React | Adapting royalties and service payments in the short and longer term economic environment

Everyone knows the Aesop fable about the tortoise and the hare. The hare sprints and takes an early lead, while the tortoise maintains a deliberate pace and prevails at the finish line. While the fable does have an important moral to impart, sometimes one must be both a little bit tortoise and a little bit hare.

Intercompany transactions involving intangible property or services can provide a valuable tool to businesses seeking to manage short and longer term challenges resulting from the COVID-19 pandemic. In this Insight, we consider practical strategies which may help groups first survive the immediate downturn and then adapt to the rather different environment which is likely to ensue afterwards.

Transfer pricing is used to price transactions between related parties. The principle underpinning it is that pricing and terms used between such parties should reflect open market conditions – thereby producing an “arm’s length” result for allocating profits and losses.

It follows that if market conditions change significantly, transfer pricing policies may also need to adapt to reflect those changes. Not only is this potentially advantageous from a cash perspective, but it also follows sound tax compliance practice. In the present circumstances, such transfer pricing changes may help businesses effectively address immediate liquidity and cash management priorities.

Looking ahead to the medium to longer term perspective, the impact of the pandemic on business models and supply chains means that strategic or operational changes will need to be considered by many groups. Transfer pricing should form a key part of any such analysis in order to ensure that any changes are cost effective and compliant.

Intangibles and services have long been key issues in transfer pricing — they have a significant and increasing impact on value creation. Therefore, the remuneration attributable to them can have an enormous impact on a group’s cash flow and effective tax rate. As a result, they have always been of interest to businesses seeking to develop transfer pricing strategies and also to tax authorities who wish to ensure that transfer pricing principles and laws are followed. Both stakeholders are expected to take an even greater interest in these issues; businesses are being forced by unforeseen circumstances to revaluate their policies, and tax authorities globally are facing huge budget deficits which need to be funded.

What should you be considering in the short term?

For many businesses, cash is now king. In the short term you can consider simply deferring intragroup royalty and service payments. This may mean late payment issues need to be considered, but the cash flow benefits may outweigh such costs. As with any adjustments to pricing, the impact on intercompany agreements needs to be considered and legal advice may be required.

Building on this approach, if intangible property is licenced from a related party entity it may be possible to renegotiate the agreement to take advantage of a royalty holiday, for example, until sales hit a specified level in the licensee entity. Alternatively, a stepped approach, for example, using a sliding scale of royalty rates linked to sales, may be preferable. Either option may result in cash benefits for the business and, given that examples of this approach can be found between independent parties, it is possible to satisfy the arm’s length requirements central to transfer pricing rules.

If intragroup services have been impacted by the current circumstances, then they should be reviewed as well. Has a reduced level of service been provided, for example, if personnel have been away from their normal location or if they have been unable to perform their usual role? In that case, the cost of providing the service may have changed materially. Given that many organisations use a cost-plus-a-margin approach for determining service fees, it is important to review actual costs incurred and not rely on budgeted amounts. The cost element usually has a far more material impact than the margin and should be analysed to ensure that the charge reflects current circumstances. Particular attention should be given to employees subject to government support or stimulus measures as there may be restrictions on the services that they can provide, or on the determination of the cost base for the service fee.

Therefore it is possible, and indeed appropriate, to change royalty and service charges when economic conditions are abnormal. The key is to follow what would happen if the parties to the transactions were independent and to ensure that robust, contemporaneous documentation is compiled justifying the reasoning and the approach. This will be needed to support tax filing positions and defend any tax authority challenges at a later date.

Medium and longer term considerations

Let’s look at the longer term. The pandemic is likely to impact the supply chain of many businesses. This could arise from any number of changes, such as the need to: reduce risks in supply chains; adopt revised delivery models; or adopt different technology and e-commerce solutions. Any such business model or operational change is likely to have an impact on the transfer pricing of intangibles and services. It is important that transfer pricing is considered as a key part of any such changes to the supply chain.

With regard to royalties, any significant change may alter the DEMPE (Development, Enhancement, Maintenance, Protection, Exploitation) analysis of intangibles for the business, and transfer pricing policies will need to be adapted so as to ensure that each group entity recognizes the appropriate reward or profit. This may well impact intangible property structures and transactions, including royalties. It is crucial that your business gets this right — not only so that you pay the right amount of tax, but also so that you can justify, evidence and defend your actions in case of a tax authority challenge. Remember that tax authorities will have large revenue raising targets to hit.

In relation to services, any change to the roles and locations of significant people in the business will need to be considered. Any material internal reorganisations, streamlining of departments, functions and service centres will almost certainly have implications for transfer pricing. As with intangibles, these will need to be considered as part of business model and supply chain realignments, to be implemented and documented appropriately.

Key takeaways

Be the hare: The priority now is to safeguard your business in these uncertain times. In doing so, remember that the arm’s length principle can be your friend in terms of cash management. Intangibles and services may offer opportunities to defer or reduce cash payments.

Be the tortoise: In the coming months, changes to your business and operating models are likely to require strategic input from a transfer pricing perspective. Intangibles and services are likely to be key issues to consider. Any changes to transfer pricing models will need to be evidenced and dovetail with commercial strategies.

Finally, it is crucial that you evidence and document the changes and then ensure that they are implemented and monitored effectively. Failure to do so will likely create a significant compliance burden risk in future.

For more information visit our Global Transfer Pricing webpage or get in touch with one of the team directly.

Read other insights in this series