COVID-19 and transfer pricing policy – comparability analysis
With the economic downturn brought about by the COVID-19 pandemic, companies face the challenge of determining whether they should modify their transfer pricing policies. The decision has to be made at a time when comparable data necessary for the analysis are not yet available. At the moment, relying on prior-year data and three-year averages of financial results of comparable companies may not be an appropriate method of setting intra-group prices.
Under normal circumstances, profit margins (of limited-risk and limited-function entities) for 2020 would be determined/tested using the data for 2016–2018 (2019). Yet, the economic downturn has introduced a volatility of profits, making it difficult to apply transfer pricing methods in a ‘standard manner’, as defined by the OECD Transfer Pricing Guidelines.
In this respect, the trends identified during the 2008-2009 global financial crisis may provide certain guidance. The KPMG LLP analysis: What’s News in Tax: COVID-19 and Transfer Pricing Policy: A Lookback Analysis of Routine Returns implies, among others, the following:
- In the analysed set of European manufacturers of motor vehicle products, the profit margins fell significantly in 2009 and 2010, resulting in a negative lower quartile and a median of < 1 %. The profit margins of these producers, however, recovered quite quickly, returning to near pre-economic downturn levels already in 2011.
- Wholesale distributors also experienced a rapid downturn in profitability – for distributors of machinery and equipment, the median of their profits dropped by 50%; the downward trend turned around in 2010, and the profitability of these distributors achieved the pre-economic downturn levels in 2011-2013.
The analysis also pointed out significant differences in the impact of the downturn, both across various sectors of industry, and across individual entities within these sectors. These differences illustrate the absolute necessity of conducting a thorough market analysis when selecting comparable entities. An appropriate market analysis – often neglected in transfer pricing documentations – has never been more important than in times of an economic downturn.
If we apply the above findings to 2020, we may recommend modifying the available data (of comparable companies or of the tested entity) so as to show the results that would have been achieved had there been no COVID-19 pandemic:
- A detailed analysis of the income statement to document changes in revenues and expenses caused by the COVID-19 pandemic, including, for instance, analyses of deviations from the pre-downturn plan.
- A detailed profitability analysis adjusted so as to show results that would have been achieved had there been no COVID-19 pandemic, including analysis and recording of all factors that had an effect (positive or negative) on the resulting profitability.
- Justification and documentation of any changes in cost allocation or decrease in revenues (and subsequent changes in operating margin) resulting from changes in contractual conditions, taking into account the functional and risk profile of the tested company.
- Quantification of the effect of various subsidies and support received in connection with the COVID-10 pandemic.
As we wrote in a previous article, the Czech financial administration has indicated that even in (post)-coronavirus times, they expect local companies’ profits to be reported in the amount corresponding to the arm’s length principle. Documenting and recording all analyses and effects to support compliance with this will be the alpha and omega of future negotiations with tax authorities regarding the profitability for 2020 and subsequent periods when the effect of COVID-19 is bound to still be felt.