In this series of articles, we have been elaborating on the challenges and difficulties of tax and transfer pricing planning under current economic conditions. We have covered cash repatriation and how transfer pricing is an integral component to consider in a corporate group’s cash repatriation strategies. We have discussed the need to revisit the target returns for routine entities and how adjusting those target returns can minimise tax cash payments to preserve cash flows within the group. Moreover, in our last article we discussed the use of analyst forecasts as a means of determining how arm’s length ranges may shift in order to support a plan to adjust those target margins, not just for routine entities but also for all intercompany transactions. As we noted in our previous article, When What’s Past is no Longer Prologue, planning for 2020 documentation is essential and should be undertaken now, since waiting for the normal documentation cycle to gather support for transfer pricing changes made in 2020 will likely result in additional time and cost outlays.
The preparation of transfer pricing documentation for any tax year should be considered an important first phase of a company’s plan for controversy management, in that it is usually the starting point for any transfer pricing audit. The assertions of fact and resulting economic analyses will be referred to throughout the audit, on to any subsequent appeal procedure, and, if necessary, in a court of law.
Addressing 2020 transfer pricing documentation is critical in mitigating the risks of both costly year-end transfer pricing adjustments and future controversy. More than any other previous tax year, there is a real need to develop a file of internal documentation supporting all of the decisions made in 2020, from planning for survival during this economic downturn, to supporting those decisions made to strive forward, and then to thriving as various industries and the economy, in general, recover.
Let’s think back to previous tax years and how, during the course of a transfer pricing audit, the tax authority starts by requesting and reviewing a company’s transfer pricing documentation. After that review, there will usually be a request for additional documents and information to support factual assertions made in the documentation. The comparables used to develop arm’s length ranges presented in support of the company’s transfer pricing model, policies, and target profit margins may also be questioned and challenged. Most of the additional requested information may be found in the source documents underlying the company’s books and records, while the data supporting comparables should largely be provided in the appendices to the documentation.
We know from our experience that when the tax authorities audited 2008 and 2009, two years significantly impacted by the Great Recession, they needed to be reminded of the effect that the financial crisis had on various companies, industries and countries. Producing evidence to support positions taken by companies during those years was difficult, time consuming, and costly.
Now let’s imagine a transfer pricing audit of the 2020 tax year. The tax authority may initiate the audit based on an assessment of risk that highlights the lower margins on intercompany transactions in 2020 as compared with previous years. The audit will start, as before, with a detailed review of the company’s 2020 transfer pricing documentation. That report should fully document the decisions made by management in response to the economic challenges of the pandemic’s impact on the company’s industry and the company’s cash flow and profit results, and the rationale for shifting margins on intercompany transactions. It will be imperative that the documentation tell the “why” story, from the industry analysis, to the analysis of the corporate group and its value chain, right through to the economic analysis.
When the tax authority requests additional documents and information regarding the facts and the economic analysis, it will be highly beneficial to provide internal documents produced now, as 2020 is still in progress, supporting why company management made certain key decisions and the evidence of market behaviour on which those decisions were based. If analyst forecasts, like those we discussed in our previous article, were used to show how uncontrolled third parties were affected by the economic downturn, what results did the forecasted arm’s length range present and how did management incorporate that knowledge of market behaviour into its decisions? How were those decisions formally documented within the corporate group, i.e.: Reports from External Consultants; Industry Publications, Economic Journals; Memos to File; Minutes of Management / Executive Meetings; Minutes of Meetings of the Board of Directors; and/or Minutes of Meetings of the Shareholders / Owners?
What should your next steps be?
As you already know, 2020 is not a normal year and it is definitely not the year to leave to the memories of the company’s executive management team.As with all tax years, it is not advisable to expect tax authorities to remember, several years after the fact, the impact of economic disruption in the current year.
In the pursuit of preserving cash and minimising cash tax outlays, there will be modifications to existing transfer pricing models, policies and the target margins used to set transfer prices.Develop a strategic plan, in conjunction with internal personnel and the company’s external transfer pricing advisor, to fully document the decisions being made in 2020 and the third party market data being relied upon to make those decisions.As with all tax years:
- Understand the specific facts for 2020 relating to the intercompany transactions at issue;
- Evaluate current industry and market behaviour;
- Research the actions being taken by arm’s length third parties;
- Consider employing analyst forecasts to assist in estimating what the arm’s length ranges for comparables may be for 2020;
- Internally document all analyses relied upon by management in making decisions relating to transfer pricing; and
- Ensure that the internal documentation is shared with your external transfer pricing advisor so that it may be incorporated into the contemporaneous transfer pricing documentation for 2020.
Always bear in mind that the preparation of transfer pricing documentation for any tax year should be considered as the important first step in a company’s plan for controversy management, in that it is usually the starting point for any transfer pricing audit. The assertions of fact and resulting economic analyses will be referred to throughout the audit, in any subsequent appeal procedure, and, if necessary, in a court of law. Transfer pricing documentation serves to remind tax auditors of the economic events that occurred in the tax year, the impact of those events on the industry and the company, the relevant facts (functions, risks and assets) pertaining to intercompany transactions, and the economic analyses to support a conclusion that the company made reasonable efforts to determine and to use arm’s length pricing.
As the Scouts say … “Be Prepared”.