The new corona virus is a mutant virus since it results from the mutation of an existing virus. In its wake, it has brought about a mutation on a global scale, be it social, societal, economic or political. Transfer pricing is no exception to the rule!
The COVID-19 pandemic is an epidemic suffered simultaneously on a global scale in terms of health but also, by way of a ripple effect, in economic terms. International relations are deeply. Transfer pricing is precisely at the heart of the regulation of intra-group flows between companies located in different jurisdictions. They are the guarantors of an "international price order" to ensure the normal and fair nature of the prices in transactions between international players belonging to the same group and having regular and intense exchanges in certain sectors. Many of these players have adopted a transfer pricing model involving a leading entity ("the principal") and entities performing so-called "routine" functions with low risk and a guaranteed level of margin. However, the pandemic has reshuffled the cards, leading in many cases to sudden falls in production, distribution and even site closures in some jurisdictions, generating a chain reaction in the management of intra-group transactions and giving rise to complex repositioning issues.
1- The necessary redistribution of the cards - How can profits and losses be reallocated without generating tax risks? First of all, the question of the necessary reallocation of profits and losses with, in particular, the level of profit guaranteed to certain entities in the line of sight will inevitably arise. How, in a new context, can we validly refocus the economic balance and how can we apprehend the consolidated loss, without putting ourselves at risk from a tax point of view? If there is one certainty, it is that the concept of “force majeure” is foreign to tax law. Consequently, any change in the tax landscape of multinational groups will be assessed in the light of the principles and mechanisms governing the pricing and transaction invoicing policies deployed by these groups at cruising speed. How then can the existing policy be respected, while adapting it as required by the devastating effects of the pandemic? Once again, this is a perilous balancing act, with real tax risks and very significant financial stakes. Some multinational groups have no choice but to get stuck in the corner. Their survival is at stake. The first observation: questioning the transfer pricing policy in place seems to be a mistake and does not seem to be a relevant approach given the high tax risks that this could generate. Rather than overhauling the pre-existing transfer pricing policy, an alternative solution could be to "play" on the margins locally. Indeed, the variation in the margin rate applied is, in principle, perfectly tolerated. However, while there is nothing to prevent a margin from being revised, it is subject to the condition that it can be supported by a study of comparables which will establish that for a given market and a given activity, the rate used is "arm's length", i.e. in line with it. However, the problem is that there is always a gap between the margin rate used by a company and the benchmarks that have made it possible to correlate this rate and which are based on financial data at least one year old. In other words, changing its margin rate amounts to taking a gamble on the future, assuming that future benchmarks will support the rate chosen as being in line with market practice and corresponding to an arm's length rate. And what if the company is forced to reduce its margin to nil: it should then be able to prove that in a commercial relationship with a third party it would have obtained from this third party that it renounces all margin, i.e. that it agrees to sell its asset "at cost". Thus, it is only when the tax authorities will control the "COVID-19 years", i.e., rather from 2021, 2022 for the years 2019, 2020 and 2021, that the future will have ruled on whether or not the margin adjustment made in 2020 in an emergency to curb the financial crisis was acceptable. Second observation: the financial stress induced by the pandemic may also unfortunately affect the reality of transfer pricing, since transfer pricing is disconnected from the reality of cash receipts. Indeed, transfer prices are based on prices that are recognized even if not collected yet. However, the absence of payment by the co-contractor, justified by the fact that the co-contractor himself has not been paid and therefore does not have the cash flow to face his liabilities, may also create a distortion between the price recognised in the accounts (which is the basis for transfer prices) and the reality of the cash flow
2- Customs duties: a real collateral risk Secondly, if the margin variation can be validly supported by subsequent comparable studies, the company could be exposed to customs duties reassessments. This is mainly because the logic of pricing in transfer pricing is not aligned with that of customs duties. Whereas customs duties are calculated on the basis of the actual value of the asset, transfer prices include the margin parameter in the sale price, which can thus result in a final sale price that is uncorrelated to the actual value in the sense of customs duties. This duality could then lead to significant adjustments in customs duties, as the administration may consider that the price of the goods has been unduly discounted for transfer price margin purposes. Thus, the significant reduction in the selling price of the same good in the context of the pandemic compared to its price just before, due to the effect of the margin, could be questioned by the administration in determining the customs duty base as it has led to an unjustified reduction in the amount of duties due. This situation could lead to a cascade of adjustments.
3- Intra-group financing flows: the weak link
The change in the economic circuit will mechanically go hand in hand with a change in financing flows. Indeed, international flows regulated by transfer prices are interconnected with the issue of the group's financing needs and, consequently, with intra-group cash flows... this is one of the inseparable links in the supply chain. Already at cruising speed, all companies, including manufacturing activities, depend on cash flows to meet major needs, in particular, continued growth and maintenance of the manufacturing process. Unfortunately, it is possible for a growing and healthy business to be cash poor. This can be disastrous for manufacturers who need to purchase raw materials to manufacture their products. What can we say then when the financial situation is already very much deteriorated by the effect of an unprecedented economic crisis? The need for intra-group financing as well as guarantees on external loans is likely to be very high. First of all, groups will have to comply with the latest OECD publications dated 11 February 2020 by qualifying their financial transactions as debt or equity
according to their characteristics and purposes. Second, groups will have several alternatives, for example: One way to increase cash flow at a local level could be for the "leader" French company to waive managements fees for support functions it provides or royalties under the license agreements it holds. In order to avoid any problem of abnormal management, the creditor company should then materialize this waiver in the form of a waiver of debt that will not be tax deductible at the level of the granting company, whereas it will be fully taxable at the level of the beneficiary entity, thus increasing the tax burden. In order to make the repayment of intra-group loans more fluid, the creditor company could also, like the mark-up rates, decide to review the interest rate on outstanding intra-group loans, but this could either adversely affect the amount of deductible expenses in application of the rules limiting the deductibility of expenses according to the rate (Articles 39-1-3° and 212-I-a of the French Tax Code or reference to market rates that may even be sustained by reference to the bond benchmark), or conversely, in the event of an excessively large rate reduction that could lead to a reclassification of the loan as an indirect subsidy that is non-deductible for the grantor and taxable for the beneficiary. In short, the group will have “the choice of weapons”: intra-group loans, debts waivers, external loans backed by financial guarantees, etc. But it will, in any case, have to adopt a strategic financial approach. In particular, the choice of financing method will have to take into account the constraints imposed by the French Government which, in response to the pandemic, issued a FAQ (updated version of April 2, 2020) imposing a ban on large companies (meaning companies with at least 5,000 employees or with a consolidated turnover in excess of €1.5 billion, including groups) from making dividend distributions in 2020. It would therefore not be appropriate to concentrate cash flow at the level of a national entity falling under this ban by means of intra-group interest rates, debts waivers etc., creating:
- a "cash trap" phenomenon by freezing cash in the entity so as not to contravene the distribution ban,
- or [in the event that the prohibition is disregarded], a review of the State financial aid granted to other entities in the group placing them in an inextricable financial situation (in which case the aid granted, such as the “PGE”, carry-over of charges, etc., would have to be repaid).
The location of cash is therefore a crucial issue in order to guarantee the free, fluid and sustainable circulation of cash in the economic circuit.
4- The spectre of double taxation
The foreign element inherent in international relations, and hence in transfer pricing, may make the issue of the right to tax even more difficult. It is likely that each state will try to cover its own coffers siphoned off by a flurry of financial aid measures, deferrals and tax freezes designed to support companies on the brink of chaos. In a bled economic world, it is likely that financially strapped and sometimes shaky states will seek to arrogate to themselves the right to impose taxes unilaterally, generating an increased risk of double taxation for companies. The deleterious climate resulting from the pandemic risks relegating the procedures and mechanisms of agreement, exchange and compromise that normally regulate international relations, particularly in the area of transfer pricing (e.g. MAP, PPA, etc.) to the background, as the management of inter-state relations is more likely to be governed by emergency measures.
What is certain is that waiting to take appropriate action on transfer pricing can be dangerous. Action should be taken now in order to anticipate the trade-offs that will have to be made, as the financial stakes can be very significant. This will require a thorough and precise audit of local situations, a mapping 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 the tax advisor. In the end, measured and strategic decisions will have to be taken to integrate the underlying risks (quantum and magnitude) and to ensure a perfect match between the transfer pricing policy applied and the actual distribution of functions and risks within the group. It will also be necessary to be able to document any adjustments that have been induced by extraordinary circumstances.
Our lawyers are at your service to help you understand how best to emerge from the crisis and to implement these lines of thought: firstname.lastname@example.org.