14/05/2020 Many multinational enterprises’ (MNEs) transfer pricing policies are structured with an entrepreneur and limited risk subsidiaries (the so-called centralised business model).
Under this structure, the entrepreneur generally owns all the IP, takes the strategic decisions, organises the financing of the whole MNE and assumes most of the risks associated with the business of the MNE around the globe.
The limited risk subsidiaries may be manufacturers, distributors or service providers. They generally have limited risk related to their manufacturing, distribution and service activities as well as their employees. Therefore, they are not completely without risk.
The MNEs which have implemented such an organisation generally use the transactional net margin method (TNMM) method to set the remuneration of their limited risk subsidiaries. When they use the TNMM, MNEs compare the net profit margin of their subsidiaries with the net profit margin of comparable companies. In doing so, MNEs examine the net profit margin relative to an appropriate profit level indicator (PLI). They generally use the Net Cost Plus (NCP) for manufacturers and service providers. With regards to the distributors, MNEs use the operating margin.
Conversely, under this model, the entrepreneur gets the residual profit or loss of the MNE.
As a result of the Covid-19 measures implemented around the globe, many MNEs are unfortunately likely to make an overall tax loss in 2020.
The OECD did not anticipate this situation nor has it addressed the way to determine transfer prices in such a context, especially how limited risk subsidiaries and entrepreneurs should be remunerated in an overall loss situation resulting from a pandemic crisis. This lack of positioning from the OECD as well as from the local tax legislations around the globe, creates uncertainties and therefore a transfer pricing and double taxation risk for MNEs with such an organisation.
As a consequence, these MNEs ought to determine whether it is still relevant for them to guarantee a profit to their limited risk subsidiaries and to allocate the entire loss to their entrepreneurs (1) assess alternative more relevant benchmarking approaches to mitigate the Covid-19’s financial impact and transfer pricing methods such as the loss split for at least the contributions which cannot be benchmarked (2) and determine how they should split their 2020 loss (3).
(1) Shall MNEs be able to guarantee a secured profit to their limited risk subsidiaries in the context of the Covid-19 crisis?
MNEs incurring an overall tax loss in 2020 and structured under the centralised business model described before, ought to ask themselves the following questions:
Will the entrepreneur be able to defend during future tax audits, the 2020 residual loss incurred by the MNE?
Under normal conditions, it is the entrepreneur who defines the strategy of the MNE, which is executed by the limited risk subsidiaries under its control and monitoring. If strategy of the entrepreneur generates profits, the entrepreneur gets the residual profit after the limited risk subsidiaries get their secured profit. Conversely, if the strategy defined by the entrepreneur generates losses, the entrepreneur gets the residual loss after the limited risk companies receive their secured profit.
In the current Covid-19 context, it is not the strategy of the entrepreneur which will generate the overall loss of the MNEs in 2020. As a matter of a fact, it is the shutdown of certain sectors of the economy, managed by all the States around the globe, which will originate the 2020 losses of the MNEs of the said shut down sectors.
Due to the above origin of the losses, it is to be anticipated that the tax authorities which will audit the 2020 taxable result of the entrepreneurs of these MNEs, will challenge the fact that they get the entire residual loss if the limited risk companies have obtained their secured profit. As a matter of a fact, since the transfer pricing leads to setting the taxable basis in the countries of the entrepreneurs, it can be anticipated that the tax authorities of these countries will fight tooth and nail to secure their taxable basis or at least reduce the amount of losses that will be allocated to their countries.
We believe that, would MNEs do not take prompt actions, the tax authorities will very likely prevail for the following reasons:
- They will argue that the 2020 losses were originated from the shut-down of the economy managed by all the states around the globe. They will add that the entrepreneurs should therefore not be held liable for the losses generated by the crisis. Consequently, they will argue that there is no reason that the entrepreneurs are allocated the entire loss of the MNEs in 2020;
- They will also likely be able to sustain that no independent company would have accepted to incur all the residual loss of an MNE in this context, using the above arguments;
- Besides, the tax authorities will likely contest the utilisation of previous years’ financials of the comparable companies in order to set the 2020 remuneration of the limited risk subsidiaries of the MNEs.
For that purpose, they will argue that in an economic crisis context, the entrepreneur will face the difficulty of validating the level of the remuneration of the limited risk subsidiaries by reference to comparable data that does not consider the impact of the crisis.
As a result, comparability studies carried out in 2020 may not reflect current economic conditions and thus prevent the setting of a fair arm's length remuneration for the limited risk subsidiaries.
Furthermore, some of the comparable companies which will be used to set the profit level of the limited risk subsidiaries are likely to be in a loss situation in 2020, as a result of the lower revenue and the shut down costs that they will incur. However, the 2020 financial results of these comparable companies will not be known before 2021.
For all these reasons the tax authorities should have strong arguments to challenge the utilisation by MNEs of comparable sets using 2017-2019 PLIs in order to set the 2020 remuneration of the limited risk subsidiaries.
- For the entrepreneurs using safe harbours to set the remuneration of the limited risk subsidiaries, the tax authorities will likely challenge the relevance of the application of these safe harbours by their entrepreneurs, on the basis that the said safe harbours do not take into consideration the financial effect of the Covid-19 crisis.
- Finally, the tax authorities will contend that limited risk companies are not completely de-risked and should be allocated losses in certain cases.
On this basis, it can be anticipated that the Tax Authorities of the country of residence of the entrepreneurs, will demonstrate that limited risk companies should trigger as well, the financial effects of the downturn of the economy generated by the COVID-19 pandemic.
On this basis, the Tax Authorities will argue that limited risk companies should be allocated a portion of the global loss of the MNE.
Shall such an allocation of the entire residual loss to the entrepreneur be efficient for MNEs ?
The question of whether or not the allocation of the entire residual loss to the entrepreneur is efficient, will need to be studied on a case by case basis by MNEs.
From a loss utilization perspective, it is very likely that in most cases, a split of the loss will be offset faster by the MNEs through carry back or other techniques available in various countries.
Conversely, if the loss is 100% absorbed by the entrepreneurs, the latter may not be able to offset it fully in the near term, assuming their loss utilisation is not challenged by the Tax Authorities during future tax audits.
From a deferred tax perspective, the MNEs will likely have more chance to record a deferred tax asset in the case where the 2020 tax losses are shared with the limited risk companies. As a matter of a fact, it should be easier for them to demonstrate to their auditors that they will be able to offset in the near term these losses against their future profits.
From an Effective Tax Rate perspective, a split of the loss within the MNEs’ subsidiaries should allow the latter to optimize in most cases their future Effective Tax Rate.
From a cash tax perspective, the sharing of the loss within the all the subsidiaries of an MNE, should reduce in most instances, the Corporate Income Tax / Local Tax global payments in the near term.
From a financing perspective, the split of the loss within the MNE should limit the deterioration of the entrepreneur’s credit rating and consequently its cost of financing of the whole MNE when the entrepreneur is the entity which borrows from the banks.
(2) What alternative approaches or methods could be assessed in 2020 by loss- making MNEs?
Given the risks and the lack of efficiency associated with the application of the TNMM without adaptation, by loss making MNEs (structured with an entrepreneur which gets the residual profit or loss and limited risk subsidiaries remunerated with a secured profit), they should assess in 2020 other benchmarking approaches, re-evaluate the utilisation of safe harbors and potentially transfer pricing adaptations.
Do loss making MNEs need to review their benchmarking approaches in 2020?
We believe that this will be required, especially if these comparable studies are used to determine the 2020 remuneration granted by the entrepreneur to the limited risk subsidiaries.
In order to validate that a current or a future transfer price is set in accordance with the arm's length principle, a search and selection of comparable companies whose financial data is most often available on databases with a time lag of one year is generally carried out.
In an economic crisis context, companies are therefore facing the difficulty of having to validate the level of their current year transfer prices by reference to comparable data that does not consider the impact of the crisis.
As a result, comparability studies carried out in 2020 are very unlikely to reflect the current economic conditions and thus prevent the setting of a fair arm's length price for the 2020 transactions.
The fact that tested parties and comparable companies can react differently during the Covid-19 crisis, particularly in terms of demand and sales, may also compromise the reliability of TP methods.
Consequently, benchmarking strategies will need to be revised by targeting subsets of comparables that are closer to the tested party (both in terms of sensitivity to an economic downturn, as well as general characteristics and timing).
These subsets can be arrived at by refining existing comparable companies’ sets, by eliminating companies that did not face similar adverse economic conditions or that do not have sufficient financial data.
MNEs should also consider broadening search criteria to include companies with similar sales declines by removing certain screening criteria that would allow for the identification of comparable companies experiencing financial distress (i.e., bankruptcy or operating losses).
Moreover, MNEs should apply certain screens to ensure that highly profitable comparable companies that are not impacted by the economic crisis are not included in the comparable sets.
In addition, the use of a multiple-year approach might not be suitable any more for generating reliable comparable companies for the year 2020.
Thus, MNEs may evaluate whether the use of a year-by-year approach could better capture the effect of events causing dramatic changes in the market in a given year.
On a case by case basis, other adjustments and approaches may be considered.
Should loss making MNEs use safe harbours in 2020?
Some countries have adopted safe harbor rules. These rules generally allow smaller companies / or less complex transactions to follow simpler rules for setting their transfer prices i.e. the safe harbours.
In the current context, entrepreneurs which may be tempted to use safe harbours rules to set the remuneration of their limited risk subsidiaries ought to check that this will not lead to a too high remuneration in comparison to the one the said limited risk subsidiaries should get in 2020.
Should loss making MNEs assess the possibility to share the loss within all the subsidiaries?
For all the reasons above, MNEs (which secure a profit to their limited risk subsidiaries) should in addition to changing their benchmarking and safe harbours approaches, also assess the possibility to share their overall 2020 loss for at least the most complex 2020 contributions in the value chain which cannot be benchmarked.
Before making such a decision, MNEs ought to perform financial simulations to assess the full implications and take decisions in full conscience.
(3) Under which conditions and process the MNEs should split their loss?
At first glance the split of the MNEs’ losses sound rather complex for the MNEs. As a matter of a fact the MNEs will have first to determine how to split the loss.
Moreover, the MNEs will need to determine which loss is to be split.
How should MNEs split their loss?
The OECD has made so far no comments about the loss split. However, the OECD has provided guidance about the profit split which could be useful in a context of loss split.
In order to split the profit, the OECD recommends the utilisation of the relative contributions of each party i.e. to perform a “contribution analysis” in order to arrive at a reasonable approximation of the division that independent enterprises would have achieved from engaging in comparable transactions.
This process can be followed as well in the context of a loss split.
The OECD recognises that it can be difficult to determine the relative value of the contribution that each of the associated enterprises makes to the relevant profits, and the approach will depend on the facts and circumstances of each case.
Where the contributions of the parties are such that some can be reliably valued by reference to a one-sided method and benchmarked using comparable companies’ financials, while others cannot; the OECD recommends the application of a residual analysis.
According to the OECD, the residual analysis divides the relevant profits into two categories:
- In the first category are profits attributable to contributions which can be reliably benchmarked: typically, the less complex contributions for which reliable comparables can be found.
- In the second category are contributions which may be unique and valuable, and/or are attributable to a high level of integration or the shared assumption of economically significant risks. Typically, the allocation of the residual profit among the parties will be based on the relative value of the second category of contributions.
This process can also be followed as well in the context of a loss split.
The criteria or splitting factors to be used to split the profit should according to the OECD:
- Be independent of transfer pricing policy formulation, i.e. they should be based on objective data (e.g. sales to independent parties), not on data relating to the remuneration of controlled transactions (e.g. sales to associated enterprises),
- Be verifiable, and
- Be supported by comparables’ data, internal data, or both.
We believe that these recommendations of the OECD can be followed in a context of loss split
According to the OECD, external market data can be relevant in the profit split analysis to assess the value of contributions that each associated enterprise makes to the transactions.
This sounds applicable to a loss split too.
The OECD recommends basing the division of the profit, upon one or more profit splitting factors. The functional analysis and an analysis of the context in which the transactions take place (e.g. the industry and environment) are according to the OECD essential to determine the relevant factors to use in splitting profits, including determining the weighting of applicable profit splitting factors, in cases where more than one factor is used.
According to the OECD, profit splitting factors can be based on assets or capital or costs or incremental sales or employee compensation or headcount or time spent etc.
Also, according to the OECD, the profit splitting factors can be used if there is a strong and relatively consistent correlation between them and the creation of value.
We believe that loss split factors can be used in our context of overall loss allocation.
Finally, the OECD advice to consider internal data, where comparable uncontrolled transactions of sufficient reliability are lacking to support the division of the relevant profits. The OECD, view is that these internal data provide a reliable means of establishing or testing the arm’s length nature of the division of profits.
We believe that the use of internal data could also be used to split the loss.
Finally, and in addition to determining an approach for their loss split, the MNEs will also need to determine which loss is to be split.
How should the MNEs determine the loss to be split?
This might also be a complex issue because of the difference in accounting standards and in currencies around the globe.
Fortunately, the OECD has provided guidance in the context of profit split which we believe can also be replicated in the context of a loss split.
According to the OECD, the relevant profits to be split are those of the associated enterprises arising as a result of the controlled transactions under review.
For that purpose, the OECD recommends to first identify and accurately delineate the transactions and from this identify the relevant income and expense amounts for each party in relation to those transactions.
Where the relevant profits to be split are comprised of profits of two or more associated enterprises, the OECD believes that relevant financial data of the parties to the transaction to which a transactional profit split is applied need to be put on a common basis as to accounting practice and currency, and then combined.
Because accounting standards can have significant effects on the determination of the profits to be split, the OECD advices that accounting standards should be selected in advance of applying the method and to the extent that it is possible, be applied consistently.
According to the OECD, financial accounting may provide the starting point for determining the profit to be split in the absence of harmonised tax accounting standards. The use of other financial data (e.g. cost accounting) should be permitted where such accounts exist, are reliable, auditable and sufficiently transactional. In this context, the OECD believes that product-line income statements or divisional accounts may prove to be the most useful accounting records.
We believe that the above guidance provided by the OECD, can be used to determine the loss to be split between the subsidiaries of an MNE.
As a conclusion, MNEs which currently secure a profit to their limited risk subsidiaries need to take proactive actions in 2020 to reduce their double-taxation risk and secure their efficiency.
Moreover, these MNEs should reevaluate their benchmarking and safe harbors approaches as well as their transfer pricing approaches.
It is our opinion that MNEs which may decide to split their loss ought to follow the guidance published by the OECD for the purpose of the profit split.
Given the complexity of the loss split, MNEs ought to consult transfer pricing advisors to assist them in this exercise.
The deleterious climate resulting from the Covid-19 will likely relegate the procedures and mechanisms of agreement, exchange and compromise that normally regulate international relations, particularly in the area of transfer pricing (e.g. MAP, APAs etc.) to the background, as the management of inter-state relations is more likely to be governed predominantly by emergency measures.
That is why a proactive review by the MNEs of these issues will be key to avoiding unilateral transfer pricing assessments from financially strapped and sometimes shaky states which will seek to arrogate to themselves the right to impose taxes unilaterally, generating an increased risk of double taxation for the MNEs.
What is certain is that taking no action on transfer pricing will be dangerous for the MNEs and that these actions ought to be taken now.
This will require from the MNEs a thorough and precise diagnosis of the local situations, an identification of the risks involved and, on this basis, determine the adjustments that can be made.
These steps will have to be taken on a case-by-case basis and will require support from a transfer pricing specialist.