After the first months of 2021, it seems that this year will also be significantly influenced by the impacts of the COVID-19 pandemic. It is especially the economic consequences of the pandemic that are discussed in this context. Even in extraordinary times like these, groups of related companies should not give up on proper transfer pricing setting. In today’s newsletter, we therefore address the issues businesses should deal with in this context, such as the transfer of a loss caused by the pandemic, a change in the transfer pricing setting due to the extraordinary situation or allocation of one-time costs.
Recently, the economic impacts of the COVID-19 pandemic have been widely discussed. This extraordinary situation naturally also influences groups of related companies, which, apart from common operational matters, have to address whether and how to change their current transfer price setting in reaction to the current extraordinary situation or how to approach the allocation of incurred costs or losses.
Towards the end of 2020, OECD also commented on the situation and issued a new recommendation concerning the impacts of the COVID-19 pandemic on transfer pricing. Below, we present several main points mentioned by the OECD in its recommendation.
Evaluation of the economic impacts of the pandemic on the analysed industry
The economic impacts of the COVID-19 pandemic are, compared to previous crises, different, as they impact individual industries differently. Across industries, the influence of government measures and the accessibility and amount of government support differs. The direct impact of the pandemic on the supply chain and demand for products/services also differs. Due to different approaches taken by governments in individual countries to the introduction of general restrictions and to support for businesses, the businesses’ economic situation and the impacts of the pandemic vary from one state to another.
When assessing the impacts of COVID-19 on transfer pricing, it is necessary to analyse in detail the impacts of the pandemic on the given industry and state.
In connection with the pandemic, companies especially face:
- Market risk, specifically a decline in demand for services and products;
- Operational risk, as supply chains and established forms of production and the way services are provided may be disrupted by the pandemic – this concerns, e.g., the introduction of home office and permanent work teams;
- Financial risk connected with an increase of financing costs in certain industries and the deteriorating solvency of customers.
Changes to the setting of transfer prices
When considering a change in the setting of transfer pricing among related companies, it is always necessary to look at the issue at hand through the eyes of an independent partner and answer the question as to whether the relevant change would be possible with an independent supplier or customer.
While companies may reflect the impact of the extraordinary economic situation on the setting of prices when renegotiating short-term contracts, changes to the conditions of long-term contracts are generally possible only if independent entities resorted to this change as well, e.g., if the survival of a party to the contract would be put at risk if the change did not occur or if said change makes it possible to improve the parties’ future economic situation. This rule, however, should apply to all intra-group relationships, including financing.
Generally, the OECD recommendation sets out that if there is insufficient evidence that independent entities would resort to the change of pricing in the same situation, it is better not to change the transfer prices given the potential tax risks for the company.
Distribution of losses within the group
Another issue group companies may face is how to distribute the incurred losses among individual companies in the group. In this case, the (im)possibility of transferring the loss to low-risk companies is often discussed. When considering the transfer of the loss among group companies, it is necessary to carry out a thorough analysis of the functions and risks borne by the companies in the given relationship.
Not all risks are the same. The fact that we call a company a low-risk company does not automatically mean that this company is not going to be loss-making under any circumstances. The profit and loss connected with the risks the company bears always belong to the particular company. For instance, if a company does not have its own storage facilities, it does not bear the risk connected with a decrease in the price of the stock and should not bear the related loss. If, however, loss is incurred for another reason, e.g., due to a drop in demand (i.e., by realization of a market risk), the company should bear the loss despite being classified as a company with limited risk exposure.
Consistency in transfer price setting is important in this context. If, according to the performed analysis, a company does not bear the market risk and the associated loss, it should not be entitled to a higher profit due to the market’s positive development in more successful times. It is exactly this which can be the subject of a tax inspection.
Extraordinary costs allocation
Due to the pandemic, most companies had to deal with a number of one-time costs incurred in the provision of protective equipment, disinfecting the workplace, mandatory testing of employees or the purchase of necessary IT equipment so that employees could start working from home. Their allocation should be made in the same way as in the case of unrelated entities, and the given costs should always be borne by the company bearing the associated risks and appropriately rewarded for bearing these risks. In the case of the distribution of products and services within a group, the question is whether a distributor, given the competitive environment, is able to translate the increase of costs into transfer prices. If this is not possible for independent customers, the distributor should also not enforce the increase for group customers.
Are you addressing possible changes in transfer pricing due to the economic impacts of the COVID-19 pandemic? Are you unsure about the analysis of risks within the group or do you need to update a comparative study? Contact us – we will be happy to help you.