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MNCs must manage their transfer pricing amid disrupted supply chains

Written by See Jee Chang, Deloitte Singapore Tax Partner, and Uziel Alvarez, Deloitte Singapore Tax Director. The below are their personal views and may not represent the views of Deloitte.

As published in The Business Times on 2 April 2020.

COVID-19, a global pandemic, may potentially change the way businesses are carried out globally. Governments, whether in developed or developing countries, are continuously developing strategies to cope with the ongoing impact as a result of the virus; particularly in areas like healthcare, global trade, and the economy.

Several countries and cities have been placed under lockdown and many countries have issued travel advisories or border restrictions in hope to contain the virus. This has also been the case in Singapore, where the Government has progressively tightened advisories and restrictions in response to how the situation has unfolded over the past months.

These measures would have repercussions on the global economy. In particular, multinationals (MNCs) with a global supply chain will be impacted by many of the measures or restrictions being put in place. MNCs would now have to review their existing supply chain with a view to restructure or relocate some of their operations to cope with the impact.

Certain supply chain vulnerabilities have been exposed with the various measures and restrictions being put in place by the various Governments. In particular, MNCs that have centralised their manufacturing capabilities in certain locations such as China and those that are highly dependent on these locations to fulfil their needs for raw materials or finished products are being impacted the most.

Singapore-based MNCs have also now been looking to procure outside of the neighbouring countries of Malaysia and Indonesia to ensure uninterrupted flow and availability of supplies, and the speed at which they are looking to diversify has now been accelerated as a result of the pandemic.

Transfer pricing considerations
MNCs consider transfer pricing seriously when they review and re-evaluate their global supply chains. Transfer pricing is the arm’s length pricing of goods, services, intangibles, and financial transactions between related entities. A simple example would be referring to the cost of the goods sold by a subsidiary to the parent company.

MNCs have organised their supply chains by looking at certain qualities of a country and the associated benefits that it will bring to the whole business; for instance, a Singapore-headquartered MNC centralising its manufacturing facilities in Vietnam due to the lower cost of production and establishing its back-end support functions in the Philippines due to language proficiency. Correspondingly, the related entities should be remunerated on their respective contributions based on the functions they perform, assets they employ, and risks they assume relative to the overall supply chain.

The disrupted global supply chain caused by this pandemic could pose several unprecedented challenges with regard to the MNCs’ transfer pricing positions.

Operating losses and low margins
This pandemic has resulted in increased business costs, either from loss of revenues or from additional spending to deploy business continuity measures. Local subsidiaries of MNCs characterised as ‘routine’ entities, due to the limited functions they perform, in affected locations may have losses or significantly reduced profits as a result. However, this does not necessarily mean that the ‘routine’ entities should bear the expenses or losses due to their limited function, even when they are incurring them. The entity which to bear the losses should be carefully identified, analysed, and documented, as this would be an area contended by tax authorities to limit the impact of lost tax revenues in their respective jurisdictions.

Transfer pricing adjustments
Tax authorities generally expect that the local subsidiaries of MNCs performing routine functions to be remunerated with stable returns in line with their characterisation, while the head office takes the residual profits or losses in line with their entrepreneurial functions and economic risks. For example, if supply and inventory risks are managed centrally by the MNC’s Singapore headquarter, it may not be appropriate for the downside costs from the disruption to be assumed locally by the routine distributors.

As routine entities are typically remunerated with a stable level of profit, transfer pricing adjustments might need to be considered to bring them to their targeted returns. It is near impossible to classify the level of market risk of COVID-19 as it is beyond the traditional bounds of market risk. Now, there is a question of whether the losses from insufficient productivity and decreased market demand should all rest with the head office or shared within the entities in the value chain.

Contemporaneous documentation
Due to elevated uncertainty, MNCs need to consider tracking and showing evidence of the business’ response, particularly the significant decisions taken and non-routine risks assumed by the entrepreneur vis-à-vis the routine entities. This is because losses or lower profits locally would have to be defended as tax authorities are likely to open enquiries and audits.

Similarly, MNCs need to examine their prior year documentation to assess the functional and risk profiles of related entities, and verify if they need to be updated in the context of any business changes as a response to the pandemic. Comparables that had been used to previously benchmark intercompany transactions may also need to be revisited as they may no longer be appropriate, particularly as they were under different economic circumstances."

Proactive mitigation strategies
Transfer pricing have been at the forefront of many countries tax authorities’ agenda since the inception of the Base Erosion and Profit Shifting project. The transfer pricing environments during both the SARS and H1N1 periods are vastly different compared to what we are experiencing. As such, the considerations listed above are definitely not exhaustive. If the pandemic continues for an indefinite period, MNCs also now need to analyse longer-term effects to their operations. They need to consider the potential impact early on, review their supply chains and the corresponding transfer pricing positions, and consider steps to mitigate compliance and audit risks. The pandemic could potentially leave MNCs with heavy tax burdens if not managed and addressed appropriately.

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