Transfer pricing and the pandemic recession: What to do about it

By Steven C. Wrappe, J.D., LL.M., Washington, D.C., and Marenglen Marku, Ph.D., Chicago

Editor: Greg A. Fairbanks, J.D., LL.M.

The COVID-19 pandemic has been globally devastating from both a personal and an economic standpoint. As of Jan. 5, more than 84 million people had been infected with the coronavirus, and more than 1.8 million people had died from the disease. Many multinational enterprises (MNEs) have suffered due to workforce issues, disrupted supply chains, and depressed demand caused by the pandemic. A lucky few industries, including digital services, biotech, and processed foods manufacturers, have achieved favorable outcomes based on specific higher demand. Nearly all businesses, even those that have fared better, are struggling to adapt to the post-pandemic business environment.

At the individual MNE level, the pandemic and the governmental interventions have forced sweeping changes in the allocation of functions, risks, and assets (tangibles and intangibles) among controlled parties and even produced material changes in the behavior of uncontrolled parties. Some of these changes were deliberate and intentional to address the impact of the pandemic (e.g., changes in functions and risks) while other allocations were simply the result of changes in demand and the resulting impact on profits (decreases or increases). In reaction to all of these material changes, MNEs will likely need to reevaluate their pre-pandemic transfer-pricing approach based on an updated application of the arm's-length principle and be prepared to defend changes in the transfer-pricing approach and results.

The pandemic and the pandemic recession

The pandemic has had a significant impact on the lives of people everywhere and on global business operations. Companies' global supply chains have been disrupted by plant closures, employee absences, and transportation issues. Contractual obligations of all types have been strained, violated, and renegotiated. Lowered sales and profitability have reduced the inherent value of intangibles and undermined risk allocations between parties to transactions. It should be noted that these pandemic-induced problems occur between both controlled and uncontrolled parties, as most businesses continue to adapt to the post-pandemic business environment.

Due to these fundamental changes to functions, risks, and assets, transfer prices need to be reevaluated and possibly altered to align again with supply chains and to recognize changes in value contributed by location. Entire transfer-pricing systems may need to be redesigned, given new sources of value creation and a cessation of some of the prior points of demand and supply.

The arm's-length principle in a post-pandemic environment

The arm's-length principle is the globally agreed standard that prevents the manipulation of transfer pricing among controlled parties. The arm's-length principle dictates that the controlled entities earn the same results on controlled transactions as would have been realized if uncontrolled entities had engaged in the same transactions. Thus, the arm's-length principle essentially sets up an equation whereby the transactions between the controlled parties, including the functions, risks, assets, and results are compared to the functions, risks, assets, and results of the transactions between uncontrolled parties (comparable companies). The pandemic and recession due to it have imposed dramatic changes on both sides of that equation. On the controlled transactions side, the functions, risks, and assets may be fundamentally changed by the pandemic and recession; on the comparables side, the transactions may also have been altered in ways (similar or dissimilar) that are not specifically reported in the available financial statements.

These changes have exacerbated some of the practical imperfections of the application of the arm's-length principle, which often relate to implicit assumptions about information on comparable transactions. The lack of sufficiently detailed information on comparable transactions often leads to the adoption of profit-based methods, most prominently the comparable-profits method (CPM) or transactional-net-margin method (TNMM). The severe disruption faced by both controlled and uncontrolled companies during the pandemic and pandemic recession has made the comparables screening process more challenging than before, leaving open the question on how to best apply the arm's-length principle.

The Organisation for Economic Co-operation and Development Transfer Pricing Guidelines and the U.S. Treasury regulations under Sec. 482 subscribe to the arm's-length principle and provide voluminous guidance on the application of arm's-length concepts. However, neither the guidelines nor the regulations specifically address how intercompany transactions might change in the face of a global health or economic emergency. The guidelines and the regulations are similarly silent regarding when the impact of a crisis would require or allow a taxpayer to depart from its anticipated lookback analysis as a result of a departure from its prior transfer-pricing policy.

The guidelines and Sec. 482 regulations both rely upon certain assumptions in the performance of transfer-pricing analysis. The "going concern" assumption posits that the tested party is a continuing operation and, therefore, the appropriate comparable third-party benchmarks would need to generate a long-run steady positive result. For this reason, it is common when searching for comparables to screen out companies with more than one year of operating losses during the prior three years, regardless of functional and risk similarities with the tested party.

This common practice creates a host of issues when companies are in the midst of an economic downturn and experiencing lower profits or losses. Additionally, there is a "survivor bias," which artificially inflates the profitability range of companies in the comparable set since companies that do not survive the downturn do not show up in the set — often they shut down or are acquired by other companies. Finally, there is an implicit assumption that financial results for companies in the comparable set appropriately reflect the segmented financials related to the controlled transactions. The differential impact of the pandemic across companies in the same industry, and sometimes within divisions of the same company, make this a formidable challenge. Consider, for example, a manufacturer of medical products that include products used in elective medical procedures and consumables used more broadly in hospitals and other practices. An evaluation of the overall results may be misleading, since the consumables segment would have fared much better than the elective procedures segment.

With respect to current or forward-looking transfer-pricing revisions/adjustments, an additional obstacle is that information from the comparable businesses is generally not available until after the fiscal year has ended (e.g., comparable data for a calendar-year-end taxpayer only begins to be available the following spring); thus, taxpayers do not have real-time data and information on the comparable companies' returns.

All the above conditions make management of transfer pricing more challenging than ever, both from a business planning and compliance perspective.

Rules regarding changed circumstances

If the planned margins and markups for controlled transactions no longer resemble arm's-length results, transfer-pricing changes should be considered. If intercompany contracts are no longer indicative of arm's-length negotiations, the intercompany contracts should be revised.

The contract "force majeure" clauses shed some light on contract validity, and some specific insight on transfer pricing can be obtained from the "critical assumption" language in advance pricing agreements (APAs). Force majeure clauses are commercial contractual provisions that excuse nonperformance by a party due to an "act of God" or extraordinary event that prevented that party from performing in accord with the contract.

The "critical assumption" clause of an APA serves the same purpose in the context of a taxpayer negotiating an APA. A taxpayer requesting an APA must propose critical assumptions — facts outside the control of the taxpayer or the IRS, the continued existence of which are material to the outcome of the transfer-pricing methodology. One general-purpose critical assumption included in all APAs requires that the business activities, functions, risks, assets, and financial and tax accounting methods of the taxpayer remain materially the same. A mere change in business results will not be considered a material change.

Reevaluation of transfer pricing

Economists broadly characterize economic shocks as either endogenous or exogenous. Endogenous shocks arise within the economic system. For example, the Great Recession of 2008 was caused by internal developments that culminated in the eventual economic shock. Events like COVID-19 or SARS are different in that they do not originate from the economy or even from human society.

One could argue that endogenous shocks can be predicted and risk-managed. For this reason, tax authorities might be less receptive to transfer-pricing changes/adjustments that leave entities in those jurisdictions with reduced profits or losses. On the other hand, exogenous shocks, such as COVID-19, are almost impossible to predict, both from a timing perspective and magnitude of impact. The following are some aspects to consider:

  • Companies could not fully control decisions of how to run the business due to government-mandated shutdowns of operations;
  • Supply chain disruptions were outside of companies' control;
  • Government assistance was different for companies and locations; and
  • Ensuing demand shocks affected businesses differently depending on types of goods/services offered, customer base, and location of customers.

Tax authorities should consider these factors in evaluating whether transfer-pricing changes/deviations from prior periods were reasonable and whether they violated the arm's-length principle. Although the burden of proof is on the taxpayer to show that it followed the arm's-length principle, tax authorities should consider the extraordinary circumstances and limited information in evaluating a company's transfer-pricing determinations.

Company defense of revised transfer pricing

MNEs should set transfer prices as close to arm's length as possible, given limited real-time information. In some cases, the market gives off clear signals regarding what controlled taxpayers can do to align with the market. In other cases, the market is silent, and the taxpayers must decide what action to take.

Controlled taxpayers can adopt arm's-length behavior, even if detailed, current information on comparables is not available. The answer is either readily apparent, or the controlled taxpayer can model out an answer, given an informed understanding of its own demand and cost situation in the current market. More broadly, taxpayers may need to rely more heavily on economic analysis that is less dependent on comparables information but instead on economic theory to determine the allocation of profits or losses among affiliates.

The IRS and the OECD have each received questions about how MNEs should think about their transfer-pricing policies in 2020, given the reality of unexpected losses. The IRS responded in an April 14, 2020, frequently asked questions document that companies should stick with their existing transfer-pricing methods and comparable sets in a downturn and find other means to explain their results.

The effect of the pandemic recession on the tested party and the comparable firms must be carefully explained in 2020 documentation. Defending the MNE's behavior and results to a tax authority will be much easier if attempts were made during this recessionary period to conduct related-party business as if at arm's length and actions are explained with supporting evidence. The tax authorities should be willing to accept these explanations, provided the taxpayer has prepared sufficient analysis. Governments can be expected to discourage aggressive taxpayer attempts to use the confusion generated by the pandemic recession to shift income to low-tax jurisdictions. Even if tax authorities agree with a reallocation of risk during the crisis, they might insist on a new post-recession transfer-pricing approach. For example, tax authorities could argue that the entities branded as limited-risk distributors that bore losses during the pandemic recession should earn higher returns following the recession.

Documenting changes

The pandemic recession is not only considerably more devastating than recent recessions, it has also had a uniquely disruptive impact on functions, risks, assets, and allocation of profits among affiliates of MNEs. Companies are currently faced with a decision whether to continue legacy transfer-pricing approaches that rely on pre-pandemic assumptions or to alter their transfer-pricing approach and document transfer prices to align with the post-pandemic realities.

As the pandemic is likely to linger well into 2021 and the recession even longer, companies should reevaluate their transfer pricing and make revisions as needed. Tax authorities will likely scrutinize changes; therefore, companies should maintain appropriate documentation and support to convince tax authorities that outcomes were the result of the pandemic rather than aggressive transfer pricing.


Greg A. Fairbanks, J.D., LL.M., is a tax managing director with Grant Thornton LLP in Washington.

For additional information about these items, contact Mr. Fairbanks at 202-521-1503 or

Contributors are members of or associated with Grant Thornton LLP.

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