Transfer pricing: review of strategies and policies at the time of Covid-19
Transfer pricing: the impact of Covid-19 on the transfer pricing approach
The Covid-19 health emergency has a significant impact on the global economy, driving companies whose commercial operations are characterized by transnational elements to reconsider their strategies and business models. Among the main changes undertaken by multinational groups are the revision of the conditions relating to intra-group financing and the adoption of agreements aimed at aligning transfer pricing policies with the market circumstances imposed by the emergency.
In this context, companies should consider whether to adopt “reasonable arrangements” for the purpose of align the TP policies with the market circumstances arising from the emergency.
“Adjusting event”: the conditions for making adjustments to justify a drop in margins.
The OECD Guidelines themselves do not exclude that companies belonging to multinational groups, such as independent enterprises, may also generate losses due to exceptional events (OECD Guidelines, § 1.129).
Therefore it is important to establish through a case-by-case evaluation whether COVID-19 could operate as an “exceptional event” or force majeure event such as to affect the operating result achieved by associated enterprises. If so, the exceptionality of the circumstance would open the way to the TP adjustments, i.e. accounting and extra-accounting adjustments aimed at guaranteeing companies performing routine functions a marginality coherent with their functional and risk profile adopted in circumstances that can be qualified as “exceptional”.
The evaluation shall be conducted on a double track:
- First of all, it will be necessary to establish whether COVID-19 could be considered an “adjusting event”.
- Secondly, an accurate analysis of the “extended” value chain must be conducted, taking into account not only the risks, functions and assets of each entity involved in intra-group transactions, but also the geographical areas in which they are located, as well as the government policies undertaken by local governments. All these elements should be considered in order to determine whether the decline in margins is the result of ordinary events (i.e., decline in turnover, increase in ordinary operating costs), or exceptional events (i.e., costs incurred to ensure the safety of employees, reduction in sales due to the lockdown).
Once the role of each company within the group has been established, according to the OECD, the economic weight of a reduction in profits should be carried mainly by the principal, based on the principle that extra profits and extra losses are normally allocated to entities with high value-added functions. The allocation of losses to the holding company could, however, require a temporary change – until the exceptional situation is over – in the prices applied to intra-group transactions (i.e. mark-up, cost/revenue sharing percentages, interest rates, etc.), in order to ensure that companies performing routine functions achieve a marginality in line with the at arm’s length principle.
The opportunity to introduce changes in the methodology of benchmark analyses
The economic uncertainty and the instability of the markets make the preparation of benchmark analyses more complex. These analyses are used in transfer pricing studies to test the marginality of PMIs compared with the one carried out by the so-called “potential comparables”. The financial data used for the calculation of the profit indicator attesting the marginality achieved by the comparables are usually calculated over a three-year period, excluding the year under analysis. By way of example, a benchmark analysis aimed at testing the margin achieved by the comparables in order to compare it with the one of the company examined during the financial year 2019, will take into consideration the three-year period 2016-2018.
With reference to the analyses that will be carried out to verify transfer pricing compliance in relation to the 2020 tax period, the 2017-2019 years should, in general, be considered. However, taking into account the negative impact that Covid-19 has had on the overall performance of markets and company profits, the question arises is whether it would be appropriate to maintain an analysis approach based on the three-year period or it would be more appropriate to consider an extension of the time period to include the 2020 annuality. This last solution could be functional to make the results of the analysis more reliable: firstly, because the negative effects of structural economic crises tend to manifest over a longer period of time than the year in which the triggering factor occurs; secondly, to allow a balance between the decrease in margins in 2019 and possible signs of recovery in the following year; thirdly, the availability of financial data relating to the financial statements closed in 2020 could also be functional to demonstrate to the financial administrations, in case of verification, the causal link between profit reduction and policies change.
The technical problem of this extended approach is, however, the so-called “two years lag”, i.e. the time lag between the closure of financial statements by potentially comparable companies and the publication of financial data in databases, estimated for the period 2020 to the second half of 2021. As a result, to implement this approach it would be necessary to wait an additional year before proceeding with the so-called “benchmark launch” in the database, with consequent delays in the preparation of transfer pricing documentation that would no longer be guaranteed by the deadline for the 2019 tax return (i.e., 30 November 2020). On this point, we have to wait for additional explanations from the Tax Authorities.
Another important aspect is the possibility of including loss-making companies in the search for comparables in the database. Normally, the best practice requires the exclusion of making losses companies from the final set of comparables on which the range of free transfer pricing competition is calculated. However, in this time when many companies may have had negative results, it would make sense to include comparable making losses in the final set.
A further aspect to be highlighted on the subject of benchmark analyses concerns the selection of countries or geographical areas to be included for the selection of comparables. The government policies undertaken by individual countries, even within the European Union itself, were not perfectly aligned: some countries established longer lockdown periods than others in consideration of the severity and spread of the virus, while in other countries, closures only concerned educational institutions and sports activities. These circumstances will have to be considered, as it is clear that companies belonging to certain sectors will be more penalized if they are located in areas where governments have decreed a slowdown or a total lockdown of activities.
The force majeure clause in intra-group contracts
The Covid-19 emergency imposed to the economic players a reflection on how and when to fulfil their contractual obligations. In particular, the containment measures could involve delays or performances at prices and fees different from those of the market, as well as, in some cases, total non-fulfilment due to the impossibility of performing the services. Such eventualities would subject the debtor, in the absence of specific contractual regulations, to contractual liability for non-performance. In the context of transactions between an Italian party and a foreign party, it’s important to provide the contractual clause called “Force majeure clause”, that expressly establishes that where one of the parties is unable to fulfill its obligations due to the restraint measures provided by government to challenge the emergency (i.e. prohibition to carry out the activity, blocking of supplies, etc.), he must be considered exonerated from any liability.
These considerations apply both to relations with independent third parties and to intra-group relations between companies linked by control and/or connection relations pursuant to art. 2359 of the Italian Civil Code.
In addition to reviewing the contracts in order to ensure consistency with the new intercompany policies imposed by the emergency context, companies must also pay attention to formal aspects in the drafting of the Intercompany Agreements.
The defensive strategy in the event of a post-COVID transfer pricing assessment should be based on the demonstration that any losses directly result from the economic slowdown due to COVID and the impact on market trends. In order to comply with the arm’s length, companies will need to demonstrate that they have carried out thorough functional analyses to assess the distribution of risks and functions among the subsidiaries of the group, including adjustments where necessary in the light of exceptional economic conditions. From the point of view of intra-group policies, there is a greater need to prepare written contracts to regulate the terms and conditions of intercompany transactions. The drafting of the Intercompany Agreement is essential not only to clearly define the role of the counterparties, but also to limit their responsibilities through the inclusion of force majeure clauses that exclude the consequences of not performing the services in the presence of exceptional circumstances such as to justify the delay or the lack of the execution by the debtor.
Based on the considerations above, the preparation of transfer pricing documentation (i.e., Country File for subsidiaries and Masterfile for holding companies) represents a certain element of benefit, with regard to the relations with the Tax Authorities, especially in the event of a tax assessment. The possession of the TP documention allows companies to benefit from the penalty protection regime, i.e. the exemption from the application of penalties (ranging from 90% to 180% of the higher tax assessed) in the event of a recalculation of the taxation deriving from a transfer price adjustment. In order to benefit from the premium regime, companies are required to communicate the possession of the appropriate documentation within the deadline for the submission of the tax return (e.g., for the period 2019, the deadline is the 30th of November 2020). The requirement is fulfilled by flagging a special box within the Income Tax Return Form. With regard to the requirements for access to the penalty protection regime, in accordance with the Law Decree of 18 May 2018, the formal compliance of the transfer pricing documentation is sufficient to recognize the penalty protection. Any discrepancy between the transfer pricing determinations of the amounts made by the taxpayer and the different calculation made by the tax auditors is not relevant for the access to the premium regime. It may only conduct to the payment of the difference between the higher amount calculated by the Revenue Agency and the lower amount calculated by the taxpayer without any surcharges.
LDP Tax & Law is available to provide you further information and technical support regarding the preparation and/or revision of intra-group contracts and the transfer pricing document set.
 OECD Transfer pricing Guidelines for Multinational Enterprises and Tax Administrations, Chapter I, § 1.13O