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Article:

How updating your transfer pricing policies can help your cashflow

26 March 2020

At this time, many groups are urgently looking for ways of managing and improving cashflow. Transfer pricing can offer an opportunity for doing so. We are seeing groups considering such approaches now, especially those with intragroup quarterly payments due by the 31 March.

Transfer pricing principles provide that pricing between connected parties should reflect that of comparable transactions between independent parties - the arm’s length principle. Given that at present comparable arm’s length transactions may be subject to extraordinary pricing or payment terms there is potential for businesses to revise their transfer pricing to assist with cashflow. 
 

Immediate action

Some examples of actions agreed between third parties which may be appropriate to replicate between connected parties include:

  1. Suppliers may allow customers to pay on a delayed basis for goods or services
  2. Lenders may allow for the deferment of loan repayments
  3. Royalty payment holidays or deferrals may be viable
  4. Reducing the margins earned by entities that earn a fixed return (such as distributors)
  5. Providing finance with extraordinary lending conditions attached.

There are other examples in addition to the above but the principle remains the same, the pricing and terms of transactions between connected entities should mirror those between independent parties.
 

Policy change in extraordinary times

Tax administrations and the OECD recognise that transfer pricing may need to be revised during extraordinary economic or commercial conditions. Adjusting the group policy is likely to constitute prudent compliance. It is important that any changes made are documented so that they can be justified from a compliance perspective.

The above are all examples of short term measures that may be available to improve cashflow. In the medium term, groups may need to undertake a more fundamental review of their transfer pricing policies to ensure that they reflect the unprecedented economic environment throughout 2020.

Groups should not only be considering such issues from a cashflow or effective tax rate perspective but also ensuring that their transfer pricing remains compliant with arm’s length conditions and pricing.
 

Example

The following example will help to illustrate the potential opportunities that a business might consider. 

It is late March. A company that is part of a multinational group pays intragroup loan interest and royalties. The interest is chargeable at 5% per annum on a loan of £100m. The royalties are charged at a rate of 5% on sales of £200m. Both are paid quarterly. 

The group has a central principal and regional hubs in the supply chain supported by limited risk group entities (limited risk distributors, sales support service providers, toll/contract manufacturers, R&D centres, and other service support providers).These entities are rewarded with a margin which is fixed or limited.

The Covid-19 outbreak is creating unprecedented economic conditions.
 

Loan Interest

The company may decide that it is simply not going to pay the 31 March interest instalment of £1.25m [(£100m x 5%) / 4]. This may result in an improvement of cashflow for the payee company but similarly it will reduce the cash position of the recipient company. The transfer pricing rationale is that many lenders in the open market are relaxing payment terms under the current economic conditions. 

The interest payment is deferred, not forgiven, and potentially the lending party may seek additional compensation for the delayed payment. The group will need to decide whether or not the deferral requires changes to the existing transfer pricing policy. Either way it is crucial that the approach and reasoning are analysed and documented in detail and can be supported as a defendable tax filing position. The overall transfer pricing model may also need to be reviewed.
 

Royalties

Again the company may decide simply not to pay the 31st March payment of £2.5m [(200m x 5%) /4]. At arm’s length however, non-payment might lead to penalties or other action under the agreement between the parties. If, at arm’s length, a deferral would not be agreed similar to the loan interest scenario then it might appropriate to consider amending the underlying transfer pricing agreement.

For example, the parties may agree to a royalty holiday with no payments due until sales in a certain market or region reach a specified level. Alternatively, a stepped royalty may be agreed to with increasing royalty rates linked to specified sales hurdles being met. Again it will be crucial to analyse and document matters thoroughly and consider implications for the wider group transfer pricing model.
 

Fixed margin entities

Without remedial action to adjust the margins of the limited risk entities, the group may suffer cash tax at the level of those entities whilst the hubs (and/or principal) potentially suffer significant losses. This may not simply impact cash but also the effective tax charge of the group. The business could consider reducing or of even eliminating the margins for a period. Eliminating them would effectively amount to a sharing of group losses. The justification for doing so is that any comparables that were used to support the pricing are now entirely inappropriate in the context of the current economic environment. 
 

Supporting your new policies

Transfer pricing can potentially provide a valuable tool for improving internal cashflow and tax rates. However, it is vital to ensure that appropriate analysis is undertaken not just of transfer pricing issues but other related tax matters. This is especially important in the context of the fundamental changes and evolution of transfer pricing principles and compliance in recent years. 

The issues discussed in this article should be considered and analysed in the context of these changes and the group’s overall transfer pricing and tax strategies. Failure to do so could lead to significant risks including tax authority and audit challenge.

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