Analysis

Gov'ts May Question Losses By Cos. Set Up As Low-Risk

By Molly Moses
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Law360 (May 1, 2020, 5:04 PM EDT) -- With businesses closing or limiting operations due to a pandemic, companies with transfer pricing structures designed to limit risk — and income — to some group members should prepare for revenue agencies to scrutinize losses to those entities.

The pandemic's impact on the global economy could result in tax authorities' stepped-up scrutiny of corporate losses declared in low-tax jurisdictions. (AP)

Large corporate groups often place routine operations such as distribution, manufacturing or services in high-tax countries, attributing minimal profits to them for tax purposes. In these structures, the bulk of the group's income is often earned by a so-called entrepreneur set up in a low-tax jurisdiction, which bears most of the risk. The routine operations, which bear little risk, are rewarded with a steady but small stream of income.

For a multinational group that suffers an overall loss after the novel coronavirus pandemic, tax authorities in the country where the routine operations are based may well continue to expect some type of positive return, according to Ryan Dudley, a partner in the international tax practice at Friedman LLP.

"Taxing authorities have a reasonable basis to argue, 'We've allowed you to recognize minimal amounts of profit for some time; you need to continue to recognize that low amount of income,'" he told Law360.

By the same token, companies shouldn't attempt to change the transfer pricing method they've used for years to one that would allow the low-risk entity to share in the group's overall loss, according to John Warner of Buchanan Ingersoll & Rooney PC.

The comparable profits method, which calculates a company's income based on the profitability of similar, unrelated companies, is commonly used to set the return for a low-risk entity. If a company has been using that method, "it wouldn't be kosher to switch to some sort of profit split, which would be a loss split," he told Law360.

"Your story really ought to be consistent throughout various aspects of the business cycle," Warner said.

The current situation is something like what companies faced after the financial crisis more than a decade ago, when multinationals in a loss position for 2008 and 2009 had an uphill battle persuading tax authorities to accept low or negative returns for their routine, low-risk operations. But the global health crisis goes far beyond anything that happened then.

"Whole supply chains are disrupted like never before," Steven Wrappe, the transfer pricing technical leader at Grant Thornton LLP, told Law360. "It's not just that customers aren't buying my product, it's that I can't open my showroom because I'm not allowed to, and nobody's showing up in my factories to work."

Much of what companies are suffering now is a result of government actions to protect the public during the health crisis, whereas the events of 2008 and 2009 were driven by the market. That may lead tax authorities to be more open to losses resulting from the pandemic, said Elizabeth Stevens, a member of Caplin & Drysdale Chtd.

"A lot of companies can't do the things they need to do to generate revenue because the government has ordered them not to," Stevens told Law360. "If you can point to government policy in a location as exaggerating the losses or the economic consequences … you have a better argument for saying the risk is borne locally."

Governments are also more likely to accept losses when companies use the same set of comparables to measure performance over a period of years — something the Internal Revenue Service recently emphasized in frequently asked questions on transfer pricing. The guidance said that when unexpected circumstances cause losses for one member of a multinational group, the company should explain those circumstances rather than try to select a different set of comparables that also show a loss.

In the current situation, the comparables a company has been using for years may well show a loss on their own, according to economist Barbara Rollinson of Horst Frisch Inc. When choosing comparables for a service provider in normal times, Rollinson said, she rejects companies that have a history of losses. If the transfer pricing analysis contains companies that normally do well, a tax authority is more likely to accept bad results, she told Law360.

"I probably have a nice set of comparables for a number of my clients — and these comparables may do very, very poorly this year," Rollinson said. "In that context, you can imagine a situation where one could support a loss for the year."

Accurately calculating the effect of the downturn is difficult right now because comparable data isn't yet available, noted Tansy Jefferies, a principal for international tax services with RSM US LLP.

"For 2020, normally you would wait until spring of 2021, and that's a huge time lag before you have visibility into that data," Jefferies told Law360.

She said her firm is encouraging businesses to try to make adjustments now rather than wait until after the end of the year and do so after the fact. Retroactive adjustments can be extremely difficult, if not impossible, in some jurisdictions.

To that end, RSM has been using data from 2008 and 2009 to predict the pandemic's impact on clients, Jefferies said. The firm has looked at distributors, manufacturers and service providers across different regions and industries and compared the impact of the earlier downturn with the years before.

"This is a very different situation to the prior recession, but at least it gives us some data points that can be helpful," she said. "We're using that as a starting point to model out what may be a defensible position for a transfer pricing adjustment now."

--Editing by Robert Rudinger and John Oudens.

For a reprint of this article, please contact reprints@law360.com.

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