Transfer pricing and covid-19 crisis: how to remunerate a routine distributor for its financial year ending in december 2020?
Many multinational enterprises (‘MNEs’) have organized their transfer pricing operations around a principal operating company (also called “main entrepreneur”) and routine entities. According to this transfer pricing structure, the main entrepreneur receives the residual profit, i.e. the profit (or loss) remaining after all routine entities have been appropriately remunerated.
In order to determine the remuneration to be attributed to the routine entities, and in application of the transactional net margin method, MNEs conduct searches for independent comparable companies on public databases and compute an appropriate profit level indicator for each of the identified comparables to determine an arm's length range of margins in which the margin of the routine entities must fall. These searches necessarily rely on the use of historical financial data since there is a timing gap between the closing date of the comparables’ financial accounts and their availability in public databases.
In a stable economic period, the use of the historical financial data of the comparables is considered as relevant and usually allows to reliably approximate the remuneration to grant to routine entities.
However, considering the current economic crisis caused by the Coronavirus, the remuneration of routine entities, when tested 2020 at year-end, may be determined based on the comparables’ (pre-crisis) results that do not reflect the exceptional economic circumstances currently faced by the market players. Hence, this situation could lead to grant non-relevant (and most likely excessive) profits to routine entities, and to deviate from the arm's length standard since the economic circumstances of the markets in which the parties operate are key to conduct reliable comparability analyses.
Therefore, the question raised under these facts is how to determine the remuneration to attribute to routine entities acting as a distributors and which remuneration is determined on the basis of their operating margin for their financial year ending in December 2020, while taking into account the impacts of the economic crisis related to the Coronavirus.
Considering the exceptional economic circumstances observed on the market, comparability adjustments are made possible by the OECD1 to mitigate the timing issue described above.
Specifically, there are economic techniques that allow appropriate comparability adjustments directly on the 2019 financial data of the comparables, with the objective of simulating the impact of the economic crisis on their accounts (i.e. decrease of turnover and associated costs with a distinction between the variable costs and the fixed costs). The adjusted operating margins obtained for each comparable company would then be considered as appropriate and would allow a reliable comparison to determine the remuneration to be granted to a routine entity acting as a distributor.
However, this exceptional comparability adjustment is only one possible approach among others. A case-by-case analysis is necessary to determine what types of adjustments should be made in order to have the best possible understanding of the market conditions observed between third parties and to determine as reliably as possible the remuneration to be granted to the routine entity.
Furthermore, due to the significant decrease in sales volume in certain sectors, it is expected that the range of adjusted operating margins obtained by applying the approach described above could lead to observe loss-making positions at the level of the comparables. Nevertheless, from a conceptual point of view, routine entities facing a loss-making position may be contrary to the arm's length principle (unless a convincing economic justification and strong arguments are provided to demonstrate that the losses booked by the routine entity reflect an actual arm's length situation).
Irrespective of the comparability adjustments made on the basis of historical financial data, a corroborative analysis should ideally be conducted a posteriori when comparables’ financial data for 2020 will be available in order to confirm the relevance of the adjusted results obtained a priori, and to support the reliability of the adjustments performed.
Hence, even though the Coronavirus crisis is a public knowledge faced by all economic players, MNEs will have to rigorously justify any reduction of remuneration for their routine entities within their transfer pricing documentation with detailed explanations related to the adjustments made.
This current article is a short abstract of a full version in French language, to be published in the coming days in « Feuillet Rapide – Editions Francis Lefebvre ».
