Tax

3 April 2020

On 26 March 2020, the CPB Netherlands Bureau for Economic Policy Analysis released its economic outlook for 2020: all four predicted scenarios result in a recession, with Dutch GDP declining by between 1.2% and 7.7%. The International Monetary Fund stated that the global economy has already entered into a recession that could be worse than the one caused by the financial crisis of 2008-2009. It has already become clear that the coronavirus (COVID-19) pandemic has resulted in a huge shock in supply and demand throughout global industries, inevitably having a far-reaching economic impact.

This newsletter addresses some key transfer pricing ("TP") challenges which might emerge as a result of an economic recession and how those challenges can be proactively managed.

Revisiting TP models

Multinational enterprises ("MNEs") might have to revise their existing TP models during a recession. For example, if a distributor is confronted with net operating losses, the arm's length nature of its transfer prices could be substantiated by an analysis based on its (unaffected) gross profit margins. Other examples include:

• A manufacturer part of an MNE group remunerated on a cost plus basis may consider applying a cost minus during recession years to reflect the need to implement a more cost-efficient production if the MNE group is making a loss.
• Headquarters or shared service centers which have already incurred personnel or other associated costs may not be able to fully or partially provide their services due to travel restrictions or lockdowns. It will become challenging for these intra-group services to pass the benefit test. Various alternative approaches, including requalifying these costs as shareholder costs, may be considered.
• A licensor of an MNE group that is making losses due to recession may consider giving a royalty break (temporary royalty-free period) if it can be justified based on similar arrangements that exist between unrelated parties.

Advance Pricing Agreements

The Dutch Ministry of Finance revised its cross-border ruling policy in 2019, already leading to significant changes to the process for obtaining Advance Pricing Agreements ("APAs"). Existing APAs should be re-examined and new or pending ones should be carefully considered due to the impact of the coronavirus pandemic on MNEs' financial results. Taxpayers may have entered into APAs with multiple year terms, providing certainty that – as long as critical assumptions are met – an agreed transfer price or resulting profit margin can be applied for the duration of the APA. A recession may mean that these transfer prices will need to be revised.

The critical assumptions agreed by taxpayers and tax administrations typically allow both parties to reconsider the APA if these assumptions are no longer met. If, due to the consequences of a recession or otherwise, the critical assumptions in the APA are no longer met, in principle the APA is terminated. As an alternative, taxpayers and tax administrations might renegotiate the APA during a recession and might agree on revised prices applicable throughout this period. Therefore, taxpayers should reconsider the terms of concluded APAs and pending APA requests, and assess whether the critical assumptions cohere to the current/future economic outlook.

The absence of a critical assumption in the APA allowing the APA to be re-opened does not remove the taxpayers' responsibility to report an arm's length result in all countries that they operate in. Furthermore, some countries in which the MNE group operate are often not covered by the APAs. If no critical assumption can be used to re-open the discussion with the tax administrations to align transfer prices with the new economic outlook, taxpayers should explore the possibility of adjusting the APA outcome to maintain transfer prices at arm's length from the perspectives of all countries involved. We expect reasonable tax administrations to be open to dialogue in these unprecedented times.

Comparability and timing issues

Comparability is an essential TP aspect and should also be reconsidered during times of recession. The determination of conditions of current and future intercompany transactions (including the price) is often based on a comparison with historic third party transactions, since the most recent publicly available data is lagged by at least one year. When a recession hits global economies there is, thus, a likelihood of comparing recession figures with pre-recession figures. Benchmarks will, therefore, possibly not mirror the economic circumstances in which 2020 and future intercompany transactions take place. Accordingly, discussions on whether to rely on single or multiple-year ranges and make recession adjustments become relevant.

Restructuring costs

MNEs that are heavily affected by a recession may experience declining margins and expected future declines in revenues, forcing them to restructure their supply chains and business operations to reduce operating costs. Downscaling business operations and premises gives rise to various TP challenges. Restructuring and termination costs should be allocated to group entities in line with the arm's length principle, while restructured entities might have to adequately compensate group entities which take over loss-making operations and excess operations. Furthermore, any indemnification as a result of terminating or substantially renegotiating intra-group agreements should be carefully examined, with a focus on any existing indemnification clauses.

Valuation aspects

If the valuation date of an asset valuation coincides with the coronavirus outbreak, this is likely to result in significant valuation uncertainty that should be disclosed as part of the valuation process (IVS 103). In this regard, valuation uncertainty should not be confused with market risk, which is the exposure to future gains and losses for the asset owner. Those risks are accounted for and quantified by an informed buyer or seller of that asset, whereas valuation uncertainty deals with uncertainties that belong to the valuation process on the valuation date, such as market disruption. In these circumstances, there may be a lack of reliable data (input availability), or an argument to reconsider the methodology to quantify the risks that are associated with future cash flows. Although a sensitivity analysis may be helpful in that respect to quantify the valuation uncertainty, the confidence level of this analysis should be clearly disclosed to the valuation's observer.

Taxpayers should act now to mitigate their TP risks

All of the indicators point to the coronavirus pandemic triggering a global recession. This will give rise to various TP challenges. Taxpayers should anticipate these challenges to be able to proactively manage the associated risks in a timely manner. With proper analysis and sufficient documentation, taxpayers should be able to significantly mitigate their TP risks and if needed successfully defend their "adjusted" TP policies before the courts. For more information, please contact the Houthoff Transfer Pricing Team.