Transfer Pricing Documentation for 2021
Already complex, transfer pricing policies may need to change this year to reflect realities of the pandemic. Documenting those changes will be key to compliance.
Across the globe, the coronavirus pandemic put 2020 into a tailspin. Hospitals were overwhelmed, schools and office buildings stood empty, and executives implemented all kinds of outside-the-box measures to keep their companies afloat. What a year.
Things weren’t any easier in corporate tax departments, as tax professionals at multinational companies faced their own challenges, particularly in the transfer pricing arena. With tax scrutiny growing rapidly over the past decade, tax, finance, and treasury teams are currently navigating a transfer pricing compliance minefield. And here’s the catch: It’s about to get worse.
Thanks to revenue deficits stemming from government-relief programs and a universal decline in taxable income—which governments will have to recoup—taxpayers can expect tax administrations to exercise a whole new level of vigilance.
How can corporate taxpayers proactively prepare for increased enforcement of transfer pricing rules? The answer is easy: through comprehensive documentation.
Granted, for tax departments suffering from understaffing and depleted budgets, the idea of investing additional time, resources, and money in transfer pricing compliance may sound like a tall order—but it’s necessary. After all, companies struggling with resource shortages aren’t in the best position to absorb costly adjustments and penalties due to transfer pricing errors, either. In fact, given the transfer pricing challenges related to Covid-19, diligent documentation might be more important now than ever before.
The following strategies will help companies prepare documentation that minimizes the risk of transfer pricing audits and adjustments for fiscal year 2020:
Produce localized documentation. The Organisation for Economic Co-operation and Development (OECD) just released “Guidance on the Transfer Pricing Implications of the Covid-19 Pandemic.” The report is useful in helping companies deal with various situations that are complicated by Covid-19, but it is by no means law. OECD transfer pricing guidance, including both Covid-19 recommendations and BEPS Action 13, must be adopted into local regulations before it carries legal weight. Like always, transfer pricing compliance begins and ends with country-specific regulations. Adhering to them is the only way to appease tax authorities.
Of course, country-specific requirements vary around the globe, which makes transfer pricing compliance that much more complicated. Keeping up with unique regulations in every jurisdiction is no easy task, especially since those regulations are changing all the time. But because fiscal year 2020 numbers will be under more scrutiny than usual, companies don’t want to wave any additional red flags. Knowing how regulations vary between jurisdictions is a necessary first step toward meeting their requirements.
BEPS Action 13, a recommendation from the OECD that advocates for three-tier documentation in the form of a master file, a local file, and a country-by-country report, may be the way to go in some countries. Jurisdictions including Germany and Saudi Arabia have adopted BEPS Action 13 as is. Others—such as Hong Kong, Belgium, and Denmark—require additional documentation: Hong Kong requires its own S2 form, attached to the profits tax return; Belgium requires the submission of a local form, with the transfer pricing analysis as an attachment; and Denmark requires a transfer pricing return attached to the corporate tax return.
Australia and India require a master file, local file, and country-by-country report, and with much more detail than BEPS Action 13 calls for. Italy and the United States require information similar to that outlined in BEPS Action 13, but the information must be submitted in each country’s unique format.
Separate from the format of the overall documentation package, different countries also vary in which intercompany transactions need to be documented, and how. Governments set their own materiality thresholds, so which parties are subject to documentation requirements can vary from jurisdiction to jurisdiction. And while many jurisdictions specify contemporaneous deadlines—i.e., documentation must be available by the time corporate income tax returns are due—timing requirements also differ between countries.
Different tax jurisdictions vary even more widely on how companies should conduct the benchmark analysis used to determine appropriate intercompany pricing. As treasury and finance teams navigate the new Covid-19–related challenges for fiscal year 2020, they will have to consider the tax authority’s expectations in every jurisdiction where their organization has operations. Many governments specify a requirement for local comparables, a stipulation that can be hard to meet but must (at the very least) be attempted. Some jurisdictions, like Canada, demand a single-year analysis, while India requires three. Even the language in which a company submits documentation may be mandated. For instance, Russia requires documentation in Russian and China in Chinese, while France will accept either French or English.
No matter what the requirement, the rule of thumb is simple: Even in an upside-down year like 2020, the local tax authority rules. Adhere to local regulations above all else.
Identify changes in functions, assets, and risks. A functional analysis is always a critical part of transfer pricing documentation, as it defines functions, assets, and risks (FAR) within the value chain. For fiscal year 2020, the functional analysis will play an even bigger role than usual, as many companies’ functions, assets, and risks have been rearranged.
Thanks to Covid-19, staff who have performed functions in certain locations may be performing them in new locales due to lockdown or stay-at-home orders. Some functions may have stopped altogether, and there could be new risks on the scene—for instance, the risk of supply chain disruptions due to lack of labor or raw materials. Even existing risks, like inventory or credit risks, may have increased last year. And tax authorities will expect to see that any entity which incurs losses has assumed some risk pertaining to them.
When a business restructures, reorganizes, and reacts, the transfer pricing documentation will have to reflect shifts in the functional analysis, which may also trigger changes to transfer pricing policy. Treasury, finance, and tax teams need to identify changes in functions, assets, and risks; pin down the period during which the business was affected; and explain how Covid-19 forced such changes throughout the group. Are the changes permanent, or will they last just long enough to get through the crisis? If they’re permanent, the transfer pricing policy will require updating.
Companies should be sure to include Covid-19–specific issues in their explanations of these changes—for example, specifying which entity was responsible for making strategic management decisions surrounding risks associated with the virus. This will help determine which entities were in control and where financial benefits—and consequences—should land.
Rethink comparability analyses. An economic analysis is only as good as its benchmarks. For transfer pricing, reliably comparable companies can be hard to find under normal circumstances. In fiscal year 2020, the process for finding comparables will necessarily be riddled with risk and bias.
Covid-19 has impacted companies in different ways: Many have taken a hit, but others, like videoconferencing services, are experiencing a boom. If the comparable companies weren’t affected by the pandemic in the same ways as the company whose transfer pricing policy is in question, the comparison won’t be apples-to-apples—which may pose problems with the tax authorities.
The more comparable a company’s benchmarks, the less disputable its arm’s-length range. Given fiscal year 2020’s ups and downs, a little creative thinking could go a long way in selecting comparables. The OECD’s recent Covid-19 guidance clearly states that taxpayers will have to exercise “good judgment and flexibility.”
Where, then, should a company start? A fresh benchmarking search may or may not solve the problem. It’s worth a try, but manage your expectations. The lag time between the end of the fiscal year and the appearance of corporate information in public databases means companies must wait to access data that reflects true market conditions for 2020. Thus, corporate taxpayers may face a lack of clearly comparable companies and an oversupply of unreliable data.
One worthwhile strategy is to go back in time. Covid-19 turned things upside down, and data from recent pre-pandemic years may no longer provide reliable comparables. Consider using data from other economic downturns to show the impact that Covid-19 might have had on a comparable business. Take a proactive approach: Explain changes in market conditions between now and the relevant time period, as well as the extraordinary circumstances that made it necessary to revisit the past.
Incorporating companies that experienced losses into the set of comparables could also prove helpful. The strategy is unpopular amongst tax authorities. Nevertheless, given fiscal year 2020’s extraordinary circumstances, unprofitable businesses may best reflect actual market conditions and therefore may be more reliable than companies with a thriving P&L.
Market conditions are always an influential factor in an economic analysis. The team developing transfer pricing documentation must make sure to consider the markets where comparable companies operate, looking for markets that mimic their own organization’s external environment. Granted, tax authorities may require local comparables—and it’s still a priority for every corporate taxpayer to demonstrate at least an attempt to find them—but countries, like businesses, have been impacted by Covid-19 in unique ways. Producing foreign comparables operating in other jurisdictions that have been similarly affected by the virus may be the best way to show that the market impact on the company mirrors that experienced by third parties.
Reinforce transfer pricing positions with supporting documentation. Thinking outside the box may be a transfer pricing strategy for fiscal year 2020, but that doesn’t mean decisions about what constitutes arm’s-length pricing can be arbitrary. In tax authorities’ eyes, supporting documentation will be the difference between meaningful adjustments and merely convenient ones.
By all means, companies should explain in analyses throughout the transfer pricing documentation how Covid-19 affected the business, transfer pricing transactions, and arm’s-length ranges. Then they must prove those statements by supplying supplemental analyses to support their case. Profitability analyses that compare fiscal year 2020 with third-party performance in recessionary periods could bolster transfer pricing positions. Financial statements—quarterly SEC filings or earnings releases, and/or industry indicators from central banks—and market information can help explain subpar performance and maintain the market position.
Think too about government assistance. What type did the business receive, and what was the outcome of receiving it? Most important, how did the business quantify the aid? Documents that support those determinations can help taxpayers stand their ground.
Practice consistency. It’s no secret that ensuring the consistency of information throughout documentation, intercompany contracts, transfer pricing policies, and advanced pricing agreements plays a role in transfer pricing compliance. The more inconsistencies a company presents, the more likely tax authorities are to investigate. And if there’s one transfer pricing strategy that Covid-19 hasn’t changed, it’s the need for a paper trail that tells the same story throughout.
Once the treasury, finance, and tax teams have a handle on how Covid-19 has impacted the business and its intercompany relationships, they should make sure those effects are reflected in all of the documentation. Explanations that anchor shifts in functions, assets, and risks should be mirrored in both the master file and local file. Depending on the extent of those modifications, it may be time to revisit the company’s transfer pricing policy, as well.
On the same note, if an advanced pricing agreement has been negotiated based on a static functional analysis that seems, at least for the moment, like a moving target, then it might make sense to reach out to the relevant tax authority and see what the most advantageous move is for all involved. If a taxpayer has an intercompany agreement that suggests business practices go one way, when the reality of 2020 took them in another direction, the company will want to address those discrepancies before tax authorities do.
Diligent Documentation Is the Name of the Game
Covid-19 may have paved the way for new approaches to common transfer pricing practices, but it hasn’t changed the game overall. The pandemic certainly gave rise to unique intercompany challenges. At the same time, it also proved—as in any tax year—that diligent transfer pricing documentation is the best way to hurdle those obstacles.