Transfer Pricing and Economic Uncertainty
Transfer Pricing, Generally
Transfer pricing compliance applies to all U.S. companies having either a foreign subsidiary or a foreign parent company. IRS transfer pricing rules require that intercompany pricing between a U.S. company and a foreign affiliate must be based on an “arm’s length” price that would be charged in a similar transaction with an unrelated third party. U.S. transfer pricing is enforced under the authority of IRC Section 482, which allows the IRS to reallocate gross income, deductions or credits between two or more organizations and, under Section 6662, impose substantial penalties (as much as 40% of the deemed tax underpayment) for failed transfer pricing compliance.
In a tax audit, the IRS will allow a U.S. company to avoid transfer pricing penalties only if the company can provide contemporaneous documentation to substantiate its transfer pricing methodology. The contemporaneous documentation should be in the form of a transfer pricing opinion (or “study”) and must be in place for the tax year by the due date of the U.S. federal tax return. It is important to keep in mind that informational returns such as Schedule M of IRS Form 5471 are the first place the IRS will look to identify intercompany transactions between the U.S. company and a foreign affiliate. As such, any client’s tax return that includes Form 5471 or 5472 should not be filed until the client has obtained a transfer pricing study before the date on which the return is due.
Impact of COVID-19 on Transfer Pricing
The increasing impact of COVID-19 on American companies – now coupled with travel restrictions – has created an international business environment unlike any we have ever seen. Existing shifts in the global economy may cause companies to revisit cash flow in order to serve capital expenditure (CapEx) needs within their group and across jurisdictions. An unanticipated and artificial shift in income allocation will create transfer pricing scrutiny, ultimately impacting pre-existing international tax strategies.
In particular, with economies around the world grinding to a halt, companies may see their related parties booking losses where they once booked profits. The question arises whether those losses should go to the headquarters company or be spread across the multinational group, which could raise disputes with tax authorities. Companies might struggle to convince tax agencies that those losses are allocated at arm’s length, when they had previously based their transfer pricing models on allocating profits. As such, transfer pricing documentation may be as important now as ever before.
More proactively, as an exceptional event, the economic and business disruption may make it possible and appropriate to temporarily revise intercompany transfer pricing arrangements. It may be appropriate to implement special pricing arrangements and reductions in transfer pricing target profits for limited risk service providers, and/or other means of support for affiliates in distress or as a means to share this unusual financial burden over a group. The legal and economic basis of such changes and their impact on future positions should be carefully considered and well supported so they are defensible in hindsight. We expect that affected companies may need to explain unusual results to relevant tax authorities to demonstrate and explain the disruption on operating results and to demonstrate that these results were not caused by an arbitrary shift in transfer pricing policies.
Corporate Governance & Income Allocation
For U.S.-based companies that have offshore entities that utilize offshore structuring techniques, corporate governance implications must be considered. In order to comply with the OECD’s BEPS initiatives, multilateral instrument, and alignment of operations tax policy, we remind multinational enterprises of the emerging “nexus approach” to global tax planning. We recommend that our clients adhere to strict corporate governance protocol, including in-person board meetings in the jurisdiction to which income may be allocated. As travel bans continue to be placed across continents, companies need to anticipate and plan for impediments to corporate governance that may impact the company’s overall international tax posture and global effective tax rate. Various countries (Luxembourg, Netherlands, Bermuda, Cayman Islands) have already introduced legislation to loosen in-person board meeting requirements. While these exemptions are intended to assist multinationals in satisfying local corporate law requirements in the short-term, they are unrelated to longer-term tax positions and may undermine income allocation across a group. For example, a multinational that intends to allocate certain income to its offshore “headquarters” or “principal” company may struggle when justifying any such income allocation when no substantive activity has taken place in that jurisdiction in 2020.
Global Mobility and Taxable Presence
Restrictions on travel could cause issues to arise over which country can tax an activity. As companies carry out economic activity in a country remotely, this could cause issues of territoriality. For example, a sales director could be contracted to perform a function in one country, but might not be able to leave another country to carry out that function because of a travel restriction. By doing so, the sales director could create a taxable presence in the country in which the work is actually being performed.
As noted above, appropriate transfer pricing documentation is an essential compliance item for any multinational organization in any year. However, the global economic upheaval caused by the COVID-19 pandemic has only exacerbated transfer pricing compliance and we strongly encourage clients to be proactive in adjusting intercompany pricing, modeling, and documentation. Taking a wait-and-see approach to transfer pricing compliance for 2020 would be an unwise course of action, as companies that can update and complete transfer pricing documentation in a contemporaneous fashion will be in a far better position to defend their positions when called upon to do so on a going-forward basis.