Shock To The System: Key International Tax Issues Associated With Supply Chain Disruption - Arbitration & Dispute Resolution

The COVID-19 crisis has highlighted the challenges a multinational enterprise ("MNE") faces when global supply chains are disrupted. Decisions must be made quickly when a distribution center is temporarily shut down, when employees in key supply chain roles cannot perform their functions in their expected locations and when the source of raw materials or components changes from one country to another.

Tax is an important component to an efficient global supply chain. Sound international tax planning consistent with global standards ensures that the proper amount of income is allocated to the functions, risks and assets employed by the supply chain and also ensures that no income tax arises where functions performed in a location do not rise to the level of taxable nexus. Moreover, indirect taxes (e.g., VAT) depend directly on how goods and services flow between countries.

The COVID-19 crisis has created a shock to the global supply chain system. This article discusses some of the key international tax challenges associated with this disruption.

I. Transfer Pricing Challenges

COVID-19 has placed unforeseen stress on distribution structures and corresponding transfer pricing analyses due to catastrophic losses and costs from supply chain interruptions and plummeting demand. In these challenging times, MNEs should consider embarking on a proactive review of these structures to determine whether they continue to make sense from both a practical, operational and compliance standpoint.

Intercompany Agreements

The starting point for any such review of an MNE's structure and transfer pricing policies should be the existing intercompany agreements. In many cases, MNEs will find that their existing agreements do not directly address how short-term losses of an unanticipated catastrophic nature should be taken into account. For example, a typical limited risk distributor ("LRD") agreement will usually provide for the LRD to earn a predictable, fixed margin with the residual profit or loss inuring to the principal. While such LRD agreements may provide for most operating costs incurred in the ordinary course of business to effectively be borne by the principal, such agreements are typically drafted with "normal" operating conditions in mind and may not directly address how unanticipated costs of a catastrophic nature should be allocated between the parties. MNEs may therefore have flexibility to support and document a position for allocating such unanticipated costs among group members in a manner consistent with arm's length behavior.

MNEs may also consider modifying, terminating or entering into new intercompany agreements in order to realign supply chains or provide additional financing to its members. Rescinding a transaction might be the easiest way for an MNE to cancel the effects of a catastrophic change in circumstances; however, MNEs should note that tax authorities have generally only respected rescission of related party transactions in part or in whole in very limited circumstances. On the other hand, if an MNE decides to terminate an existing agreement, such as a distribution and supply agreement, careful attention must be given to what damages a supplier or distributor may be entitled to receive as a result of the termination; as it would be the case between independent parties. "Liquidated damages" provisions or penalty clauses can be helpful in limiting the amount of damages for which a related distributor or supplier may be entitled, to the extent such clauses are accepted in the jurisdiction of concern. Conversely, "hardship", "force majeure" and other provisions may allow for one-time reallocations of profit or loss.

MNEs may also need to modify intercompany financing arrangements, for example, if external borrowings are in default or thin cap thresholds breached. There may also be valid business reasons to depart from original agreements if it improves the potential profitability of both parties. Modifications could include extension of maturities, grace periods, adjustments to interest rates, alteration of covenants, etc. Consideration should be given to the transfer pricing implications of modifying the terms of intercompany financing and any adjustments should be adequately documented and reflect the actual conduct of the parties. In addition, MNEs should consider whether a modification could trigger cancellation of indebtedness income for the issuer¹ and a taxable exchange for the holder.² It is also important to consider whether new or modified financings would still be respected as debt for income tax purposes or whether the modifications undermine the original treatment of the transaction as debt. ³ Moreover, modifications that cause an instrument to be treated as new debt may cause the debt to lose grandfather status with respect to newly enacted interest deductibility limitations.⁴

As discussed above, administering intercompany agreements designed for "normal" operating conditions during the COVID19 crisis will require considerable judgment and may give rise to numerous interpretational issues. MNEs should address these interpretational issues now and document their rationale for interpreting any relevant provisions. Further, while new intercompany agreements and clarifying amendments enacted to address COVID-19 may have less persuasive weight with tax authorities than preexisting arrangements, such agreements could nevertheless be considered as part of a proactive strategy to document uncertain transfer pricing positions.

Transfer Pricing Documentation

The impact of COVID-19 on an MNE's comparability analyses and transfer pricing documentation should be considered based on the particular circumstances of each company. In many cases, a fresh look may be required and an MNE may find that it will need to make exceptions to longstanding transfer pricing and benchmarking practices designed for "normal" operating conditions.

For most MNEs, identifying comparables for 2020 transfer pricing analyses will be particularly difficult since the economic conditions during 2020 are unlike those during any other year. Moreover, MNEs that experience near total shutdown as a result of a major supply chain interruption may find that there are simply no good comparables for 2020. Some MNEs with a calendar fiscal year might be able to take a "wait and see" approach and make appropriate retroactive adjustments for transfer pricing purposes once full-year 2020 financial data for comparable companies similarly adversely affected by the COVID-19 crisis becomes publicly available. However, MNEs with earlier fiscal year ends or with entities in jurisdictions that do not allow retroactive adjustments, may not have the option to "wait and see" and may need to take more urgent action to adjust margins for the current conditions without the direct benefit of complete comparables-based data.

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Footnotes

1. See generally Section 61(a)(11) and Section 108. All Section references are to the Internal Revenue Code of 1986 (as amended) (the "Code") and Treasury Regulations promulgated with respect thereto.

2. See Treas. Reg. Sec. 1.1001-3(b), which provides that if a debt instrument is "modified" in such a way that it is considered to have undergone a "significant modification," then such modification will be treated as an exchange of the debt instrument for a new debt instrument.

3. Section 385 and Treas. Reg. Sec. 1.385-3. See also new OECD Transfer Pricing Guidance on Financial Transactions, February 2020, Section B - Accurate Delineation of Financial Transactions

4. When implementing the interest limitation rule enacted by the EU directive ATAD I, EU member states were allowed to opt for the grandfathering of loans concluded before June 17, 2016. When applicable, the grandfathering clause provides that a loan concluded before the effective date is excluded from the scope of "excess borrowing costs," unless there was a fundamental change to the terms and conditions of the loan after June 17, 2016. Belgium opted to include such a clause. In the context of COVID-19, the Belgian tax administration published Circular 2020/C/62, which clarifies that the granting of specific payment modalities, related to bank or intercompany loans, should not constitute a fundamental change in relation to the interest limitation rule if the changes are designed to support borrowers with payment issues resulting from the COVID-19 outbreak.

Originally published by Thomson Reuters' Journal of International Taxation (subscription required), August 2020.

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