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Coronavirus effects for transfer prices – Reviewing and adjustment requirements

Multinational groups of companies have to grapple not just with the challenges of national tax law, but also the effects on their transfer pricing systems arising from COVID-19; in particular, the decisions that are made will have to be promptly documented and contracts adjusted accordingly. It can be assumed that in the course of future tax audits the impact of COVID-19 on international income allocation will come under more intense scrutiny. In the sections below we discuss the areas where a “coronavirus-induced” need to review and make adjustments could arise.

Adjustments to target profit margins for entities that perform routine functions

Generally speaking, crisis-induced losses have to be allocated to the “entrepreneurial entity”. Entities that perform routine functions (e.g. sales companies) normally have lower and relatively stable profits allocated to them. A loss is basically incompatible with the status of being an entity that performs routine functions. A transfer price for an entity that performs routine functions can be determined according to the transactional net margin method (TNMM) and on the basis of database analyses as well as according to the cost plus method or the resale price method. The TNMM uses database analyses that are backward looking and they would not yet reflect the current global slump due to COVID-19. However, it is obvious – and verifiable on the basis of past experience in the context of the financial crisis 2008/2009 – that target profit margins will decline after some delay; therefore, it will be necessary to adjust the comparative data for the previous years.

The fact that corporate groups in particular sectors are generating considerable and extraordinary overall losses due to the COVID-19 crisis will lead to the consequence – irrespective of the selected transfer pricing method – that, besides the entrepreneurial entity, entities that perform routine functions will likewise suffer a decline in profitability and will, potentially, even have to bear a share of the losses; even more so as, in such an extraordinary situation, unrelated third parties would likewise agree to make adjustments.

Please note: It is important to make adjustments to the respective agreements as well as to have available accurate and transparent documentation with adequate justification to provide to the fiscal authorities in the future.

Adjustments to regular royalty payments and intragroup service charges

Generally, royalties should also be regularly examined with a view to adjustments that might be needed. Royalty payments are admittedly mostly linked to sales so that a decrease in sales would also be accompanied by lower royalty payments. However, it may be necessary to look beyond that and to adjust the royalties themselves or, in consideration of the economic conditions, to suspend them altogether. If licensees are in ongoing loss-making situations then a temporary adjustment or suspension of royalties could be appropriate since the fiscal authority would consider a licensee’s loss-making situation to be a general indicator for an unreasonable price.

However, the situation would be different in the case of intragroup service charges where the amount is generally determined on the basis of the cost plus method. Waiving or reducing the charges in the case where the recipient of those services is in a loss-making situation cannot be considered whilst taking into account the arm’s length principle. The only option would be to defer the service charge – this would then have to be offset subsequently, within an appropriate period of time, once the group company had attained profitability.

Safeguarding liquidity and financing

The forced business closures, nose-diving sales markets and uncollectable receivables resulting from COVID-19 coupled with unchanged cost structures etc. could lead to liquidity shortages at individual group companies or across the group. Therefore, to preserve liquidity it is essential to have short-term and medium-term internal as well as external liquidity planning that takes into account appropriate transfer prices.

Cash pooling – especially if this has already been implemented – is a suitable way to safeguard liquidity in the short term and to ensure that the group and the participating group companies have sufficient liquidity. The cash pool leader is responsible for ensuring that the group has sufficient funds available, potentially also via external financing. If the external liquidity costs of the cash pool leader have gone up then the cash pooling conditions should be examined with a view to their appropriateness. In particular, there should be a review as to whether the cash pool leader’s risk was appropriately remunerated and whether individual companies that are particularly at risk should, potentially, be removed from the cash pool and have to have separate financing via longer-term loans.

If the COVID-19 crisis additionally results in group companies not being able to pay their outstanding debts that become due as per the agreement, it is recommended to adjust the payment terms for intragroup trade receivables, where necessary by adding interest in accordance with arm’s length principles, and to prolong intragroup loans.

Please note: In this connection, the interest rate should likewise be adjusted to the new term of the loan and the amount of interest should be reviewed to determine whether or not it is appropriate in view of the crisis situation and stands up to an arm’s length comparison.

However, with “coronavirus-induced” support measures it could even be possible – based on the ECJ ruling in the “Hornbach-Baumarkt“ case – that, in an ongoing loss-making situation, an interest-free or unsecured loan could be granted between a parent company and its subsidiary, or the parent company could provide the financing bank with a comfort letter without receiving liability remuneration for this. If it were possible to provide documentary evidence of a relevant commercial justification that requires an agreement that deviates from the arm’s length principle in order to ensure the economic viability that would otherwise be threatened then the fiscal authority would not be permitted to attribute profits.

Recommendations: Besides the areas discussed above, there could still be other areas that will require adjustments because of the coronavirus crisis, such as, e.g., a reappraisal of transfers of functions or IP evaluations. Companies should therefore check existing structures and, if necessary, reorganise themselves. Any readjustment of the transfer prices would have to be documented accordingly and the relevant contracts updated.

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