Mimi Song is not only CrossBorder Solutions’ Chief Economist but also an economy pundit rock star all in her own right. We speak with her in-depth about about her new article in Bloomberg, “Tax Scrutiny and What you can expect in 2021” and what new OECD guidelines mean for the post-COVID transfer pricing landscape.
Matthew DeMello: Not only do you offer strategies in your article, but the OECD also just released guidance on how to handle transfer pricing for fiscal year 2020. What is the purpose of that guidance?
Mimi Song: Well, I think that the OECD’s guidance is just to reinforce the arm’s length principle because a lot of companies are probably trying to understand, given the pandemic’s impact to our organization, “What should we be cognizant of?” “What should we be considering?” “Are changes in the facts and circumstances going to have a material impact the application or the interpretation in the arms and principle as it relates to my business?”
And the answer is, “Actually yes, it will!” Right? Because transfer pricing is a facts and circumstances exercise. And so the application of the arm’s length principle still stands and still needs to be considered on its merits.
Matthew DeMello: That’s right. And the OECD focuses on four points that you covered in your article. What are they and why are they such a concern for transfer pricing during COVID?
Mimi Song: Well first and foremost, the two easy ones, right? I mean, comparability analyses, loss-making companies… And then there are two others that perhaps haven’t been as considered, which relates to the intercompany agreements and along the same vein, advanced pricing agreements.
But let’s just start with the first one — comparability analyses. We know that transfer pricing analyses and reports, they’re always a historical snapshot. So there’s a delay or a lag in terms of the availability of information to taxpayers. So are you able to accurately determine that your related parties were operating at arm’s length if you’re comparing it to businesses that were not yet impacted by COVID?
So there could be a lack of comparables, or sufficient comparables in that regard and perhaps that needs to be more explicitly considered. So that’s comparability. Now, on losses: clearly companies all over the world, they’re losing money and losses usually trigger a red flag for audits. But I think the tax authorities ultimately understand that losses are inevitable in this pandemic environment.
And so they’re not going to be overly sensitive about losses, as perhaps in a non-pandemic environment. However, remember every tax agency is out for themselves. And I’m not saying that because their intention is to be malicious, it’s that they still have to look out for the wellbeing of their country. And so even though they can anticipate that a company is going to be losing money in its jurisdiction, which decreases the tax revenue locally, you still – as a taxpayer – need to prove that those losses are valid, and you need to be able to justify those losses.
Matthew DeMello: You also wrote that multinational companies should prepare for even more tax scrutiny than we’ve seen. Can you tell us why more transfer pricing scrutiny is on the horizon?
Mimi Song: Well, I think one of the main points here is that governments have been helping taxpayers with relief programs and those really programs are extremely costly. And so tax authorities are going to look for rates to shore up that lost tax revenue. And how are they going to be able to do that? I mean ultimately, they’re going to have to figure out who is manipulating the system once again.
And by the way, this is the tax authority’s perspective. It’s not my perspective! I don’t think any multinational’s necessarily manipulating the system. It’s more that everybody’s operating within the confines of the law.
Now it’s different if you’re looking at it unilaterally. From a jurisdiction standpoint, let’s just take Germany. For example, Germany will basically say, “Hey, you know, all of a sudden my tax revenue has declined by 20 percent versus maybe the U.S. only declined by 10 percent. Clearly this is an uneven swing of the pendulum! And therefore we need to look at this more closely.”
Now we’ve all been through recessionary environments and well, I think so… [Laughs.] because the last one was only about 10 years ago and I’m pretty sure we’re all older than 10 years old! [Laughs.]
Matthew DeMello: Yes. [Laughs.]
Mimi Song: So back in, back in 2009, the IMF actually did some research and, and, and they wrote about how multinationals were tended to be less compliant during recessionary periods. And I think we understand why companies sort of… They deprioritize compliance, they prioritize other issues… But remember, you know, everyone has a different mandate and the tax authority, their primary mandate is to collect tax revenues. And so let’s face it, we know that tax dollars are going to be looking at this and they’re going to try to figure out ways to shore up those deficits over the next upcoming years.
And I think that’s part of what the OECD has published in terms of recommendations, at least, you know, for all these countries to come together and figure out the right solution that is not only going to keep their sovereign interests in mind, but also minimize the potential of trade wars and things of that nature, the negative the downstream impacts of tax reform.
Matthew DeMello: That’s right. In one thing we keep hearing about in terms of transfer pricing during COVID-19 is that benchmarking stands to be an issue. Why is that?
Mimi Song: So it was what we were talking about before. I think that the timing of the data is a problem. Now that’s number one, but number two: economic downturns don’t impact companies exactly the same way.
Every company deals with market crises a little bit differently. Every company has a slightly different competitive advantage. I mean, these are all the challenges we would have in a normal situation anyway, but at the same time, there is an idea here that functionally comparable companies may start to differentiate themselves in this type of marketplace. What is that expression? “The cream rises to the top”?
Matthew DeMello: Yeah, I guess so. Or rather, that the kind of benchmarking you’re going to see during COVID is going to make for different functional analyses than you would from before COVID, purely because the functions of companies are changing to fit this new landscape.
Mimi Song: That’s true. Or to… address this new landscape, right? Supply chains are changing. Operational frameworks are changing. The infrastructures are being modified to accommodate the new world. So you’re right: I think from a functional profile perspective, perhaps we end up getting more diversification, which diversification when it comes to a compatibility analysis, makes it even more difficult to find the right comparables.
Matthew DeMello: And the OECD guidance on transfer pricing implications of COVID-19 pandemic just debuted. One point the guidance makes in terms of benchmarking is to compare profitability, to recessionary periods, a point you also made in your article. Can you tell us about this benchmarking strategy and why it might be helpful in terms of COVID-19?
Mimi Song: It’s helpful because you get at least a sense of how the market reacted or how the market was impacted by a recessionary environment. And so if you look at the prior recessionary period, and you look at the differential of how were companies impacted pre-recession, post-recession, and during recession, it should give some insight as to what we can expect to see from this pandemic environment. I think comparing the 2020 profitability to third-party behavior that’s actually observed in the previous recessionary periods could help to provide some indicative understanding of what we would expect to see from a market response perspective.
Matthew DeMello: And what about losses? Can you include companies with losses in your comparable set?
Mimi Song: So I would say yes. Simply speaking in this situation, yes. Now tax authorities, normally don’t like loss-making companies because that’s never the intention of a business. However, fair market value of organization, of prices, of goods have to reflect real market conditions. And the reality of 2020 is that losses are abundant and inevitable for various sectors.
So ultimately, having those loss-making companies I think will be a true reflection of the market conditions — number one. And number two is even if you tried to reject them, by the way, I think that would leave the set of comparables with nothing. You’d have nothing to even begin with because the reality is so many companies are in loss, making situations
Matthew DeMello: That’s right, and country specific requirements often dictate local comparables. How can you manage that in a year like 2020?
Mimi Song: So for local comps, I think, also will be challenging. I think different countries have had different responses in relation to the pandemic. So that’s going to be interesting to see, whether or not we see market conditions being impacted explicitly by government responses to that.
So this actually helps the argument for the tax authorities to say, “You should use local comparables.” Because ultimately, each market has responded differently. And because of that, the impact to businesses locally will be different, the responses will be different, the profitability will be different. In fact, businesses might have explicitly reacted because of the government response to the pandemic locally. So I think this is also very much in line with the OECD recommendation of using local comparables when possible to show market conditions.
Matthew DeMello: Let’s say if your businesses had to take on many costs related to COVID, many companies supplied employees with masks, gloves, face shields, dividers, oceans of hand sanitizer, so on… Obviously these costs will have to find their way to the corporate balance sheet, but under which line items, and how does that effect transfer pricing?
Mimi Song: So that’s a great question because to be honest, this goes to the underlying costs that are either allocable for transfer pricing purposes depending on the types of service, or they’re not eligible and depending on where they’re actually booked.
Now, I think there’s probably a little bit of inconsistency in terms of how companies are tracking these types of expenses. Some companies are probably thinking that they’re just one time costs that can increase non-gap earnings. Some of them are actually considering them as ongoing BAU costs, or BAU business-as-usual costs. So I think that this going to be a challenge, one of the things we all know as transfer pricing practitioners is that the costs that are being picked up for purposes of the profitability analysis, or the economic analysis to test the arm’s length nature of the intercompany transaction, is sensitive to the underlying costs.
Whether you’re using an operating margin profit level indicator, or a net cost plus profit level indicator, all of that is going to be impacted by which costs are being picked up. So this is going to be important to figure out how we create consistency or how we evaluate companies against one another consistently, apples-to-apples. We don’t want to compare apples-to-oranges.
Now, the IRS even says that the payments of the expenses covered by the foreign PPP loan, right under the CARES act will no longer be deductible. And that also could impact the profit level indicators.
So it’s important to understand what that means. If you have certain expenses that you’ve incurred, perhaps you’ve paid employee salaries because of the CARES act, you were able to get government support on that. So the salaries of those employees are not deductible. And so that’s going to have a clear impact to the profitability as it relates to transfer pricing. So should those costs be picked up? Probably, but then you have a difference between your book versus tax and then even between your tax versus transfer pricing. [Laughs.] So it creates a little bit of a reconciliation nightmare, to be honest.
Matthew DeMello: That’s right now, what is the OECD’s recommendation for handling losses?
Mimi Song: I think they OECD’s generally saying it’s on a case-by-case basis. It’s their position is still very much aligned with value and value creation and bearing of risks, which is the basic premise of transfer pricing and the arm’s length principle. So ultimately, if entities don’t bear risk then they really shouldn’t absorb losses.
But that also goes back to the intercompany agreements. If you’ve modified your intercompany agreements, similarly to how you’ve modified your third party agreements, perhaps that the burden of risk has shifted. And so, it might make sense to share losses in accordance with that risk.
Matthew DeMello: In your article, you talk about transfer pricing policies. What should MNEs and practitioners be aware of about that?
Mimi Song: So the transfer pricing policy should reflect the economic reality of the company’s operations. We know that in this current environment, companies may have had to modify some of their operational frameworks. They might’ve had to mix and move their chess pieces in the overall supply chain. And that’s going to be really important in terms of the application of your transfer pricing policies in response to those changes. You’re going to have to understand what companies are doing and how they should be remunerated on an intercompany basis for such activities. So transfer pricing policies may have to be revisited after this year just to make sure that the policy matches the underlying facts and circumstances.
Matthew DeMello: Many MNEs think of APA – advanced pricing agreements – as the answer to tax certainty. How has COVID challenged that line of thinking
Mimi Song: So an APA, just for everyone’s edification… I mean, it takes many years to negotiate an APA, whether or not it’s just unilateral or bilateral. Most companies go for bilateral, which means at least two countries agree on the terms of the APA. And there’s one component of it that’s called the critical assumption. And so if this critical assumption is broken, the APA is no longer acceptable or it’s no longer honored.
And so that’s the main question here in my mind: Does the global pandemic change the market conditions to the extent that the critical assumption in many multinational APAs would be challenged and broken? So that’s really where [we ask,] “Does an APA really help or hurt during these extreme market fluctuations?”
My take on this is essentially that it hurts. It doesn’t allow the company to be flexible enough to adapt, to react, to figure it out. And by the way, the whole point of the APA is to provide a certain level of tax certainty. And when you talk about extreme market conditions, you perhaps lose that certainty anyways.
Matthew DeMello: And what’s making financial transactions so tricky during the pandemic?
Mimi Song: So financial transactions are really tricky because interest rates themselves are pretty hard to understand. And what I mean by that is remember, interest rates have been basically going down to zero in order to help economic stability, if you will. And the question about what that arm’s length interest rate should be between related parties is it’s impacted by the market conditions as it exists today.
So if a company would typically, under non-pandemic situations, be considered “investment grade,” then should they continue to receive the benefits of that investment grade credit rating so that once the pandemic is over, they’ll be able to bounce right back? Because we know that is a one-time loss situation or a extreme market situation that’s impacting their earnings. Or does an interest rate have to be established in line with the fact that that borrower, based on the current facts and circumstances, would be considered risky, right? So which one is the right answer? And Matt, if you know the answer I’d love to know. So… [Laughs.]
Matthew DeMello: Cat caught my tongue, [laughs] but there are also intercompany agreements. What should multinational companies be aware of when it comes to them with regard to COVID-19?
Mimi Song: So intercompany agreements have been challenged. Or are probably coming to the forefront in a lot of ways, because many companies are able to, or have invoked, the force majeure clause. Now we’re talking about situations where there is actually a decrease in demand because of unemployment workers are all being displaced. There could be a variety of different reasons why an intercompany agreement may not be effective anymore. Especially when you talk about limited risk arrangements.
As we were talking about before, perhaps on a pre-pandemic level, there was a limited risk distribution arrangement in place where the intercompany agreement actually stripped out the risk of the affiliated distributor. But then in response to current market conditions, it didn’t really make sense to continue to do that, because ultimately then is it fair for one side of the transaction to bear the brunt of the entire economic impact of the pandemic?
So I think that with intercompany agreements, you need to make sure that they are representative of the current situation of the company and to the extent that you need to renegotiate them based on how your companies and affiliates have reacted to one another, how that’s impacted the actual transfer price for your organization – that will be a good exercise.
And what I mean by that is, nobody looks at the agreements until there’s an extreme situation. I feel like that’s always the case, right? Nobody actually looks at what are the major details of the agreement, but let’s be fair. The agreement was put together to respond to these extreme conditions. It is there to help companies and give them certain assurances and protections in these extreme situations. And so now that we have encountered it, will the intercompany agreements be honored accordingly, or have they been honored accordingly?
That’s going to be the question, or have they been challenged and perhaps modified accordingly and should they be modified? A lot of times they should. So agreements need to actually align with the facts and circumstances and the functional profiles of the organizations and how these related parties want to interact going forward, especially under extreme situations.
Matthew DeMello: I was actually listening to the old podcast we did earlier this year with [Texas A&M Professor] William Byrnes from the Sarasota retreat that we did. And he mentioned how, even with what we knew about COVID at that point, which was a fair amount, it was… we were about a week away from lockdown of our own offices. But he mentioned that coronavirus is going to be a bad year for many things, but it’s going to be a great year for stress testing entities along these lines, especially with what we’re seeing in supply chains. And I think that’s absolutely born out in the nine months since.
Mimi, we’ve talked in many podcasts about good documentation practices, like contemporaneous documentation and robust documentation. How can these practices help you in terms of transfer pricing during the year of COVID?
Mimi Song: Well, I think documentation should be contemporaneous especially in these times. And part of the reason why is because people have short-term memories, right? I mean, [laughs] let’s be fair. There’s a reason why I can’t personally remember the horrors of, of child rearing… birthing [laughs].
Matthew DeMello: [Laughs.]
Mimi Song: Maybe too extreme, but [laughs] there’s a reason I might not have had my second child, if I remembered stuff like that. I think the human brain is a little bit wired to be able to, um.. deal with stressful environments. And part of that is perhaps looking at the glass as half full, right? Taking a .. Looking back at it and only remembering the good and not necessarily remembering all the bad. I think that’s kind of true for the pandemic…
Matthew DeMello: Yeah.
Mimi Song: Because the company has done a lot of changes organizational, or as if the company has engaged in a lot of organizational changes then ultimately, that company is going to want to document how and what happened because they want to be able to respond accordingly.
And by the time they get audited it, which could be anywhere from next year to seven years later, some cases even longer sometimes ten years… ultimately, the people who are going to remember why the company reacted in such a way are not necessarily going to still be with the company — number one. Number two: Even if they are with the company, like I said, people’s memories are not flawless, right?
And so it’s going to be harder for them to understand exactly why certain decisions have been made, which is why now’s the time to document it. Now’s the time to put it down on paper to make sure that, whatever responses were undertaken from an intercompany perspective, should be written down so that by the time people are picking it up to understand exactly what happened, they just need to pick up the piece of paper. They just need to open that file and document, and they can easily understand how the company reacted and survived the pandemic if they did.
Matthew DeMello: Right, right. Narrative first and take tax authorities along that narrative. In your article, you also talk about how technology can help with a year like 2020. Can you tell us about the ways transfer pricing technology can be a real service in 2020 transfer pricing?
Mimi Song: Oh yes. Technology helps us in our daily lives everywhere, but especially in a year like 2020 when we’re talking about tax departments that are even more stressed and asked to further budgets, and now they have to figure out how do they respond to all these changes of the facts and circumstances and these moving parts within the entire organization.
I think technology is the only way to be able to address that and technology can help in a variety of ways. Number one, clearly technology can help with benchmarking and run those different scenarios very quickly. They can do forecasting and modeling and planning and reaction to the changes in the facts and circumstances. It also alleviates those budgetary pressures because it’s a much more long-term sustainable investment as opposed to paying billable hour consulting fees. I think a dollar invested in technology is a dollar better spent than a dollar invested in a minute of a consultant’s time or an hour of a consultant’s time, or whatever that is, because you can’t take that with you necessarily. But the technology will continuously be there to support whatever initiatives you need to have.
Matthew DeMello: That’s right. And so much of a consultant’s work happens in a reactionary context. As we tell everybody about being proactive versus reactive.
Mimi Song: I also think it helps to keep track of all the changes and the deadlines. I mean yes, it’s beneficial that a lot of governments have extended their filing timelines in response to the pandemic environment, which is great. But if you take advantage of that, and then you forget that those extended deadlines are no longer applicable, you have to be able to turn that off if you will in the future year, next year. Right? And so you got to keep track of those deadlines.
Once again, you have to figure out how are you going to store all this information, all this great contemporaneous documentation you’re keeping to make sure that your successors understand the choices that were made for the business during this pandemic… Where is all that going to be saved? Even stuff like that. It’s the simple stuff, but if people can’t find what you’ve done well, that’s a problem in and of itself too.
Matthew DeMello: And what is the takeaway given you’re given your own expertise and OECD guidance?
Mimi Song: I think it’s important to evaluate the transactions as they occurred over this past year. You know, a lot of companies might say, “Well, we didn’t really do anything on a related party basis. We just had a slight decline in the sale of goods…” Or, “We had to shift some of their burden of responsibility because we had to furlough people in this jurisdiction…” or something along those lines.
Well, what are the implications of that from a facts and circumstances perspective? What are the implications from a functional analysis perspective? Has that changed anything? I mean, I think that needs to be evaluated and this is why documentation is so critical for 2020. And then in addition to the standard economic analysis and the application of the arm’s length principle, I think it will be important to look at different types of corroborative methods, whether or not that’s looking at historical years, previous recessionary periods, or ensuring that you have specific details related to the intercompany contract negotiations and minutes of that. All of that is going to be utterly important to make sure that you’re not exposing your company to unnecessary transfer pricing risk.
And finally, clearly technology is going to play a more important role. I tend to feel like technology is more embraced after these times of crisis, if you will. If we think about the last recession, that’s when these new business models like Uber and Airbnb came out. And I talked about this before, but this is when people start to embrace these new opportunities because they say, “Hey, you know what? Maybe it’s okay that we don’t continue to do the same thing because we can be impacted by this thing called a pandemic or the coronavirus, and maybe there are better ways to deal with it?”
Maybe people don’t have to be in an office space together. Maybe we can still continue to operate this global business by working remotely. And maybe it’s okay that people don’t have offices in every jurisdiction around the world. And in fact, embracing technology to keep ahead of information and the changing regulatory environment, I think, is going to be key to helping the tax department move to the next level, if you will.