How to set the terms of group transactions in response to a state of emergency

In the October issue of our newsletter, we presented a set of steps that should prevent the adjustment of profits between routine entities and their parent company during the global coronavirus pandemic.

In this article, we will explain why it is necessary to have transactions in a group of related parties supported by written contractual documents and what risks their absence brings. Using the example of a manufacturing company, we will demonstrate how it is possible to set the level of risk of uncovered costs to which a routine entity may be exposed in times of crisis by appropriate adjustment of contractual relationships.

According to the methodology published by the General Financial Directorate in 2019, a company can be defined as contractual or routine. The decisive criterion for classifying a company as a routine entity is the extent to which it is contractually obliged to follow the instructions of another entity in the group when ensuring the production, distribution or provision of services. The more detailed the group's instructions which the company is obliged to respect, the smaller the company's profit potential and the lower the risk of loss to which the company should be exposed.

A routine entity can recognise a loss only if it is able to demonstrate a link between the decision it made and the occurrence of the loss.

In practice, we often encounter situations where companies belonging to a group referred to as a "family business" engage in cross-border trade for a long time, without having terms of business agreed in writing. This can be due to a simple, initially clear strategy, trust in the business partner, a long-term good situation on the European market and stable financial results of the entire group. During the boom period, the group did not have a problem guaranteeing the Czech routine entity a price adjustment so that it would consistently show low but stable profits.

However, the situation in the EU's internal market has been changed significantly by the pandemic. Differences in state aid provided by individual governments may, for example, lead the group to decide to discontinue the production of products provided by a routine entity in the Czech market and to transfer this task to another tax jurisdiction. In guideline D-34 devoted to start-up and shut-down costs, the Directorate-General for Finance states: "Undertakings in a group with a limited functional profile (e.g. contract manufacturers) should receive a stable remuneration, regardless of the position of the undertaking or group in the market." This idea is based on the assumption that Czech companies were in most cases established with the strategic intention of a foreign group to use the potential of the Czech market as much as possible and to develop, produce or distribute products for the benefit of the group at the lowest possible cost. However, the opinion that even contract manufacturers should achieve permanent remuneration on the Czech market blurs the difference between the contract manufacturer and the routine entity in terms of possible market fluctuations to which the contract manufacturer may be exposed during a pandemic. At the same time, the return on investment strategy of the group, which was invested in the establishment of the company, is completely neglected.

A prerequisite for the routine entity / contract manufacturer achieving stable profits is compliance with long-term planned production volumes.

If you are a routine entity / contract manufacturer, distributor or service provider (paid work), assess to what extent your production or distribution plans for 2020 could be considered long-term at the time they were drawn up and to what extent these plans had to be revised due to the pandemic.

We recommend, in cooperation with legal specialists, examining how the contractual relationship based on which your company manufactures or distributes the group's products regulates the responsibility for drawing up a financial plan. We consider it important to set the conditions of subsequent adjustments to price arrangements for cases where deviations from the financial plan will be caused by force majeure. Deviations from the long-term financial plan should not be underestimated, especially if you are the recipient of investment incentives.

As a result of quarantine measures, your company may be forced to cooperate with external entities to meet its commitment to produce the production volume planned for 2020. If such cooperation results in the planned costs being exceeded, it is important that the contract for production determines who was entitled to decide on the conditions of cooperation.

A crisis requires crisis management. If, as a result of limited cross-border movement of persons in your company, the management sent by the parent company has been replaced by local management, which possesses the necessary decision-making powers in some areas, such as purchasing materials for production and selling products, or responsibility for compiling price lists for end customers, the pandemic does not have to have only negative effects. Let us imagine that the new management will be able to replace missing orders or deliveries from the group with advantageous cooperation with external domestic business partners. In such a case, we recommend compiling a new functional and risk analysis based on which your company will be granted a higher profit potential as a reward for the risk you have taken.

The new age requires new procedures. For 2020, your documentation should reflect the adjustments to the contractual arrangements. Right now, functional and risk analysis can be considered the most important part of the documentation. Fluctuations in management caused by an emergency can only be defended against if it is assembled correctly. It is possible that some companies will be expected to use a different method to verify the correct setting of prices in transactions with related parties than they did in the past. The solidarity of long-term business partners is a common market phenomenon in a state of emergency.