How to transact transfer pricing in era of Covid-19

The Covid-19 pandemic has led to profound disruptions in business operating models.

Supply chains, difficulties in accessing working capital funding due to suppressed cashflows, new costs associated with investing in new ways of working, cost increases occasioned by idle capacity as a result of suppressed demand and other factors have all proven to be disruptive.

Kenya hosts the subsidiaries of many multinational corporations (MNCs), which have experienced the human and economic impact of the pandemic, at both the local and global levels.

One of the common issues that multinationals face is the pricing of intercompany transactions between members of the same group of firms, especially where this happens cross border.

This is commonly referred to as transfer pricing and covers aspects such as the purchase and sale of goods or services, financing arrangements and licensing for intellectual property, among others.

These transfer pricing arrangements have an impact on the profits of multinationals. Typically, revenue authorities worldwide are keen to ensure that intercompany transactions are priced at arm’s length.

In other words, they would expect to see pricing consistent with that of unrelated third parties, should those third parties provide the same services or sell the same products.

In our current tax environment, the Kenya Revenue Authority (KRA) is paying increasing attention to transfer pricing matters in a bid to ramp up revenue collections.

During the pandemic period, several interesting transfer pricing issues are beginning to emerge.

Oftentimes, MNCs conduct comparable studies to look for data on what comparable companies dealing with unrelated third parties would declare as profits. These profits are then used by the MNCs as the benchmark for the returns that they should make, to ensure that their transfer pricing arrangements with related parties are not resulting in ‘advantageous’ pricing which could impact the profits declared and taxes paid in-country.

Usually, the data for comparability studies are obtained two or three years after the relevant financial period has passed since the data is dependent on the filing of financial records with various registries. Therefore, comparable data for the first pandemic financial year (2020/21) will only be available from 2022 onwards.

The challenge then becomes how an MNC dealing with its related parties should price its transactions, given that the data on comparable entities is currently unavailable.

One of the approaches under consideration is the use of economic modelling tools that utilize pre-Covid-19 data to model the impact of past economic crises such as the 2008/9 economic crises. It remains to be seen whether KRA will accept such economic modelling approaches given that they are likely to indicate reduced profits (and therefore reduced tax revenue) on account of the pandemic.

A further consideration concerning comparability studies involves the statistical tools that are often used to identify a point in the range of comparable companies that can be considered arm’s length. For example, a multinational may have identified 10 comparable companies and may use an interquartile range as a statistical tool indicating that the points between the lower quartile and the upper quartile are most representative of an arm’s length range.

In a pandemic environment, however, one could argue that the MNC should consider the full range of results as indicative of arm’s length, provided the entire data set is closely comparable to the MNC carrying out the comparability analysis.

The full range would provide the MNC with leeway to choose arm’s length comparable companies that have either made losses or experienced suppressed returns as these conditions are in any case, typical in a pandemic environment and indicative of suppressed economic demand.

This approach is untested so far among many revenue authorities, KRA included.

Taxpayers can only wait and see what approach KRA will take when reviewing taxpayers’ transfer pricing matters for the 2020/21 Covid-19 period. They will have to wait a while, given that tax audits take place a few years (two to three) after the financial period ends.

Therefore, in anticipation of potential KRA tax audits covering the 2020/21 pandemic period, it would be wise for taxpayers with related-party transactions to consider putting in place comprehensive transfer pricing documentation that covers the pandemic period.

This documentation should outline the transfer pricing positions that they took during the year(s) in question, the reasons for those positions and in cases where there are losses, an analysis of the loss position and where available, data on the performance of comparable companies.

This is especially pertinent and timely because a tax audit is likely to take place after the pandemic period has passed.

Memories fade and in some cases, by the time the tax audit occurs, employees with the institutional knowledge may have left the organisation.

These are just some of the many transfer pricing issues to consider in a pandemic environment.

Taxpayers with transactions with their related parties should start evaluating how the positions they have taken can be documented and presented to regulators — sooner, rather than later, whilst the data and the memories are still fresh.

Alice Muriithi, Associate Director at PwC Kenya's tax department and a specialist in transfer pricing.