Transfer pricing audits may be around the corner. Make sure your multinational company is prepared to substantiate the arm’s length of its related party transactions.
Key insights
- Tax authorities looking to make-up for lost revenue may start transfer pricing audits with closer scrutiny this year.
- OECD and IRS are likely to view limited-risk subsidiary losses as tolerable, given the pandemic.
- Keep proper documentation to help protect yourself during an audit.
- Recent guidance may encourage companies to be more proactive about reassessing transfer pricing policies, and to feel more comfortable claiming a loss.
Need help reviewing your transfer pricing compliance?
In light of the economic challenges felt
during the pandemic, companies with an international footprint need to be proactive
in reassessing their transfer pricing positions. Multinational companies may find themselves in more precarious positions where they need to explore unconventional economic approaches to substantiate the arm’s length pricing of their related party transactions.
Governmental tax authorities have also experienced the economic effects of the pandemic, and may attempt to recover lost revenues via increased transfer pricing audits and closer scrutiny of transfer pricing positions, beginning in 2021. Therefore, it is important to review your transfer pricing policies and documentation as there are tax and audit risk implications related to recent guidance.
Recent guidance on transfer pricing
On December 18, 2020, the Organization for Economic Cooperation and Development (OECD) released guidance to address transfer pricing implications and application of the arm’s length principle in the context of coronavirus. This guidance is largely welcomed by companies that have suffered a tough year for any number of reasons, including drastic demand drop, cash shortages, unstable supply chains, idle capacity, debt buildup, and bottom line losses. All the while, companies are expected to balance these operational challenges with required compliance involving heightened complexity and costs.
Meanwhile, tax authorities anticipate deteriorated compliance efforts by companies surrounding local transfer pricing requirements. Even prior to the COVID-19 pandemic, the IRS and other tax authorities voiced their intent and took action to enhance their transfer pricing resources — these efforts are now amplified by the pandemic.
Given the current economic challenges, many limited-risk subsidiaries (e.g., distribution, service support subsidiaries) are likely to justifiably find themselves in a loss position, which typically requires robust documentation and analysis validation. Coming to the rescue, the new OECD guidance stressed the importance of continued reliance on the OECD Transfer Pricing Guidelines (OECD TPG), despite the exceptional conditions presented by COVID-19. Specifically, this guidance clarifies how the OECD TPG should be applied to issues presented by COVID-19, which include limited-risk entities that face an operating loss.
Further guidance for foreign-owned U.S. companies
This fact pattern is also high on the IRS’s list, as demonstrated in a recently issued IRS FAQ on transfer pricing documentation. The example given in Question 1 of the FAQ describes a foreign-owned U.S. distributor of goods that experienced a sudden demand drop, and as a result, sustained a loss — the IRS views this as acceptable. The language in this example provides some comfort for the possibility of the IRS’s willingness to accept a company’s loss position caused by business circumstances, should — with proper documentation — certain aspects be addressed and analyzed.
To help shed more light on the necessary and required analysis, the OECD guidance dedicated an entire chapter to address losses and allocation of COVID-19 costs. Furthermore, the OECD provides approaches with regard to the following questions. Consider each separately:
- Can entities operating under limited-risk arrangements incur losses?
- Under what circumstances may arrangements be modified to address the consequences of COVID-19?
- How should operational or exceptional costs arising from COVID-19 be allocated between related parties?
- How should exceptional costs arising from COVID-19 be taken into account in a comparability analysis?
- How may force majeure affect the allocation of losses derived from the COVID-19 pandemic?
Moving forward
This economic turmoil may indeed have a silver lining. Inevitably, many companies may become more proactive in the contemporaneous reassessment of transfer pricing policies. If multinational companies prioritize reevaluating the functional and risk profiles of related parties in a timely manner, it could also enhance company alignment with operational and efficient tax goals.
Until recently, taxpayers have felt pressure to show some profit in their low-risk entities to avoid raising red flags for local tax authorities. COVID-19 has provided an opportunity for some companies to justify losses — as long as there is an effective argument as viable defense for possible future audit adjustments.
How we can help
At CLA, we can offer you guidance through a potential transfer pricing audit — but even better is to get prepared for that possibility beforehand. Our transfer pricing professionals can help you develop strong transfer pricing policies that comply with regulations around the world.
As part of Nexia International, an international advisory network, we work closely with affiliates worldwide who understand both the U.S. and international transfer pricing requirements.