Routine Entities and Principals - Adjusting Profits

09 October 2020

Lenka Lopatová, Partner, Head of Transfer Pricing |

The global coronavirus pandemic affects all aspects of business and can have a significant impact on setting or reassessing transfer prices in your group. In this article, we focus on one of the key issues, namely the adjustment of profits between routine entities and the parent company.

This Insight takes you through immediate short-term actions to consider minimising overall tax payments to increase net cash flow within a multinational enterprise. We discuss how changing target profits for, or adjusting the relevant cost bases of, routine entities may boost cash flows and help companies survive this crisis.

Pre-COVID-19 transfer pricing model

Your company, like so many others, may have adopted a transfer pricing model wherein there is an entrepreneurial, risk-taking entity, being the principal, using routine entities in other tax jurisdictions to perform fairly limited functions while bearing low risks, such as Limited Risk Distributors ("LRDs"), Contract R&D Service Providers, Contract Manufacturers or Selling and Marketing Service Providers. For the limited functions performed and limited risks borne by the routine entity, it receives a routine level of profit each year. It is important to note that these routine entities are not "no risk" but rather "low risk" entities. It is the principal, on the other hand, that bears most of the economic risks facing the group. For its role within the group, the principal earns all group profits in excess of the routine profits provided to the routine entities.

Unfortunately, to preserve the characterisation of the routine entities, the principal may also bear losses in business and/or economic downturns while still ensuring that the group's routine entities earn their routine profits.

The result is that the group is paying cash taxes in the tax jurisdictions that the routine entities operate within, while incurring tax losses in the principal's tax jurisdiction. While that result is not ideal, this works to preserve the characterisation of the routine entities and principals under the OECD Transfer Pricing Guidelines, and the tax legislation / regulations of those countries that follow the OECD Transfer Pricing Guidelines.

COVID-19's impact on the transfer pricing model

The business and/or economic downturns mentioned above contemplate situations within the realm of normal cycles following the somewhat natural ebb and flow of businesses and economies. COVID-19 is not a normal business or economic event; rather, it is a highly unusual, disruptive world health event that, by its nature, is creating a world economic crisis that eclipses the financial crisis of 2008 and all other recessions and economic crises, other than the Great Depression of the 1930s.

In this article, and using the example above, we are assuming that LRDs are still distributing the group's products, the routine service providers are still providing services, and the principal is still benefitting from those services. If this is not the case, you may want to consult your transfer pricing advisors and legal counsel to determine whether, under existing intercompany legal agreements, the payments being made by the principal to the LRDs and to the routine service providers can be stopped during the relevant period.

Reducing target returns for routine entities

In light of that, what are your alternatives to preserve and manage your Group's cash while preserving the characterisation of the group's routine entities and the principal? We would suggest the following be considered:

  • Determine whether, under relevant transfer pricing guidance regarding limited risk entities in the particular country, the operating margin for the LRDs can be reduced within the current range, below the range, or even to zero; and/or
  • Determine whether, under relevant transfer pricing guidance regarding limited risk entities in the particular country, the mark-up for the service providers can be reduced within the current range, below the range, or even to zero.

At the end of your group's 2020 fiscal period, evaluate and assess the overall group profit/loss position to determine if year-end adjustments may be required in order to determine if year-end adjustments may be possible to minimise the situations in which a routine entity is paying tax in one country while a principal is incurring losses. The third-party comparables that you used to establish the group's target operating margins and mark-ups will not be available at year-end, so your decisions will have to be made on the best available information at the time of making those year-end adjustments. This might include evaluating comparables' quarterly financial data for Q2 and Q3, anecdotal or industry information on loss sharing in your industry or published governmental information. The hope would be that the arm's length range for 2020 derived from all of this information will reflect the economic impact of COVID-19 across industries and businesses, and would support your final financial results for the 2020 fiscal period.

By taking this action in response to the impact of COVID-19 on your group, you are preserving as much of the group's cash as possible, while maintaining the characterisation of the entities in the group from a transfer pricing perspective.

Analysing the cost base used to determine service fees

Another strategy that is specific to your group's routine service providers is whether there needs to be adjustments made to adjust the cost base used in the determination of the total intercompany service fee, i.e. total costs of providing the service plus an arm's length mark-up, by removing:

  • Costs relating to employees with significant idle time that can be linked to the downturn in the group's business activities due to COVID-19; or
  • Cost relating to idle manufacturing capacity that arose as a direct result of the downturn in the group's business.

If this strategy fits your group's situation, it would be important to try to determine what third-party service providers are doing in their service relationships to deal with the same issues of idle time and idle capacity. Would the recipients be willing to pay for the provider's idle time or idle capacity, and can the service fees be changed under the existing legal agreements between third parties? Third-party evidence should be sought as a means of supporting the decisions made by group management.

By taking this action you will be lowering the overall amount of the intercompany service fees which will allow the principal to retain more cash than it otherwise would.

Next steps

Consider the alternative adjustments to your group's transfer pricing model and whether these changes may be made under your existing intercompany legal agreements. This may require seeking independent legal advice. If considered feasible, then perform financial modelling to determine the benefit to the group in the form of reduced tax expenditures. Carefully document within the group the decisions made by group management with respect to these alternatives, and preserve that documentation to be ready for any future transfer pricing audit by any of the tax authorities. Ensure that you prepare contemporaneous transfer pricing documentation for 2020 that fully documents the impact of COVID-19 on your industry and your business, and the transfer pricing-related decisions made by management to survive the economic impact of the pandemic.

We are also preparing further information on this issue for you in the next issue of our newsletter. At the same time, we invite you to participate in the webinar CURRENT CHANGES IN TRANSFER PRICING, which we will hold in cooperation with a representative of the General Finance Directorate on 26 January 2021.

Dan McGeown, Transfer Pricing Leader, BDO Canada