Introduction
Has your company carried out the business with related companies in 2020/2021 and has its profit performance declined as a result of the economic crisis? Transfer pricing may not be the cause, but a deterioration in performance may cause a “red alert” to go on next to your company name with the State Revenue Service. Fortunately, both the OECD and, on the basis of the OECD, the SRS have issued recommendations on how to deal with this situation.
In most cases, the COVID-19 pandemic has affected not only the profits of the related company per se, but also the results of transactions directly with the related companies, which can create difficulties in determining the market value of such transactions. The OECD reacted swiftly by publishing the COVID-19 Transfer Pricing Guidelines at the end of 2020, which you can read more about in our article ” Guidelines for transfer pricing under the impact of the COVID-19 pandemic” (in Latvian) or on the OECD website.
Earlier this year, the SRS also published guidance material on the application of transfer pricing during the COVID-19 pandemic. While the guidance broadly sends a similar message to the OECD guidance, here is an outline of what is most important for the SRS to expect when taxpayers justify the impact of the COVID-19 pandemic on related transactions. We highlight the key points below.
What information should be included in the documentation?
Taxpayers are encouraged to include in the documentation all available public and internal data information that helps to characterise the impact of the COVID-19 pandemic on the business as such, on the sector in which the company operates and on related transactions, including the impact on the allocation of functions, risks and assets in related transactions, etc.
Hence, when justifying transfer pricing under the impact of COVID-19, it is worth looking at the performance of the industry, competitors before and during the pandemic. Provide a more detailed explanation from the company’s experience of operating during the pandemic of how the COVID-19 containment rules have affected the business environment. For example, there could be a situation where demand has fallen sharply due to consumers being more cautious in their spending, but production or commodity costs have, on the contrary, risen sharply, while administrative costs have remained at their previous level. The inflation rate could be a reinforcing indicator. In Latvia, the headline inflation rate reached as high as 7.9% at the end of 2021. The price inflation rate for a given transaction segment could serve as a justification for the impact of COVID-19 on related transactions.
Does the State aid received have to be documented?
To compensate for the negative impact of the pandemic on business, some companies received various forms of State aid, including grants. When preparing transfer pricing documentation, a company that has received State aid to cope with the COVID-19 crisis should consider the following key issues in the documentation:
- Whether and how the State aid received has affected the transaction price or changed the company’s pricing strategy or created an advantage compared to other companies in the sector;
- What has been the impact of the aid on revenue growth and cost reduction;
- Whether and how the aid is used in settlements with independent customers or suppliers;
- How the aid would be used by comparable companies;
- How the distribution of business functions and risks is affected by the aid received;
- Differences in accounting treatment and procedures between the countries involved and the impact on the comparability of the chosen profit level indicator (most commonly operating profit);
- What are the requirements for the preparation of the financial statements of the country of residence of the comparable companies, in the context of the assessment of the need for comparability adjustments.
In brief, the documentation should demonstrate and justify the role of the State aid granted in the company’s performance during the reporting period. In particular, if the grant has given the company a certain advantage among its competitors in the sector, or if the aid has been used to cover losses on transactions directly with related companies, while the unrelated segment is highly profitable, there is a risk that the objective of the State aid granted, namely to compensate for the effects of the spread of COVID-19, has not been achieved.
Analysis of comparable data
The selection and analysis of comparable data may lead to adjustments of the results obtained in order to align the conditions as closely as possible to the undertaking under analysis. Importantly, whereas previously market value was considered to be between quartiles 1 and 3 of the range of results of comparable companies, the SRS has now given the green light to extend the range by defining market value as any value between the minimum and maximum of the financial ratios of comparable companies. Thus, even if the comparable companies include a company with an operating profit loss in 2021, this aspect can be used as a justification that companies in the sector were exposed to COVID-19 risk as a result of incurring losses. However, in such a case, it would be advisable to reinforce the position with other publicly available industry indicators or calculations, for example by adjusting the selected companies by excluding the impact of items such as debtors, creditors or other balance sheet items on the company’s financial performance.
If the limited risk entity has entered into loss-making related party transactions during the reporting period, an assessment should be made of whether an unrelated entity would take a loss in such circumstances, on what terms and whether it would agree to a restructuring of the transaction and a contractual amendment. This is because, given that a limited-risk entity bears risks to a limited extent, i.e. the impact of various external factors on, say, a manufacturing entity is relatively small, unlike a full-risk manufacturing entity, a limited-risk entity should earn a small but stable profit regardless of the impact of the risks.
It is clear that 2020 and 2021 have created challenges in the business environment which have left their mark on the profit performance of companies, including transactions with affiliates, but we can understand from the SRS publication that the SRS is not going to sound the alarm as soon as it sees negative profit performance in transactions with an affiliate in the transfer pricing documentation, however, such a result should be substantiated in the documentation using all information available to the public and the company.
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