Transfer Pricing & Brexit: A Piece of the Pandemic Puzzle?

published on 13 November 2020 | reading time approx. 4 minutes

 
• The UK government have provided significant funding during the pandemic to help support the UK economy. HMRC may put a greater focus on TP policies in order to improve government finances post Covid-19.
• Limited risk distributors are usually not expected to bear losses as a result of the pandemic as third party distributors are unlikely to accept making losses.
• Documentation and justification of transfer pricing policy adjustments must be retained to defend during a tax audit by HMRC (UK tax authority). E.g. updated benchmarking studies, comparability adjustments etc.
• Review of intercompany agreements will give groups a chance to re-evaluate the functions and risks of local entities which may result in adjustments to TP policies.
• Intercompany lending must consider the local interest rates of the borrower and lender.
• The combination of Brexit and Covid-19 may present an opportunity for UK entities to assume greater functions and risks. This could provide access to the UK market in order to benefit from any new trade deals negotiated between the UK and non EU countries (e.g. USA), which may not be accessible through EU companies.
• The unique hybrid status of Northern Ireland and any potential favourable trading conditions should be monitored closely by multinational groups to determine whether it would be beneficial to trade in Northern Ireland.

The current worldwide pandemic has resulted in global challenges for multinational corporations around the world. With operational challenges and long-term future considerations, the area of transfer pricing is another piece of the pandemic puzzle to consider.

 
The UK government have provided significant funding in the form of grants and loans in order to support the UK economy. This will inevitably result in greater pressure from HMRC to increase tax revenues. Therefore Transfer Pricing (TP) policies in the UK must be robust and actions taken by subsidiaries must be reasonable and proportionate to the functions and risks assumed.

 
Covid-19 will have an effect on a large number of businesses resulting in greater supply chain risk, market risk and fluctuations in currency. The culmination of these issues will result in a number of businesses reporting losses. The question which then arises is how to allocate the losses across the subsidiaries in the various tax jurisdictions?

 
As at the time of writing this article, the UK tax authority (HMRC) have not released any guidance on this area. As the UK operate a Self-Assessment regime for Corporation Tax purposes, it is important that groups evaluate UK TP risks themselves. Historically TP models would have been designed with groups having an overall profit. The majority of limited risk entities, who have non-entrepreneurial functions, are generally expected to distribute goods to third party customers and receive a low but stable profit to recognise and remunerate for the limited risks assumed. Historically, limited risk distributors within a TP model have accepted low margins on the basis that a third party distributor would also receive a similar level of remuneration.

 
Fast-forward to 2020 and we can see a very different economic environment. Covid-19 has caused distributors to incur significant losses not historically seen by either related parties or third party distributors. One can argue that third party distributors will not accept making losses as this could lead to the closure of the company. Third parties may accept lower profit margins and in extreme cases may decide to break-even in order to survive this pandemic. Similarly, from a transfer pricing perspective, limited risk distributors are not expected to bear losses as a result of the pandemic. It would be more appropriate for entities with higher levels of risk and entrepreneurial activities (e.g. R&D, manufacturing etc.) to assume the losses as they have assumed greater functions and risks within the group. Where TP adjustments have taken place, existing TP policies will be questioned and tax authorities will question the low operating profits or loss positions for previous and current tax years.

 
An increase in intercompany lending is also expected as multinational groups attempt to manage the working capital of its subsidiaries. Care should be taken on the pricing of intercompany loans with various factors to consider in both the borrower’s and lender’s economic environment and local interest rates in each jurisdiction.

Brexit & Covid-19

Negotiations between the UK and EU are currently taking place but given the deadlock it is more than likely that a no deal Brexit may be the final outcome on 31 December 2020.

 
The UK is looking to negotiate new trade deals with other non-EU countries and in particular the US. Therefore entities trading in the UK may be able to benefit from favourable trade terms with countries that have agreed new trade deals. As the European Court of Justice (ECJ) will no longer be part of UK law after Brexit, further opportunities may arise for multinational entities who are frustrated by rules set out by the ECJ. These aspects may provide an opportunity for TP policies to be adjusted for UK entities to assume a greater number of functions and risks through an increase in investment for the long-term. Changes in TP policies may also be driven by shifts in the global supply chain as a result of commercial decisions taken by the parent company post Covid-19.

 
The most fascinating part of the negotiations have revolved around the hybrid treatment of Northern Ireland. Depending on how favourable the terms are for Northern Ireland, they may become a hub for business activity given this unique status in the EU.

 
TP models will need to be adjusted in order to accurately reflect these changes and provide clear functions, risks and assets analysis in each entity. This may result in a need to change the characterisation of certain entities which will in turn change the level of remuneration expected.

Conclusion

To conclude, pandemics such as Covid-19 and the knock-on effect on the global economy would not have been considered or predicted by global entities when TP policies were first implemented many years ago. Entities must review and, where appropriate, modify TP policies. These changes must be well documented and supported by updated functions and risks analysis as well as updated benchmarking results where available. During the good times we witnessed limited risk distributors achieving a modest margin and the majority of the profits transferred to the entities within the group assuming the main entrepreneurial functions and risks. Therefore during these bad times, it is reasonable to expect limited risk distributors continue to achieve a small profit margin with losses being transferred to the entities within the group assuming the main functions and risks. It may well be that revised benchmarking/comparability adjustments indicate towards a lower margin for limited risk distributors but the UK tax authorities may challenge losses in these entities as ultimately the functions and risk profile of the limited risk distributor is unlikely to have changed significantly due to Covid-19.

Recommendations

• Review of current TP policies/structures to identify necessary modification to achieve an arm’s length result.
• Real time analysis of industry performance during Covid-19.
• Updates to benchmarking reports.
• Financial modelling of the Covid-19 impact and comparability adjustments (if applicable) – This will provide evidence that any changes in the TP model were not as a result of non-arms length TP policies.
• Ensure evidence of TP adjustments are well documented.
• Monitoring Brexit trade negotiations and adapting TP policies/documentation accordingly.