COVID-19: Unexpected & Unfavorable Economic Conditions with effects in Transfer Pricing
Dear valued clients and friends:
HLB MAAT Asesores, S.C. is aware of the financial situation that Mexico currently faces as a country regarding the world-wide health emergency, and also the potential impact that could interrupt the normal course of business activities. As a response, we have developed this document for you to identify relevant aspects of transfer pricing for your business, in order to mitigate the risks and effectively prepare for the consequences of the pandemic COVID-19.
In recent years, Globalization has introduced the facilitation of international economies and people, as well as the transmission of positive and negative effects that come along with it. Thus came about the necessity of an international Transfer Pricing regime with the application of the “arm’s length” principle for intercompany transactions, making it possible to arrange and encourage commercial interactions between members the multinational groups.
This was definitely not an exception in health-related issues, as in the current outbreak of the coronavirus (COVID-19) that was first reported on December 31, 2019 in the city of Wuhan, China, which turned into a world-wide Pandemic declared by the World Health Organization (WHO) a few weeks later (March 11, 2020). Establishing measures and recommendations for all countries around the world with the purpose of minimizing fatalities.
In response to the crisis, individuals, corporations and national governments have implemented modification in their standard behaviors and activities. Which has initiated (and increasingly so) a notable impact in the bottom line of their businesses, with the vast majority of them being negative. This has thus affected their current quarterly profits and future revenue projections. Nevertheless, the severity of the impact is still unknown and will depend on the duration and speed of recovery from the crisis.
These negative effects for corporations and businesses have been caused by the following reasons: alterations in global supply chains, reaction measures by governments and companies, individual mobility restrictions (physical distancing), macroeconomic effects (due to altered pattern of supply and demand trends in products and services), and investor reactions in the financial markets as well. All of the above are associated with the adaptation and dynamism of businesses who have adopted broadened market horizons and ways of operating (e.g. assimilation of data/information technology and e-commerce).
In the case of Mexico, finance authorities have yet to approve stimulus or financial support for Mexican enterprises in these times of crisis and liquidity shortage. Moreover, Corporate income tax payments and informative tax returns have kept their deadlines intact (including those related to transfer pricing), along with increased efforts in auditing despite OECD recommendations that many countries have followed.
Given these circumstances, in order to circumvent and diminish the effects of the current pandemic translating into major tax contingencies for companies, it is highly advisable for enterprises to become familiar with the following transfer pricing recommendations as a priority during this time and for the foreseeable future:
- Appropriately identify, quantify and record all effects of the crisis and of the applicable corrective measures.
- Establish and strengthen internal policies and intragroup agreements from a transfer pricing perspective.
- Examine all possible changes that could affect not only the applied transfer pricing methods, but also the comparables considered.
- Prevent the necessity of year-end transfer pricing adjustments and if required to do so, to execute them in a timely manner, minimizing possible contingencies. Explore, evaluate and apply any changes in the business activities, which involve the reassignment of functions, assets and risks, or the termination of operations.Re-evaluate the implementation of administrative measures in transfer pricing (e.g. APA’s).
Based on the aforementioned, the accelerated (and unpredictable) changes up to date and its imminent future consequences, it is imperative that companies identify the facts and developments which are generating a decrease or disruption in its business (e.g. change in the demand of a product caused by changes in market trends or government restrictions, and any obtained State-related support), set forth corrective measures that are to be taken (or had been enabled prior), quantify the negative effect, and also document the complete process (including relevant dates).
Another good practice for businesses would be to document former business projections and analyze how these projections will be fluctuating in relation to the time elapsed since the declaration of the pandemic by the WHO, and what is then the expected impact in the company’s financials and to the intercompany transactions. While the OECD Transfer Pricing Guidelines (TPG) mention that experienced changes in the business can be caused “… by a natural disaster or some other unexpected event that was clearly unforeseeable at the time of the transaction (…) then the ex-ante pricing should be recognized as being at arm’s length…” , force majeure or unforeseeable circumstances can lead us to different results.
As part of the proper definition on the responsibilities and risk assumption capacities of each one of the group’s entities, it is appropriate to establish or strengthen intra group policies, the process of the transactions pricing and the set-up or renegotiation of the intercompany contracts; therefore it would be possible to implement a compensation mechanism that is aligned with the nature of the business, clearly identifying where decision making lies and the risk assumption capacity. In particular it will be useful to distinguish if it is stipulated as part of the contracts a reasonable control over the compensation mechanism and the possible implementation of economic adjustments in particular circumstances.
As part of the aforementioned argument, it is appropriate to perform a detailed analysis being able to identify assets, functions and risks specific for a realistic delineation of not only the business of the company, but the intercompany transactions as well, including all relevant functions and value drivers (i.e. DEMPE functions), which could derive in the recognition of a routine activity from the opposite, consequently, to the accurate selection of the appropriate transfer pricing method (TPM).
In considering that the financial deterioration caused by the crisis is extensive among companies, it will be essential to review that the employed comparables in previous years remain constant, incorporating the effects of the COVID-19. As an example, if the analyzed entity is a routine entity, it should be confirmed with more scrutiny that the comparables are also routine entities, regardless if they produce losses at the end of the year (as a consequence of the crisis), or in case of lack of comparables it should be dig deeper into the appropriate TPM selection to establish, in due case, the market value.
It would also be crucial to take into account the timing when searching comparables for the year 2020, given that the financial information of the comparables covering the period at stake (COVID-19) will be available from the beginning of year 2021, and it will become to indispensable to evaluate, and if necessary reconsider, this contemporary information in the moment it is available. Likewise, multi-period financial information from comparables will hardly be useful under these specific circumstances, due to the foreseeable atypical financial effects for 2020.
If the manner in which the company calculates its transfer pricing and the adverse financial situation caused by COVID-19 require the adjustment of transfer pricing, the recommendation would be to clearly identify the causes, and the aberration from extraordinary events and the said amount, so it can be applied accordingly (monthly or quarterly); hence avoiding a significant year-end adjustment that could be challenged from a tax audit standpoint.
Should such preventative measures be taken, this would thus strengthen through a defense file should the tax authorities wish to question the nature and magnitude of the possible financial deterioration experienced as a result of COVID-19; including cases where financial and tax losses are generated. Furthermore, when there are routine activities that ordinarily would expect to have low but stable margins, it would be convenient to demonstrate that financial deterioration or losses have happened by unexpected external events, unfavorable economic conditions, inefficiencies or other legitimate business reasons, such as stated by the TPG’s: “… associated enterprises, like independent enterprises, can sustain genuine losses….”.
In addition, it is relevant to mention that the Tax Authorities may attempt to compare financial and tax results of the party in question to those (consolidated financials) of the multinational group (information that may be encountered in both the Master File and the Country by Country Report), which can be scrutinized if the local entity reports financial and tax losses, where they could compare the loss ratio of the local entity to that of the consolidated group, as a risk assessment measure.
Depending on the impact of the health crisis, companies may be forced to make substantial changes to their intercompany transactions, which sometimes would involve the termination or reassignment of activities from one place to another (e.g. due to the closure of Chinese productions plants it was necessary to increase production in manufacturing facilities abroad), or the liquidity needs of the entity, which can be translated into new intra group financial arrangements, internal cross guarantees to back up external loans, the sale of assets, or in the extreme, to suspend certain intercompany payable accounts. In the case of business restructuring it is also suggested to review if it qualifies as Reportable Scheme for domestic tax purposes.
These changes or corporate restructurings can happen in time to validate the reasonableness, recurrence and the amount of the intercompany transactions, and be evaluated should they need to be amended or terminated. Likewise, as this exercise is sensible from a tax perspective, it is necessary that the enterprise has prepared the economic rationale involved in its implementation and possible consequences, as well as the supportive appropriate documentation. To develop this reasoning it will be convenient to dig into the behavior of independent parties operating in similar circumstances, which includes the options realistically available at the moment of the transaction (paragraph 1.40 of the TPG).
To the administrative measures that allow the establishment of a prior transfer pricing methodology for a period of time, such as Safe Harbours or Anticipated Pricing Agreements (APA’s), circumstances like the COVID-19 crisis can question the fundamentals and make us re-evaluate the founding premises. In the specific case of settled APA’s still in force, it would be key to know if within the terms of the APA, financial adjustments are allowed as a result of unexpected economic events, and the implementation details. Now, for the APA’s in negotiation phase it would be prudent to look for mechanisms that offer protection in the face of unexpected economic events.
One aspect associated indirectly to transfer pricing, involves other domestic tax rules relative to the economic substance and the limitation of financial schemes. On the one hand, the aforementioned recommendations will bring increased supporting arguments in terms of economic substance and strict indispensability of expenses, which on the contrary could threaten the tax viability of those items. On the other hand, in the case of intragroup financial transactions beyond the transfer pricing analysis, it would be necessary to confirm if they comply with thin capitalization rules and interest limitations on profitability margins.
In conclusion, given this scenario, it will become an increasing priority that companies fortify their efforts to implement measures that can prevent, mitigate and correct any possible effect as a consequence of the COVID-19 crisis as an unexpected and unfavorable economic condition, since on the contrary, they could be facing significant and unnecessary tax risks for transfer pricing, possible leading to tax contingencies.
We hope that the content of this feature release has been useful to you. Once again, our team at MAAT Asesores S.C would be happy to further assist you in resolving any issue or doubt related to the information mentioned above.
In the meantime, please stay safe!
Carlos Perez Gomez Serrano
Carlos has over 15 years’ experience in Transfer Pricing, having served as Head of Transfer Pricing at the Mexican Tax Administration, for audits and procedures, and acting as the Competent Authority for Transfer Pricing cases, which includes unilateral APAs, bilateral APAs with Mexico’s main commercial partners and MAPs regarding foreign and Mexican audit procedures, and as a delegate of the OECD’s Working Party No. 6 on the Taxation of Multinational Enterprises. Carlos now uses his Transfer Pricing expertise in the private sector, and by providing Transfer Pricing training to governments, regional organizations and NGOs. He is a member of the United Nations Subcommittee on Transfer Pricing.
This document and the information contained therein only refers to Mexican law and is issued exclusively for educational purposes in relation to the subject matter, and may not be modified or reproduced in any way without prior written consent from MAAT Asesores, S.C. Furthermore, it is not and should not be considered as a legal opinion, nor as a result of our advice on a specific matter. Consequently, and despite the desired accuracy when preparing this document, we cannot accept any responsibility for errors or omissions in it, regardless of its cause. MAAT Asesores, S.C. disclaims all liability for acts and / or omissions.
Transfer Pricing Alert collection: 2020 – 04 – 001