Transfer Pricing in the Wake of COVID-19
Multinational enterprises (MNE) in all industries will be adversely affected by the coronavirus disease 2019 (COVID-19). In addition to a declining global economy, they will face disruptions to their supply chains and challenges of moving personnel across borders, which will likely lead to an erosion of profit margins.
A few governments have announced emergency funding for governmental efforts to contain the virus or to provide a stimulus to the economy, with many more expected to follow. Many of these governments are already strapped for funds and will need a means of boosting tax revenues to finance these measures. Unfortunately, MNEs—which generally may be perceived by governments and the broader population as not paying their fair share of taxes—will likely be in the tax authorities’ crosshairs as an appealing revenue source to cover recovery package costs. MNEs’ transfer pricing arrangements will no doubt be the focus of the governments’ efforts to boost tax revenues. Tax audits that focus on transfer pricing are frequently launched when tax authorities believe the MNE’s taxable income is too low relative to its business activities in that country. For example, the IRS has an audit campaign that specifically targets U.S. distribution subsidiaries of foreign companies because the IRS believes their taxable income is often understated through non-arm’s-length transfer pricing arrangements.
Unfortunately for MNEs, transfer pricing audits are likely to spike in tax years where their profit margins have been adversely affected by disruptions caused by COVID-19, leading tax authorities to challenge the underlying transfer pricing arrangements. Given that tax audits are retrospective in nature, in the coming years MNEs are likely to face questions about their transfer pricing for the historical tax year(s) affected by COVID-19. To defend themselves, MNEs must be able to explain to tax authorities that their transfer pricing arrangements were valid during this period but there were unexpected deviations caused by extraordinary adverse factors beyond their control, namely business disruptions caused by COVID-19. This discussion is particularly critical if the transfer pricing arrangement is predicated on an entity achieving a set profit margin or markup that has not been achieved due to COVID-19’s adverse economic effects. It is imperative that taxpayers document their transfer pricing arrangements now, including a discussion of COVID-19’s extraordinary effects and any other extenuating market or business-related factors, to memorialize these positions in defense of a potential future audit covering the COVID-19 tax years.
In the wake of COVID-19, in certain cases it may be necessary for an MNE to alter its transfer pricing arrangements. Some MNEs had to modify their supply chains due to disruptions in countries hit hard by COVID-19, such as China. Such changes would lead to discrepancies between the historical transfer pricing positions taken with respect to the MNEs’ supply chains and the altered structures necessitated by COVID-19. MNEs should revisit their transfer pricing arrangements to help ensure they match their current supply chain and fact patterns. If there are significant discrepancies, MNEs may need to change certain transfer pricing arrangements.
While it is currently unclear how long the COVID-19 pandemic will last, it is clear the economy will be profoundly affected. MNEs should constantly monitor their situations to identify and address changes to their transfer pricing arrangements. They also will need to be vigilant in preparing their transfer pricing documentation to address any COVID-19-related effects.
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