The COVID-19 pandemic is being felt in the operations of businesses worldwide and one of the most striking disruptions is evident in supply chain arrangements. This has brought on transfer pricing implications of how one realigns existing supply chain arrangements to adapt to challenges and undertakes comparability or benchmarking analysis in absence of data to determine the arm’s length prices. This article discusses the transfer pricing considerations that should be top of mind for multinational corporations (MNCs) in the time of a global recession induced by COVID-19.
Transfer pricing refers to the determination of prices charged in transactions between related parties. Related parties are entities belonging to the same multinational enterprise group or entities under common control. Such transactions include the sale or purchase of goods, provision of services, borrowing or lending of money, use or transfer of intangibles, etc. This practice extends to cross-border transactions as well as domestic ones and mandates that prices charged or profits earned in transactions between related parties should be at ‘arm’s length’. In other words, prices charged or profits earned by related parties should be similar to prices that would have been charged or profits that would have accrued to the transacting parties, had the entities been unrelated.
Reviewing transfer pricing policies
One of the key steps to determine the arm’s length price is to undertake comparability or benchmarking analysis after the transacting parties have been characterised (i.e., whether the transacting parties are low risk manufacturers, ordinary distributors, entrepreneurs holding valuable intangible properties, etc.)
The pandemic recession has necessitated a review of comparability adjustments in transfer pricing, triggering immediate concerns that whilst a transfer pricing analysis for financial year 2020 (“FY2020”) should be undertaken on ex-anti basis, the data for comparability is only available ex-post. It may become more difficult for companies to undertake benchmarking analysis for FY2020 as public databases used for comparability purposes are unable to report real time financial information for FY2020. There will be a time lag in testing and supporting positions taken as companies have to consider prior year financial statements of comparable companies, which will have no or minimal impact of COVID-19 business disruptions, for benchmarking returns. To enable apples to apples comparison, adjustments to these prior year financial results should be reviewed to realign profits based on the current economic situation.
Companies also need to consider the COVID-19 impact on supply chain disruptions and re-evaluate the characterisation of entities or transactions before moving on to determine their arm’s length price.
To put into perspective the current situation, we look at five cases of Singapore-based companies that outline the challenges from a transfer pricing perspective whilst its businesses deal with the operational impacts of COVID-19.
Case 1: Regional principal entity
An MNC headquartered (HQ) in Europe operates in Asia-Pacific (“APAC”) through a regional HQ principal entity in Singapore. The Singapore entity (“SGCo”) is the ‘economic’ owner of the group’s intellectual property (‘IP’) for the APAC region and participates in cost-sharing arrangements for joint development of the group’s IP and thus has been characterised as an entrepreneur for APAC. The SGCo utilises its contract manufacturing facility in China for production and sale of goods in APAC. Due to COVID-19 lockdowns in China, the manufacturing plant was shut down for four months, which necessitated SGCo to directly procure finished supplies from the European parent entity (‘economic’ owner of IP for the European region) to cater to demands in APAC. What challenges do we foresee in determining the arm’s length price of goods procured by the Singapore principal from the European parent entity?
a) Should SGCo be re-characterised as a distributor for the APAC region in relation to the supplies sought during the four months? What about the APAC IP owned by and customer contracts/list owned by SGCo? Other strategic functions/decisions made by SGCo in relation to this business?
b) Should we just consider SGCo as the entrepreneur whilst re-characterising the European parent entity as a contract-manufacturer (or supplier to OEM) for goods supplied to SGCo during the four months?
c) Should the two principals continue to be characterised as entrepreneurs and the transactions be treated as dealings between two principals? Will this necessitate a profit split? How should the profits be split?
When the Chinese manufacturing facility restarted its operations after the four months shutdown, the European contract manufacturing facility of the European principal went into lockdown phase necessitating the European principal to source supplies from SGCo for resale in Europe. Exactly the opposite situation with similar issues.
Case 2: Research & development activities
A Singapore-based research and development (‘R&D’) service provider, wholly catering to its overseas parent, undertakes research activities in the chemical industry and is being compensated by its parent at cost plus arm’s length mark up. The group’s global Director and their global head of R&D travelled to Singapore at the beginning of the year to lead some of the path breaking research that the Singapore entity was tasked with. Due to travel restrictions, both of them had to remain in Singapore for a significantly longer time and was directly supervising the activities of the R&D facility in Singapore where they successfully led the team to develop a unique formula that can be commercially exploited by the group.
a) Would the continued presence of the senior R&D team from overseas at the Singapore facility change the characterisation of the Singapore entity given that ‘significant’ value creation was undertaken in Singapore?
b) Can the Singapore entity then be considered as the joint ‘economic’ owner of the IP given that some of the major value creating development functions were undertaken in Singapore due to presence of the overseas R&D lead team?
c) Should the Singapore entity be entitled to anything more than a cost plus return?
d) What transfer pricing defence strategy is required and what should be the transfer pricing documentation approach?
Case 3: Centralised support services
A Singapore-based entity (part of a regional group that operates in the hotel industry) has been assigned with the responsibilities of providing support functions to its group entities. Due to the COVID-19 pandemic, vast majority of the group entities ceased their operations. Therefore the Singapore service provider has not been involved in providing any in-house support (management/intra-group) services to its entities and did not generate any income/revenue. However, it still incurred fixed costs (rental, salaries and compensation, etc.). The Singapore service provider has always been characterised as a low risk entity involved in dealings within the group and has been remunerated with a cost plus arm’s length mark up.
a) Given that no services have been rendered, the ‘benefit test’ analysis leads to a conclusion that services fees should not be charged to group entities since none of them had benefitted from any service (which was not provided in the first place). Does this mean that risk allocation between parties need to be updated and the characterisation of the Singapore service provider altered?
b) Should the parent entity of the group finance or bear the costs being incurred by the Singapore service provider? If so, is there a basis for assuming these costs?
c) What are the options realistically available to the Singapore service provider and what would a third party do in such circumstances? Offer its services to other non-group entities in some other industry sector to recover some costs to continue to operate as a going concern?
d) What transfer pricing documentation should the Singapore service provider have in place to support its losses?
A limited risk distributor or a contract or toll manufacturer will have similar issues to deal with.
Case 4: Funding
Another pertinent and significant issue is that of cash flow (i.e. lack of cash to maintain normal business operations). Creditworthiness of companies have been adversely impacted and considerably weakened due to lack of cash flows resulting from the economic downturn. Given the weaken credit quality, it is now relatively expensive to get funding from third party financial institutions despite lower market interest rates. On this account, group treasury centres along with regional and global HQs are providing new intragroup financing at a considerably reduced rate (mostly lower than market rate).
a) How do we assess the arm’s length remuneration of the above arrangements whilst third party arrangements would result in comparatively higher borrowing costs due to a weaker credit rating of borrower (even after factoring in implicit support from the group)?
b) That said, payment of interest rate below market rates should not lead to a transfer pricing issue from the borrower’s perspective since the borrower is not making any excessive payments to its related lender. But will this be acceptable with the revenue authorities in the lender country?
c) Will the difference between arm’s length interest rate and actual interest rate paid by the borrower be characterised as a subsidy/income in the borrower’s country depending on the local corporate tax regulations and taxed (which will be seen as an aggressive stand on the part of the revenue authorities)?
d) What documentation do we need to support the interest rate charged?
Case 5: Treatment of subsidies/grants received from government
Special budgets have been passed by governments around the world including in Singapore to support business establishments to tide over the crisis and protect thousands of jobs. Under such budgets, entities receive cash grants/support from the local governments. In Singapore, entities receive cash grants through the Jobs Support Scheme (JSS) to offset local workers’ wages during the COVID-19 outbreak.
a) For an entity operating in Singapore and having a transfer pricing policy based on the cost plus model, should the JSS cash benefits received be deducted from the total cost base, and an arm’s length mark-up be charged on the remainder of the costs? Or should the entire costs be marked up as usual without deducting the JSS grant received?
b) Similarly, should the JSS grants be considered as operating income in computing the operating margin earned by a routine distributor or manufacturer in Singapore?
The list of scenarios in supply chain disruptions could go on and the issues arising are specific to the facts surrounding each case. The transfer pricing model has to be customised for each taxpayer. There are no easy answers to a lot of these questions and off-the-shelf solutions would not be applicable for these cases.
The working committee of The Organisation for Economic Co-operation and Development (OECD) has taken up the issues of COVID-19’s impact on transfer pricing and is currently analysing challenges faced by taxpayers. Hopefully we might have some directions from the OECD in the coming months to address the above questions.
As the COVID-19 situation continues to evolve, it is critical to monitor the situation closely, consider all implications upfront and start collecting evidence to prepare contemporaneous documentation to support the change in economic circumstances. These measures will adequately prepare companies for audit challenges arising from “the transfer pricing audit of the pandemic years”.
The views expressed in this column are the author's own and do not necessarily reflect this publication's view, and this article is not edited by Singapore Business Review. The author was not remunerated for this article.
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Avik is a Tax Partner at Deloitte Singapore. With over 16 years as a global transfer pricing professional with Big4 accounting firms, Avik has a wealth of experience in transfer pricing planning structures for various types of business models, supply/value chain realignments, intellectual property valuation, structuring and pricing intercompany financial transactions, corporate guarantees, cash pooling, debt factoring and leasing arrangements, thin-capitalisation analysis as well as planning and executing global documentation projects for multinational corporations (MNCs).
In his work with clients, Avik helps MNCs in industries spanning automotive, aerospace, financial services, shipping, IT, oil and gas, chemicals, pharmaceuticals, real estate, consumer goods and telecommunication, develop and implement commercially viable transfer pricing policies to achieve tax efficiencies across jurisdictions. He has represented his clients before revenue authorities in several Mutual Agreement Procedure (MAP) and Advanced Pricing Agreement (APA) cases, including representing before the Tax Courts. Avik is also an active speaker at various transfer pricing discussion forums.
Before relocating to Singapore, Avik worked in Australia, India, the United Kingdom and the United States.
Avik is a Chartered Accountant by profession and holds a Master Degree in Commerce. He is also an Accredited Tax Professional with the Singapore Institute of Accredited Tax Practitioners.