Transfer Pricing Issues in the Changing Global Tax Climate

The rapidly changing political climate and global tax environment are expected to affect the transfer pricing strategy of multinational entities (MNEs) with related entities worldwide.

It is important that MNEs are prepared to adjust their transfer pricing policies to maintain their profit margin while complying with regulations. Even though each situation is expected to be unique, some recent events have had a significant impact on transfer pricing.

Impact of COVID-19 Pandemic on Transfer Pricing

From the disruptions caused to the supply chain, to the availability of resources, and workforce, the COVID-19 pandemic has caused operational impacts and led to practical challenges in applying the arm’s length principle. 

Many businesses had to relocate their functional profiles for business continuity purposes when countries went into lock-downs. These temporary arrangements could affect the intangible property transactions, including the brand/IP, licensing, and royalty payments. MNEs increased or provided new cross-border financial support to keep businesses running and employees paid, despite closing production facilities due to lock-down requirements and supply chain disruptions. Agreements with long-standing customers and vendors were canceled or renegotiated under the force majeure clause as terms of the agreement could not be kept.

The impact of COVID-19 was so profound that the OECD provided guidance on the transfer pricing implications of the COVID-19 pandemic representing the consensus view of 137 members of the Inclusive Framework on BEPS. The OECD guidelines provide clarifying comments and examples concerning: (i) comparability analysis; (ii) losses and the allocation of COVID-19 specific costs; (iii) government assistance programs; and (iv) advance pricing agreements.

Transfer pricing related changes have also been announced in various jurisdictions around the world in response to the COVID-19 pandemic. Many countries have extended their due dates for submission of relevant transfer pricing documentationfor filing years 2020 and 2021. MNEs should properly account and document for the impacts of COVID-19 in their contemporaneous documentation.  

Impact of Brexit on Transfer Pricing

After multiple extensions to the time period under the Article 50 of the Treaty on European Union, the United Kingdom (“U.K.”) finally withdrew from the European Union (“E.U.”) on January 31, 2020. As the Brexit transition closed on December 31, 2020, MNEs now have to deal with additional paperwork relating to customs, tariffs, and border checks. Similarly, complying with the safety and regulatory standards in the E.U. region and the U.K. separately will increase the cost of products and reduce the margin.

The interconnectedness of the European economies has increased the complexities of operational challenges. MNEs have started considering the transfer of functions, risks, and assets from a U.K. group entity to an E.U. group entity. Intercompany agreements might have to be updated to provide for a revised functional profile of the associated entities. In addition, business restructuring warrants changes in the transfer pricing policy. Other challenges include delays in customs clearance resulting in disruptions to the just-in-time supply chains for manufacturing entities. Pre-Brexit, the U.K was part of the E.U. VAT regime and did not require separate registrations for VAT in each of the E.U. countries. However, post-Brexit, importers have to account for VAT on their next VAT return. Businesses have to review their intercompany transactions to comply with the new anti-profit fragmentation. On a positive note, Brexit has significantly reduced the reporting requirements under DAC6, the mandatory reporting of cross-border tax arrangements affecting at least one E.U. member and where the arrangements fall within any of the Hallmarks. U.K. businesses are now required to report under the OECD mandatory disclosure rules, the only arrangements falling within Category D of Part II of DAC 6.

Pursuant to the U.K. withdrawal from the E.U., on July 26, 2021, the U.S. and U.K. competent authorities signed an arrangement clarifying the terms in the Limitation of Benefits provision of the U.S-U.K Treaty[1]. This arrangement agreed that, for the purposes of applying paragraph 7(d) of Article 23 of the US-UK Treaty, a "resident of a Member State of the European Community" continues to include a resident of the U.K. to be eligible to qualify as equivalent beneficiaries for purposes of applying the derivative benefits test in paragraph 3 of Article 23.

Impact of Digital Services Taxes and the G7 Minimum Corporate Tax Deal on Transfer Pricing

Trade, transparency, and taxation are the founding agendas of the BEPS action plans. According to the recent OECD publication on corporate tax statistics[2], the average statutory tax rate fell to 20% in 2021 as compared to the 28.3% in 2000. The country-by-country statistics compiling financial and economic activities of around 6,000 multinationals shows that companies report a high share of profits in investments hubs (i.e., low tax jurisdictions) compared to locations with employees, tangible assets, or customers. This statistics suggest the continuing misalignment between the location where profits are reported and the location where economic activities occur.

With the rapid digitalization of economies, global tax solutions have been the primary focus of G20 nations.  As of July 9, 2021, 132 countries and jurisdictions have joined the new two-pillar plan for International Tax Reform.

Pillar One of the proposed solution would give the jurisdiction where the customer or user is located a right to tax a share of foreign producer’s profit. The new market jurisdiction tax based on an allocation formula intends to replace the digital services tax (DST) enacted by various countries. Regarding the marketing and distribution activities, the need to apply the arm’s length standard, which is the fundamental principle of transfer pricing, would be simplified by adopting a profit-safe harbor.

Pillar Two, which interlocks two domestic rules, namely – Income Inclusion Rule (IIR) and Undertaxed Payment Rule (UTPR), together referred to as the Global Anti-Base Erosion Rules (GloBE), proposes a global minimum tax rate of 15%. A global minimum tax rate of 15% affects the low-tax jurisdictions where the incentive for investment in the countries has been the lower tax rates. OECD member countries including Ireland, Estonia, Hungary, Barbados, Kenya, Nigeria, and Sri Lanka have not yet signed the international tax deal. However, the United States has negotiated for the co-existence of the US GILTI regime with the GloBE rules.

A treaty-based rule referred to as the Subject to Tax Rule (STTR) allows source jurisdictions to impose limited source taxation on certain related-party payments subject to tax below a minimum rate. The plan is to implement a minimum STTR rate that ranges from 7.5% to 9% into the bilateral treaties.

The political and economic landscape has been drastically changing, and the geographical borders are blurred in this digitalized global economy. MNEs should adopt a robust transfer pricing policy and review them periodically to ensure compliance and manage risks.

This article was originally published by Taxation and can be viewed here

[1] Convention between the United States of America and the United Kingdom of Great Britain and Northern Ireland for the Avoidance of Double Taxation and Prevention of Fiscal Evasion with Respect to Taxes on Income and on Capital Gains, signed on July 24, 2001, as amended by the Protocol signed on July 19, 2002.


Published on November 08, 2021