19 January 20217 minute read

Transfer pricing – analysing and documenting emergency decisions during the current crisis

Transactions with other group companies are always a potential point of interest on the agenda of a tax audit, all the more so in times of economic turmoil, when certain transactions can be carried out as a matter of urgency, without adequate documentation. Given the current global situation, the question may arise as to whether this vulnerability is exacerbated and whether special efforts need to be made to reduce the risks involved.

Under normal market conditions, a company may opt for the prudent approach to test the transfer pricing policy prior to the financial year in question. Thus, the company can reduce the likelihood that the prices used in regard to related parties will be adjusted by the tax authorities. Of course, there is also the post factum approach, in which the way of setting transfer prices is analysed after the end of the financial year in question, in order to observe if the compliance with the arm’s length principle has been met. In this case, the company has the possibility to voluntarily adjust the transfer prices in order to comply with the arm’s length principle.

These reviews performed under normal market conditions are, in many cases, based on historical market information, regarding either the financial statements of potentially comparable companies or certain types of transactions.

But historical information cannot reflect the evolution of a market during a crisis, regardless of the root cause. In addition, information on a previous economic crisis cannot reasonably reflect the evolution of another crisis, each historical moment having different benchmarks.

The pandemic adds an extra level of complexity, medical difficulties piling up on economic difficulties and leading to various types of restrictions (e.g. on the movement of goods and people) or urgent demands (e.g. medical equipment or basic goods).

Given the multitude of variables, which cannot be clearly defined, and the need to make quick decisions, transfer prices during the pandemic may be unpredictable territory, where strict rules set for an entire financial year (or for even longer periods of time) can no longer be complied with.

Do we review the situation now or later?

In order to mitigate, to a certain extent, the unpredictability of transfer prices in times of crisis, a company, together with the group to which it belongs, may review the situation in two stages:

  • Current analysis – by documenting any distinct elements that were connected to a transaction with related parties;
  • Post factum analysis – by comparing the results of the company with the results of other companies considered as comparable.

The current analysis can focus on special, unpredictable situations, which occurred at certain point in time and for which emergency decisions were taken. Most likely, in such situations a preliminary transfer pricing analysis was not possible, as a quick decision was critical for the business. If we were to analyse the first months of the pandemic, we could take as an example the purchase of protective materials or, later, the purchase of certain raw materials after some states have decided to close their borders. In such situations, if there is a centralized purchasing system at group level, the costs subsequently passed on to subsidiaries may appear excessive from the perspective of the tax authorities if no additional details and supporting documentation can be provided to demonstrate that the higher level of costs was not determined by a potential transfer of profit to the group, but by the existing situation in the market at the time of the transaction.

The level of costs can also be interpreted differently depending on the accounting standards applied, in many cases the accounting being based on systems implemented at group level, which are afterwards converted based on the Romanian accounting standards. In case of a tax audit, the results recorded by the Romanian entity will have to be documented and supported according to the local accounting standards, regardless of the invoicing method used at group level.

The post factum analysis is useful whether or not a current analysis has been performed, insofar as the company's results have suffered as a result of the pandemic – which is very likely to have happened, regardless of the company’s industry. If a current analysis was performed whenever necessary, the post factum analysis can be used to further support the company's compliance with market developments and, implicitly, with the arm’s length principle. If no current analysis has been performed, then the post factum analysis is critical to demonstrate that the transfer pricing policy applied by the company has complied with the arm’s length principle.

Even if the post factum analysis reveals that the company's result did not respect the market developments according to the benchmarking study on comparable transactions or companies, its usefulness is maintained in terms of the two possible approaches for the company:

  • Make a voluntary adjustment – the company makes an adjustment to the revenues or expenses, as the case may be, recorded in relation to the related parties for the analysed transaction so that the company’s result complies with the arm’s length principle according to the results of the study; or
  • Limit the financial impact of a possible adjustment imposed by a tax audit – to the extent that the company does not present any documentation demonstrating the arm’s length range for the analysed period, the tax auditors will perform their own benchmarking study on the conclusions of which they may calculate additional corporate income tax.

Limiting the financial impact by providing a post factum analysis is very important because the Romanian transfer pricing legislation explicitly mentions the right of the tax audit team to conduct its own benchmarking study if the company does not provide transfer pricing documentation for transactions performed with related parties. Of course, as with any tax audit, there is the possibility of challenging the tax adjustment, but as tax authorities gain more and more practical experience with transfer pricing matters, the chances of a successful challenge based on errors or technicalities are decreasing.

Thus, we can consider that there are no technical peculiarities related to transfer prices during this pandemic as compared to the approaches we could encounter during a classic recession.

Beyond internal factors

However, the situation is complicated by factors external to transfer prices, but which can lead to major, perhaps even sudden changes at group level. Such external factors may include:

  • operating losses, generated in a very short time, for which there are no backup/restructuring plans;
  • the usual remuneration (i.e. a margin added to the total costs of manufacturing entities or services centres) generates a profit margin at the level of subsidiaries and consolidates losses at the level of the parent companies;
  • the emergence of new economic aspects based on which a restructuring or decrease of activity at regional/global level may be decided.

Each of the external factors may, most likely, generate conflicts at the level of several tax jurisdictions, each administration wanting to add to its own state budget (i.e. by reducing the tax loss or increasing the local tax base) or to ensure a local taxation when a company is liquidated, whether or not local law provides an "exit tax".

What we can do

In conclusion, in addition to the usual adjustments made to transfer prices (which must be thoroughly supported by documents and information, beyond just the invoices, so as not to be challenged during a future tax audit), the overall impact of the current crisis on all group companies and transactions must also be taken into account, so that a certain update of transfer pricing policies does not lead to a domino effect which may amplify the negative effects in terms of both additional taxes due, and costs generated by the consultancy services necessary to defend and coordinate the company/group position in front of the tax authorities from various jurisdictions.

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