The Coronavirus outbreak and its Transfer Pricing implications on Companies

Key Transfer Pricing implications 

Due to the ongoing difficult situation, almost every operating business (whether a captive service provider, limited risk/normal distributor, contract/toll manufacturer, commission agent or a full-fledged risk taking entrepreneur) might face one key challenge - Ensuring the continued applicability and suitability of their existing Transfer Pricing policy or business models. However, depending on the nature of the taxpayer’s business, there would be several other key Transfer Pricing implications as well. For the sake of simplicity, we have discussed below such implications for captive service providers, limited risk distributors and contract manufacturers who generally operate on a pre-agreed cost-plus mark-up or a fixed return on revenue based remuneration model in relation to their related party transactions. 

The above business setups generally operate on the lower end of the overall value chain of their Multi-National Group and have a limited and agreed scope of work/activities while assuming very limited or minimal risks. Thus, they have relatively a simplified business model as compared to other complex business models like a full-fledged manufacturer or a risk-taking distributor.      

However, the current volatile situation has greatly impacted the business operations of almost every business setup which includes the aforementioned entities as well. Accordingly, we have discussed some of the key Transfer Pricing implications and have tried to map them with the relevant functional risks (generally captured in the Transfer Pricing Documentation) for such entities which might have significant impact on their existing Transfer Pricing policy or business model on a going forward basis: 

1. Change in the fixed mark-up/margin

First and foremost, such entities who operate on a pre-agreed remuneration model generally provide services to a single overseas related party (their immediate or sometimes, ultimate parent entity) who could be either a full-fledged manufacturer or a distributor - who provide products to customers across the globe. As the current situation is impacting and causing several operating disruptions in supply chains (whether it is procurement, manufacturing, assembling, selling and marketing etc) across the globe, the overseas related party might find it difficult to ensure smooth running of its business operations or erosion of its existing customer base, thereby impacting its revenues and profitability. As a result, if there is a significant dip in the revenues and profitability of the immediate/ultimate parent entity, the impact would automatically trickle down and could lead to a decline in the mark-up earned by a captive service provider or a contract manufacturer, as it is facing what is known in Transfer Pricing parlance, a “Single Customer risk” (the single customer of the captive entity is its immediate/ultimate parent). Moreover, the revenue and profitability forecasts/future projections for the captive entity might also get affected significantly. Further, adverse situations can also arise wherein both the parent entity and the limited risk entity might have to share losses., depending on the fact and circumstances. 

2. Manpower risk and Capacity Utilization risk

Secondly, if the captive/limited risk entity is not able to get sufficient work/projects/assignments from its overseas related party, the existing employees of the captive entity might be grossly underutilized. This leads to a significant exposure to both “Manpower risk” as well as “Capacity Utilization risk”, which would again lead to a decline in the revenue and profitability of such an entity or might even lead to losses.

3. Difficulty in finding comparable companies

Thirdly, it would become more difficult for taxpayers to justify the arm’s length price of their related party transactions if most of the comparable companies which were historically selected in their Transfer Pricing Documentation are now earning wafer-thin margins or have started to incur heavy losses.

4. Need to undertake several comparability adjustments

Fourthly, due to the difficulty of finding sufficient number of comparable companies, the taxpayer might have to undertake several comparability adjustments like capacity utilization adjustment, working capital adjustment, risk adjustment etc in order to arrive at the desired arm’s length range. However, this becomes a difficult situation which might raise a question on the correct arm’s length price itself as the basic principle of Transfer Pricing suggests that transactions should be benchmarked using fewer comparability adjustments, which might not be the case due the current situation. Thus, the taxpayer is caught in a predicament situation. 

5. Delay in outstanding receivables

Further, due to the current crisis, there is a strong possibility that the overseas related party might delay the payment of outstanding receivables which are balances due to the captive entity for rendering services. This might impact the overall working capital cycle, policy and position of the captive entity and create significant exposure to “Credit & Customer risk” and might also create liquidity issues for the captive entity.

6. Revision of inter-company agreements

In addition, the intercompany agreements entered into by the captive entity with its overseas related party would have to undergo significant amendments in order to properly delineate the contractual allocation of risks and safeguard the interest of both the transacting parties in the wake of an external and uncontrollable factor (example: the current COVID-19 situation) which might impact the individual contractual roles and responsibilities and could possibly place one party in an adverse situation, thereby, leading to non-fulfillment of its scope of work as mentioned in the agreement. 

7. Increased scrutiny by the tax authorities

As a result of the significant reduction in the margin earned by the taxpayer or in extreme cases where the taxpayer might earn losses for a longer period, the tax authorities could tighten the Transfer Pricing scrutiny process and increase the number of cases to be audited. Moreover, they can ask for several key details from the taxpayer which might make the entire audit process more complex and cumbersome.  

Possible measures that can be taken by businesses 

In order to withstand or be ready to face the above challenges, businesses should adopt a proper Transfer Pricing planning and defense strategy wherein they can consider the following:

• Undertake a diagnostic review of their existing Transfer Pricing policies (both at a Group and Company level) and intercompany agreements and adjust/modify/realign them in the wake of the global economic impact of Covid-19 by inserting relevant clauses and safeguards. 
• Prepare realistic and achievable future projections over longer time periods (five to ten years) based on scientific assumptions and allocation keys (if possible).
• Properly document the reason for losses or dip in the mark-up/margin in their Transfer Pricing Documentation, policy documents, audited financial statements, invoices and other relevant documents.
• In cases wherein the entire Group is suffering heavy losses, the limited risk entity might have to adopt a loss-split methodology (similar to a profit-split method), depending upon the functional and risk profile of the entity vis-à-vis its related parties. However, this will primarily be on a case-to-case basis. 
• Undertake proper benchmarking processes and steps to find a potentially large comparable set and adopt only the relevant comparability adjustment which is directly related to their business operations.
• Might consider the possibility of using single year benchmarking data instead of multiple-year data for comparability purposes.
• Revisit the existing intra-group credit policy, keeping in mind the cash flow position of both the service providing as well as receiving entity

In the wake of the current situation, companies might need to alter/modify/amend their existing transfer pricing arrangements in order to realign their existing policies and supply chain with the new facts and circumstances. Furthermore, properly documenting and making changes to the Transfer Pricing Documentation in a contemporaneous manner will allow companies to defend the pricing of their intercompany transactions more effectively and with a higher chance of success in case of increased Transfer Pricing security initiated by the tax authorities. 

Moreover, one of the most difficult situations that would arise is when the entire Group is suffering heavy losses. In such a case, the limited risk entity might have to adopt a loss-split methodology (similar to a profit-split method), depending upon the functional and risk profile of the entity vis-à-vis its related parties. Also, a change in the benchmarking approach might also have to be adopted wherein single year benchmarking data might have to be given due consideration. However, all these changes will purely depend on the facts and circumstances of each case.