in the software sector.
A U.S.-headquartered group may provide software-as-a-service (SaaS) to customers worldwide and may also provide consulting support to those customers to help them implement the relevant software. The intellectual property rights in the software may be held by a group entity in the United States. Local subsidiaries in various countries may act as principals in licensing the software to customers in the local markets, and may also act as principals in providing consulting services relating to the implementation of the software.
From a transfer pricing perspective, the subsidiaries may be regarded as performing “routine” functions in their distribution role, on the basis that strategic management and control over the marketing activities takes place in the United States, and the relevant U.S. intellectual property holder also assumes the commercial risks inherent in the distribution activities. On that basis, each distributor may receive a modest but guaranteed return from its activities (e.g., a net operating margin of five percent). This arrangement would be reflected in the existing inter-company agreements. The contractual allocation of risk and reward is a key element of the transfer pricing analysis, based on the OECD’s Transfer Pricing Guidelines.
However, in the current economic environment, the group as a whole may be incurring losses — perhaps because its customers are in a sector heavily affected by the coronavirus, such as tourism or travel. In such a situation, it may not be appropriate for local distributors within the group to be making taxable profits, even based on a low margin. The group may therefore want to revise its transfer pricing policies and its inter-company charges to reflect the overall loss-making position of the group.
Clearly, updating transfer pricing policies is not simply a matter of reviewing the economic analysis and comparables and replacing the existing policy documents. It also involves considering the current legal structure of the group and its inter-company agreements, designing an appropriate future structure (whether this is intended to be temporary or ongoing as the new normal), and considering how to make the transition from the current to the future state in a manner consistent with both the arm’s length principle and the legal duties of directors.
ACTIONS GENERAL COUNSEL SHOULD TAKE
General counsel should engage proactively with their tax and transfer pricing colleagues to ensure that the process of revising transfer pricing policies accounts for the wider needs of the group, such as intellectual property protection and asset protection.
As with any other group restructuring project, the fundamental task is to:
A. Identify the current state of affairs, including current transfer pricing policies and the terms of the intercompany agreements currently in force.
B. Design the intended state of affairs following the restructuring of the relevant entities and supply chains.
C. Create a plan for transitioning from A to B.
The assessment in A includes reviewing the impact of any force majeure clauses contained in inter-company agreements, as well as the other legal rights of the relevant associated entities.
However, the question of whether one party, or group entity, has a unilateral right to terminate or suspend performance of a contract is just one factor in the process for planning a transition in legal arrangements. As between unconnected parties — even where no such right exists and the parties are locked into a long-term contract — it may be in both parties’ interests to renegotiate or restructure the business relationship.
The OECD’s Transfer Pricing Guidelines recognize this. For example, the 2017 edition of the Guidelines states that “business restructurings may be needed to preserve profitability or limit losses, e.g., in the event of an over-capacity situation or in a downturn economy.”
In this respect, there is a substantial convergence between transfer pricing considerations, such as the “options realistically available to the parties,” and considerations arising from principles of corporate governance and the legal duties of the directors of the individual legal entities concerned.
SUGGESTED LEGAL FRAMEWORK
The following points are suggested as a framework for considering the revision of inter-company agreements from a legal perspective.
1. Identify which legal entity or entities within the group need to be restructured (e.g., because they are accruing inappropriate profits or losses within the internal supply chain).
2. In relation to each such entity, identify which are the key inter-company transactions that contribute to the unintended and inappropriate result.
3. For each such inter-company transaction type, identify the terms of the inter-company agreements in place, whether express or implied.
4. Consider how the relevant terms operate in the current environment. This includes pricing clauses, the presence or absence of contractually guaranteed returns, and contractual allocation of risks such as inventory risks and credit risks.
For example, in cost-plus arrangements for the provision of services by local entities to the parent or entrepreneur, a key question is whether the definition of “cost” is such that additional costs relating to the coronavirus are included in the costs recharged, or are outside the recharge mechanism and therefore borne by the service provider.
1. Consider the proposed transfer pricing policy that is intended to apply going forward. This may merely involve a change in the pricing provisions or may instead involve a more fundamental restructuring of the terms of the inter-company relationships.
2. If the existing inter-company agreements need to be revised, which will often be the case, consider which party is seeking to terminate, suspend or renegotiate the agreement or, importantly, would be seeking to do so if the parties were not related parties. This is usually the party that is considered to be paying too much or receiving too little for the goods, services or intangibles (intellectual property rights) in question.
3. Identify what legal grounds exist which that party may rely on to terminate or renegotiate the arrangements.
4. Consider whether the termination of contractual arrangements may entitle one party to compensation or indemnity, whether from a legal perspective or from an economic (transfer pricing) perspective.
5. Consider whether the proposed restructuring of contractual arrangements entails or implies a movement of people or assets. From a legal perspective, implementing such actions without proper consideration of third-party elements (e.g., the potential impact on defined benefits pension schemes) may trigger statutory liabilities that are far in excess of the value of the assets involved.
In principle, the legal considerations when reviewing and revising inter-company agreements in response to Covid-19 are no different than any other exercise for reviewing intra-group legal structures in connection with the revision of transfer pricing policies and business restructurings. As always, intragroup agreements need to be considered from a holistic perspective — including considerations of regulatory compliance, VAT, customs duties, intellectual property licensing, and other asset protection — in addition to governance and transfer pricing. In-house legal functions have a vital role to play in managing these issues.
Finally, it should be remembered that for the purposes of managing personal liability risks of directors, the process by which legal intra-group arrangements are restructured is as important as the outcome. For this reason, and in order to comply with the principle of informed consent in all but the simplest restructurings, it is important to brief directors on what they are being asked to approve, why, and what the actual and likely implications are.
Paul Sutton is the co-founder of LCN Legal, an independent law firm specializing in advising clients on the legal design and implementation of corporate structures. Prior to establishing LCN Legal, he held positions as a director at KPMG’s UK law firm and as a corporate partner in the London offices of McGrigors and of Pinsent Masons. paul.sutton@lcnlegal.com
