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Limited-risk distributors and intra-group service providers: Should you adjust your transfer prices in connection with COVID-19?
As multinational groups face unprecedented negative economic pressures, transfer pricing understandably might not be on the top of priorities.
However, transfer pricing policies will potentially need to be modified to consider the financial and economic impact of COVID-19 when companies finalize their transfer pricing adjustments, to comply with local jurisdiction requirements and be in line with the arm’s length principle.
This is particularly true for companies that have a transfer pricing structure involving limited-risk distributors or services centers, as the profitability of such entities is generally constant from one year to another. The reason for this is that these entities assume limited risk.
Challenging transfer pricing structures
In fact, limited-risk distributors are named this way because they are usually exposed to general market risks, but are not exposed to significant risks with respect to inventory, credit and collection, product liability or foreign exchange.
On the other hand, entities that act as service providers for the benefit of other entities of their group are usually remunerated on a cost plus basis, meaning that their profitability is equivalent to the markup they applied on their costs. Accordingly, these intra-group service centers are not exposed to risks other than general market risks.
The negative impact that the COVID-19 will have on the profitability of many companies challenges these intercompany structures and will need to be reflected in the transfer pricing adjustments for fiscal year 2020.
Although negative results are caused by extraordinary circumstances, they are part of the market risks that should be shared between all entities of a group, including limited-risk distributors and intra-group service providers.
Determining profitability
The profitability of limited-risk distributors and intra-group service centers is usually determined by applying the transactional net margin method and by performing a benchmarking analysis of public companies that have a comparable functions, risks or assets profile.
The profit-level indicators of the companies selected as comparables (operating margin, markup on total costs, return on operating assets, etc.) are used to establish an arm’s length range, and the profitability of the limited-risk distributor or service center is considered to be arm’s length if it falls within this arm’s length range.
When the results of a limited-risk distributor or service center are outside the arm’s length range, transfer pricing adjustments are booked, either at year-end or during the financial year.
The financial results of the public companies used to benchmark the profitability of limited-risk distributors and group service centers will be impacted by COVID-19. The annual financial results of the comparable companies for 2020 will be available in the first half of 2021, and it might be too late for companies to adjust their transfer prices at that time.
While this delay in the availability of financial information might not be an issue in normal times, when the arm’s length range does not vary significantly from one year to another, this could become an issue for the fiscal year 2020.
Look at the quarterly results of the public companies
In these circumstances, a solution could be to look at the quarterly results of the public companies used as comparables and assess the impact of COVID-19 on their profitability in the first half of 2020. The transfer prices of limited-risk distributors and intra-group service providers could then be adjusted to reflect the decrease observed in the market.
These adjustments should be carefully documented by the multinational groups, and reflected in their transfer pricing documentation for fiscal 2020 and beyond. Such documentation will be important to explain changes in transfer pricing policies to tax authorities in the event of an audit, and to explain potential losses for limited-risk distributors and intra-group service providers.