The impact of a restructuring on transfer pricing policies
In a deteriorated economic environment following the Covid-19 crisis, corporate restructurings are likely to soar. A restructuring generally has great impacts on transfer pricing policies. Before specifying how to assess and limit the risks associated with transfer pricing during a restructuring, let’s start by recalling some definitions and issues.
The expansion of international trade
The current harsh economic environment coupled with heightened competition is creating strong economic pressures on businesses. Transfer prices are defined as intra-group and cross-border transactions. Therefore, they are a way for companies to reduce their tax burden, and thus remain competitive. In fact, transfer pricing is more than ever at the heart of current debates. Transfer pricing entails major financial challenges for both multinationals and the tax authorities. Several reasons explain this observation :
- Globalization of the economy : given the growing interdependence of economies, the playing field of companies is becoming global. As the companies expand overseas, they tend to optimize the allocation of their activities in the territories where they are located. The increase in the size of companies and the concentration of markets lead to an increase in the share of intra-group transactions.
- Dynamics of large organizations : the search for economies of scale and the attainment of a critical size allow companies to achieve dominant positions.
- Requirements of financial reporting : the improvement of the terms of financial reporting requires in particular the minimization of the overall effective tax rate displayed. The amount of taxes paid to all countries is highlighted in the financial reports of listed companies.
At present, the amounts involved are difficult to estimate. However, two elements can be mentioned. On the one hand, the share of non-taxed profits of large companies is estimated at several tens of points. On the other hand, the proportion of intra-group transactions tends to increase in international trade. These two trends suggest that transfer pricing contributes to eroding the tax basis of developed countries.
Restructuring as a means to remain competitive
In response to these trends, recent pronouncements tend to show tougher regulations to stem tax evasion. The GAFA tax voted in France is the latest illustration.
This is why companies are using reorganizations to stay competitive in an uncertain economic environment. The OECD defines business restructurings as a cross-border reallocation of functions, risks or assets between related businesses. If these restructurings are mainly motivated by strategic and economic reasons, the associated tax consequences should not be overlooked. One of the consequences of these restructurings is the alteration of the economic balance between companies within the same group. This results in the modification of the tax bases of the companies involved in the restructuring. However, some countries are inclined to question the transfer pricing policy. Particularly when they can demonstrate an improper shifting of profits. Therefore, how to document your transfer pricing policy during a restructuring to avoid a tax adjustment ?
Determining realistic options
A restructuring generally bears commercial reasons, and induces operational and tax savings. At this stage, it is not possible to conclude directly on compliance or not with the arm’s length principle. It is indeed necessary to prove beforehand that independent parties will only conclude a transaction if they do not find a more advantageous alternative. This is paramount to saying that no company would agree to conclude a transaction to its detriment if it had another more favorable option. Unless the company receives fair compensation in return. Therefore, a realistic option represents an alternative available to the restructured entity and which could have been chosen by an independent company in a comparable situation.
Thus, during a restructuring, each entity of the group must study all of the options available to them. As such, the OECD indicates that realistic options are not intended to force the company to describe all possible scenarios. Indeed, the question is rather to substantiate the most advantageous solution to be retained for the analysis of the restructuring.
Ultimately, the concept of realistic option is key for two reasons :
- When paying a compensatory allowance during the restructuring
- During the review of the restructuring by the tax authority
The allocation of risks borne by the entities
Before determining the compensation of the entity which suffers damage, it is necessary to examine the allocation of risks between the parties involved in the reorganization. The main problem in this area is the lack of perfectly comparable data in this case. There are no two identical reorganizations from one company to another. Consequently, the analysis of the degree of risk borne by each subsidiary of a group is based on two elements :
- Risk control : ability to make the decision to bear the risk
- The financial capacity to bear the risk : entity capable of assuming the risk allocated to it financially
Compensation for the entity undergoing restructuring
According to the OECD, a breach of an existing agreement does not necessarily give rise to compensation for the damage suffered. To determine whether to pay compensation or not, the following points should be considered :
- Facts and circumstances of the restructuring
- Contractual terms binding each of the parties
- Realistic options available to each stakeholder in the restructuring
This is explained by the fact that an independent entity would not accept that a contract be broken without compensation. OECD publications, including the latest applicable guidelines, give few details on how to set this compensation. Therefore, practice should be used to determine the level of compensation. More specifically, the objective will be to determine what a third party would claim as an amount of compensation. This will ensure compliance with the arm’s length principle, the current founding principle of transfer pricing.
Key challenges for companies and for governments
Nowadays, the loss of income for the tax authorities remains colossal. This explains the adoption of reinforced measures to justify transfer pricing policies, with the BEPS project. Despite these significant advances, there is still no international tax coordination. This makes it more difficult to set up a global governance regulating the shifting of profits. Recently, the Covid-19 crisis has further worsened the situation. In the absence of clear guidelines, companies will need to further substantiate the impact of the restructuring on their transfer pricing policies.