The COVID-19 pandemic has wrought havoc on multinational corporations’ (MNC) supply chains, which has in turn created transfer pricing uncertainty for tax directors in the form of comparables, business projections and profit and loss allocations. Below, CrossBorder Solutions Co-Founder and Chief Operating Officer David Bukovac, Chief Economist Mimi Song, and Chief Revenue Officer Christy McDonald, discuss transfer pricing compliance best practices for MNCs in 2020.

MNCs are facing challenges on multiple fronts to keep operations running during the COVID-19 pandemic. Why should transfer pricing compliance also be a top priority?

David Bukovac: One of the things we know for sure is that countries have experienced a huge hit to tax revenues, and will be looking closely for ways to offset that loss. In this economy, it’s all but impossible to impose the burden on voting taxpayers, so we anticipate that the focus will turn to MNCs to raise revenues.

To that end, we expect transfer pricing to be one of those places where tax authorities dig deep looking for adjustments—not just for the 2020 tax year, but possibly open years as well. MNCs should prepare to be audited.

Christy McDonald: Among many prospects, complacency has set in because many tax authorities are giving them additional time for filing and completing documentation. However, part of the reason that the tax authorities are giving this extra time is because they are putting a process in place so they can dig deeper and begin audits. This is a prime time for tax authorities to be combing through material to make sure that what MNCs have put into place to illustrate how they’ve been impacted in 2020 can be supported through documentation.

Mimi Song: Another reason to focus on transfer pricing now is that intercompany agreements (ICAs) need to be updated. While MNCs have negotiated vendor or customer contracts to offset losses from the pandemic, many haven’t done so accordingly for their related party contracts. The inability to produce these ICAs will be a major red flag to the tax authorities this year.

What should tax executives keep in mind about allocating loss?

Mimi Song: The number one question I’m getting from customers is what they should do about losses. For example, does it make sense for an entity to continue to earn a routine rate of remuneration when everyone within the entire multinational organization is bleeding money?

When we do transfer pricing analysis using a profit based approach, it benchmarks the distributor, for example, and then ensures that their margins fall within a specified range. However, given the current volatility, many tax executives are worried about that approach and how they’re going to treat these COVID-19 related expenses.

For the time being, our recommendation is that COVID-19 related expenses (losses) should be recorded separately. These losses are extraordinary expenses—while it impacts daily operations today, it’s not a forecasted expenditure. At year end, tax directors will need to determine how those expenses should be treated for transfer pricing purposes. When it comes to negotiating intercompany contracts, if the contractual terms are revisited and renegotiated, these extraordinary expenses should be shared.

Also be aware that some jurisdictions have created special treatment provisions. For example, The Netherlands actually enabled MNCs to forecast their losses and accelerate it for their tax return, which is a nice benefit for those filing their tax return in this country 15 months after their year-end.

To allocate losses:

• Show that they aren’t related to transfer pricing.
• Take notes on relevant details now in preparation for developing 2020 documentation.
• For those routine functions, look at the roles each entity played during COVID-19. Did a routine entity help alleviate COVID-19 consequences? Who should bear the reward? Then look at your transfer pricing policies and see if changes are needed.

How should tax directors obtain comparables in 2020?

David Bukovac: MNCs must find comparables that reflect the changes they made to operations in response to the pandemic. Simply refreshing the comparable set that you had last year might not support your broader 2020 story.

Mimi Song: For the 2020 tax year, there are many ways for MNCs to think about comparables. For example, they could review data from the last recession in 2008, and build out forecasted financials for 2020 to get a better understanding of how adverse economic conditions affect margins.

Benchmarking is important because tax directors need to determine a baseline to help quantify the impact of COVID-19. It could be very reasonable for the tested party and for all the third party comparables to be in a loss-making situation this year. In addition to looking at data from the last recession, look at a comparable company that went out of business in 2019. Even though it occurred in a pre-COVID state, it’s still important for understanding the implications post COVID-19. Finally, MNCs should consider if their business model has evolved during the pandemic, which could impact the functional characterization of the tested party against which they’re benchmarking profitability. If this is the case, tax directors need to be prepared to craft a narrative that details the evolution of the business as a way to reduce their risk of a potential transfer pricing challenge or adjustment.

David Bukovac: Another important aspect is to localize comparables, as regulated by the various tax authorities. Otherwise it will leave MNCs exposed at a time when tax authorities are looking for excuses to initiate adjustments.

What should MNCs keep in mind when it comes to documentation?

Mimi Song: Tax directors should document the decisions they make in response to COVID-19 related events in real time rather than rely on memory after the fact.

Christy McDonald: This information will be imperative next year as tax directors create an accurate narrative around the impact of the pandemic in their transfer pricing documentation.

David Bukovac: I agree that taking notes in real time is absolutely essential. To create the narrative, tax directors need to document what the business went through at every stage, not just a “we were here.  And we’re here now.” Also make sure that your story is consistent across the entire organization and is reflected in the documentation. Tax authorities share information so they can easily spot discrepancies, and that’s where they’ll dig deeper for possible adjustments.

It’s critical to be in compliance with rules in every jurisdiction in which an MNC operates. That includes knowing which tax authorities are providing relief on deadlines due to the pandemic and which ones are not. While it’s not uncommon for tax directors to take a risk-based or reactive approach to developing documentation, 2020 is not the year to do so as tax authorities are making a concerted effort to offset pandemic-related revenue loss through adjustments.

To learn more about transfer pricing in the time of COVID, listen to this episode of The Fiona Show.