article banner
Tax and Legal

COVID 19: The Transfer Pricing Battlefield

As Thailand is currently combating the deadly COVID-19 pandemic, life seems to come a full circle for many multinational corporations (MNCs). More than a year back, Thailand taxpayers with cross-border related party transactions were wondering how to set transfer pricing for their related party transactions amidst high business uncertainty caused by this once-a-century pandemic. After having battled a nearly two-year business uncertainty, the transfer pricing margin question has come back to haunt many of the Thai taxpayers.

In the above context, this article focuses on the following key transfer pricing question that MNCs are struggling with:

  • Can a ‘limited risk’ bearing Thai entity, which is remunerated on a cost-plus margin, bears losses?

Varied impact on businesses

One must recognize that a ‘one-size-fit-all’ approach will not work given the varied impact of the pandemic on businesses, not only in Thailand but also globally. While sectors, such as Trade, Tourism, Hospitality, Transport and Communication have been severely impacted, there are also a few bright spots such as increase in the monthly consumption of OTT videos, wireless subscriber additions, boost in gaming industry.

OECD Guidance on TP implications of COVID

The ‘OECD Guidance on the Transfer Pricing Implications of the COVID-19 pandemic’ (“the Guidance”) issued in December 2020 provides some direction on the above issue. To begin with, the Guidance acknowledges that several unique practical challenges have emerged due to the pandemic. However, it emphasizes that the ‘arm’s length principle’ continues to apply and the taxpayers should rely on the same principle to address the new situation that may have arisen due to COVID-19.

Throughout the Guidance, OECD emphasizes that the transaction must be accurately delineated to identify which of the parties to the transaction bears the relevant risks; consider how third parties would have acted under similar circumstances; and observe the actual conduct of the parties during the
pre- and post-COVID phase.

One key takeaway from the Guidance is that it is critical to analyze the nature and significance of the risks being borne by the entity and assess how these specific risks have materialized due to the COVID hazard risk. Therefore, the mere fact that the industry or the MNC Group has been affected by the pandemic cannot be used as sweeping argument that the entity should also bear the negative consequences. There must be a specific and clear evidence of such adverse effect on the Thai entity. For example, a Thai entity is characterized as a limited-risk entity - mainly bearing the capacity utilization risk. Due to the disruption caused by the COVID pandemic, the Thai entity was not able to adequately utilize its capacity that resulted in the under-absorption of its fixed overheads and financial losses.  In this case, one can argue that there is a sufficient basis for the Thai entity to bear the losses occurring due to the materialization of capacity utilization risk caused by COVID.

Let us consider another case involving a Thai manufacturing company that sells products to its foreign associated enterprises (AEs). This entity operates in an industry, which is highly exposed to raw material price risk. Per the functional and risk profile, the raw material price risk is borne by the Thai entity.   Due to the pandemic, there is disruption in the supply chain resulting in the shortage of raw materials causing a significant increase in the price.  Accordingly, the margin of the Thai entity was reduced significantly.  In this scenario, as the raw material risk is being borne by the Thai manufacturer, such losses should ideally be absorbed by the Thai entity.

In both the above examples, the MNC Group should quantify the losses, maintain supporting documentation and make necessary economic adjustments to the results of the tested party (which usually involves exclusion of the abnormal costs associated with under-utilization of capacity or higher raw material costs, as the case may be, from the operating cost base for margin computation) in order to perform a reliable comparability analysis.

In some cases, these challenges may trigger a change in the transfer pricing method, comparability analysis, or the tested party itself - topics which are beyond the scope of this article.

Can entities operating under limited risk arrangements incur losses?

On this core issue, the Guidance highlighted that since the term “limited risk” is not defined in the OECD Transfer Pricing Guidelines (“OECD TPG”), the functions performed, assets used, and risks assumed by “limited-risk” entities tend to vary. Therefore, it is not possible to establish a general rule that limited-risk” should or should not incur losses. 

Further, it noted that the mere labelling of activities as a “limited-risk”, or the fact that an entity receives a fixed remuneration does not of itself mean that the entity operates on a limited risk basis in a controlled transaction.

Interestingly, the Guidance acknowledges the possibility that under certain facts and circumstances, simple or low risk functions may incur losses only in the short term.  These facts and circumstances must be supported by an accurate delineation of the transaction and performance of a robust comparability analysis.

In determining whether a “limited-risk” entity may incur losses, an examination of risks assumed by an entity will be particularly important. This reflects the fact that at arm’s length, the allocation of risks between the parties to an arrangement affects how profits or losses resulting from the transaction are allocated.

The extent of the loss that may be earned at arm’s length should be determined by a robust economic analysis of the controlled transaction, per the Guidance and the OECD TPG. Further, the selection of the most appropriate transfer pricing method should be made only after undertaking a full and accurate delineation of the transaction.

Per the Guidance, it will not be appropriate for a “limited-risk” distributor that does not assume any marketplace risk or another specific risk to bear a portion of the loss associated with the playing out of that risk. For instance, a “limited risk” distributor that does not assume credit risk should not bear losses derived from the playing out of the credit risk.

Another key point to note is that the tax office is likely to scrutinize the commercial rationale for any purported change in the risks assumed by a party before and after the outbreak of COVID-19.  As such, taxpayers cannot simply argue that since an entity was characterized as a limited-risk distributor before the pandemic, it was only entitled to a low return. After the outbreak, it assumes some marketplace risk (for example, due to changes in risk management functions), and hence, should be allocated losses.

The taxpayers should avoid an abrupt change in their position without adequate commercial rationale as it is likely to invite detailed scrutiny from the tax office and may ultimately lead to a conclusion that the change has resulted from business restructuring.

So, what should the taxpayers do?

Given the varied impact of the COVID-19 pandemic across economies, industries, and businesses, MNCs need to contemporaneously document how, and to what extent, they have been impacted by the pandemic.

Any allocation or reallocation of risk, or of losses caused by the materialization of risks; and any change in intercompany agreements should be based on an accurate delineation of the controlled transaction and the associated risks.

Ultimately, taxpayers should not lose sight of how third parties would have acted under similar circumstances. They must also ensure that their position in the pre and post pandemic situation is consistent.

The taxpayers should be careful and prepare robust transfer pricing documentation, which can take care of all the requirements listed above.