End-of-Year Transfer Pricing Considerations to Account for COVID-19
2020 is probably a year many of us would like to forget. However, multinational enterprises (MNE) need to prepare robust transfer pricing documentation for the 2020 tax year to document and memorialize any changes to their transfer pricing arrangements or profitability related to the COVID-19 pandemic—it may be more important this year than ever before. Unfortunately for MNEs, tax authorities tend to increase the number of transfer pricing audits in years when the economy is in decline or in a recession, and 2020 will be no exception.
During 2020, most industries were adversely affected by COVID-19. In addition to an economy that—according to a World Bank forecast—will decline by 5.2 percent for 2020, MNEs face and will continue to face disruptions to their supply chains and challenges in moving personnel across borders, which have already led to an erosion of profit margins.
Many governments have enacted emergency funding for governmental efforts to contain the virus or provided stimulus measures to boost the economy. For example, to date, Japan, Canada, and the U.S. have spent 21.1 percent, 15 percent, and 13.2 percent, respectively, of their gross domestic product to fund COVID-19 stimulus measures. These same governments were already strapped for funds and will need a means of boosting tax revenues.
Tax authorities will likely target MNEs as an ideal source of generating additional tax revenues to fund the emergency COVID-19 stimulus measures, and MNEs’ transfer pricing arrangements will receive much of the focus. Tax audits that focus on transfer pricing are frequently launched when a tax authority perceives that an MNE’s taxable income is too low relative to its business activities in that country. As mentioned previously, upcoming transfer pricing audits will focus on the 2020 tax year because MNEs’ profit margins have suffered due to COVID-19’s effect. This will likely cause tax authorities to challenge the underlying transfer pricing arrangements, which may have been modified by MNEs during 2020 to address and counter the adverse effect of the COVID-19 pandemic. Therefore, taxpayers must be able to explain to tax authorities that their transfer pricing arrangements were valid during 2020, but there also might have been unexpected deviations caused by nontransfer pricing-related factors, namely the economic damage caused by COVID-19. This discussion is especially critical if the transfer pricing arrangement hinges on an entity achieving a set profit margin or markup, which is not achieved due adverse economic factors caused by COVID-19 that were beyond the taxpayer’s control. It is imperative that taxpayers document their transfer pricing arrangements for 2020 and address any extenuating market or business-related factors to memorialize them in the event of a future audit covering the COVID-19 tax years.
In certain cases, an MNE might have altered its transfer pricing arrangements in the wake of COVID-19. For example, some MNEs had to modify their supply chains due to disruptions in countries hit hard by COVID-19, such as China and Italy. Such changes in the supply chain lead to discrepancies between their transfer pricing arrangements under their prior supply chain and their revised, post-COVID-19 supply chain. MNEs should ensure they document any new intercompany transactions and their revised transfer pricing arrangements so they match their current supply chain and fact patterns. Moreover, MNEs will need to explain how such supply chain disruptions may have led to a decline in profitability.
While it is unclear how long the COVID-19 pandemic will last, it is clear the economy will continue to be profoundly affected for an extended period of time. MNEs will need to routinely monitor the situation to identify and address changes to their transfer pricing arrangements. They also will need to be vigilant when preparing transfer pricing documentation to address any COVID-19-related effects.
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