COVID-19 and transfer pricing

Many enterprises are now facing issues as regards ensuring necessary funding for their operations, covering additional expenses of staff layoffs, or allocating profits and losses incurred as a result of the coronavirus crisis.

Many MNEs operate a business model where companies performing certain activities within the limited functions assigned to them, such as limited risk distributors (LRDs), contract manufactures (CMs) or contract service providers, are gathered around a key entrepreneurial entity. These companies are generally expected to report stable profitability, such as EBIT margins for LRDs or mark-ups for CMs between e.g. three and seven percent.

In the Czech Republic, many companies operate precisely in this regime – as limited risk entities. Is it realistic to request from them the same profitability as under standard economic circumstances?

To answer the question about the “right” profitability of entities with limited functions and risks in the times of crisis, especially the following must be considered:

• How would uncontrolled entities behave? Numerous examples of uncontrolled relationships can be found in the market, for instance in the automotive sector, which allow reduced or zero margins during an economic downturn.
• What is the contractual arrangement? Many contracts contain a force majeure clause, limiting the parties’ obligations in situations beyond their prediction or control. Will this clause apply to indemnity for losses incurred as a result of the COVID-19 pandemic?
• Which negative impacts will be compensated? It is necessary to identify the individual factors contributing to the occurrence of a loss or decrease in profit, so that only those actually connected with the crisis are considered.
• Does the pre-crisis transfer pricing setup support the group’s requirement to share the current loss? The question must be viewed both from the perspective of the group’s principal and of the limited entity; the existence of advance pricing agreements (APAs) with national fiscal authorities may further complicate the situation.

If a change to the transfer pricing model is made to the detriment of the limited entity, will the new model bring sufficient post-crisis profits to the company? Any contemplated changes to transfer pricing should be balanced. We can imagine that it should be possible to explain to the state authorities the need to respond to the emergency, e.g., by sharing the loss of the entire chain; however, this should be compensated by a corresponding increase in rewards once the situation is over. The OECD’s Transfer Pricing Guidelines assume that low risk entities shall achieve stable margins under standard economic circumstances. A global economic crisis can hardly be subsumed under such a standard, but the practical application of this premise by individual states in the context of the coronavirus crisis is only to be formed in the months and years to come.

In the Czech Republic, we may draw on our experience from the aftermath of the 2007 financial crisis. At that time, the Czech authorities generally required limited entities to report profitability corresponding to their limited risks, while considering the specific circumstances of the transaction and entity. Some of the tax audits focusing on the period following the financial crisis are still pending; hence, there is currently no clear precedent to help entities find the right approach quickly.

Considering the above, it is necessary not to postpone the preparation of transfer pricing documentation, but to consistently and as soon as possible document the application or deviation from the chosen transfer pricing model during the crisis and immediately after, and to include economic grounds for the applied approaches.