Contributed by Artzi, Hiba, Elmekiesse, Cohen - Tax Solutions Ltd. Israel

Transaction between entities within a multi-national group forms a significant part of global commerce. There are elements that perform centralized functions, such as procurement or intellectual property (IP) management, there are those that perform R&D services and there are distributors of products and services. As is well known, the legislation of transfer pricing provisions in the Income Tax Ordinance was intended, inter alia, to prevent the diversion of profits, which are supposed to be charged with tax in Israel, to another territory, where generally, the tax rate is lower, in a manner that would reduce the Group's overall tax liability.

We would like to quote the Income Tax Department's circular, which deals with transfer pricing, regarding this issue: "International transactions have especial significance from the tax aspect, in light of the fact that the improper determination of the price between the parties,  is likely to divide the overall profit from the transaction such that the part thereof that it will be appropriate to charge with taxation in Israel, may well not be chargeable in Israel and it would not be deemed to be profit that has been produced or has accrued in Israel in accordance with the regular principles".

At the present time, we are coping with an unprecedented crisis in the form of the Novel Corona Virus (COVID-19). In normal circumstances in the market, the transfer pricing policy between entities in a multi-national group leads to a stable and low yield for routine activity that accords with the relative value of the functions that they perform and the risks to which they are exposed, whereas the initiating companies are entitled to the residual profit or bear the residual loss after the entity that bears the lower risk is remunerated.

Since the COVID-19 crisis is an exceptional, exogenous realization of risk, the question arises of the degree to which entities that have a low business risk are required to participate, if at all, in the business change that derives from the crisis, already in the current tax year (2020), in which the crisis has broken out. We believe that there are claims that support this approach, inter alia, specifically against the background of the business conduct between unrelated companies at the present time, and that the possibility of a change in the inter-company pricing, at least temporarily, should be examined, with an emphasis being placed on the examination of the implications deriving from the possible change from a long-term perspective. We would mention that the implementation of the existing transfer pricing model with the economic analysis (the benchmark) being updated in accordance with the implications of the crisis, would lead to expression being given only to the implications in the results for the coming years since the implementations of the crisis will only appear in the results of the comparative companies in their financial statements for the year 2020, which will be published in 2021. This state of affairs requires changes in accordance with other models, for example the forecasting of the changes that are expected and the implementation thereof already in the current tax year, or for there to be a certain reduction in the pricing.

We will take as an example a company that provides inter-company services, which operates under a profitability policy of Cost-plus 10%, but which is not succeeding in fulfilling the function that it is responsible for as a result of the Corona crisis. Is it fair that the Company will continue to report on profitability at a fixed rate without any impact on its results on the assumption that it has not succeeded in reducing the full cost and in certain cases, it is even exposed to an increase in expenses? Is it fair, in the circumstances in the market, that providers of routine services will bear part of the damage that derives from so exceptional an event?  Numerous questions arise on this issue, such as: What are the justified commercial  reasons – in the circumstances that are relevant to the company that is being examined – which enable a supplier to record a reduced profit (as compared to previous years)? Should the related parties conduct new negotiations on their arrangements, as third parties may do, including opening agreements retrospectively? Do losses of this sort accord with the service or the production function, the asset and the risk profile? Should and how should the supplier be compensated in the coming years when the conditions in the market improve?

In our opinion, in certain cases, it will be possible to support an approach that in the exceptional circumstances that have arisen – on the assumption that they will continue over time in 2020, the results of the parties that are connected to the global crisis event should be adjusted and the profitability target that has been agreed between the parties (the target operating margin) should be diverged from, based on an up to date economic analysis and the general provisions in contract law. In the current state of affairs, at the height of the crisis, it can be assumed at a high level of probability that it would also be possible to come to similar understandings with a third party supplier. We would add that the reduction of the profitability even constitutes the implementation of the existing transfer-pricing model, in accordance with the implications of the crisis, and the selection of a lower profitability rate fits with the model, so long as it is within the inter-quarterly range. Furthermore, an analysis of the losses and the exceptional events that are particular to the company being examined, as the result of the crisis (such as bad debts) should be made.

The crisis even has implications for the analysis of inter-company credit transactions. Thus, for example, it is possible to consider the extension of the payment term timings in respect of inter-company transactions without exceptional interest or indeed, any interest at all being charged, the deferral of the payment times for interest in respect of credit transactions, the re-examination of the interest rate on inter-company transactions in light of the change in the risk conditions, the increasing of the inter-company credit facilities, the making of new credit available between companies in the Group and the shareholders, since all of these are part of the activities that are required in a crisis. In these cases, it is important to act in accordance with generally accepted transfer pricing principles and to ensure that there is appropriate documentation of the transactions.

We would emphasize that any change in the model and the attribution of risks between the parties to a transaction (even where this is done due to the crisis) in contravention of an inter-company agreement and in contravention of the transfer pricing policy (and the transfer pricing works) as applied before the crisis – could endanger the possibility of defending the model in relation to previous years that are not closed and it could certainly lead to a change in the Taxes Authority's approach in relation to the coming years – and therefore it requires thorough examination and extra care should be paid. Serious consideration should be given to any change, and if changes are made then this must be documents and very good reasoning given, with full disclosure being given. In certain cases, consideration should even be given to approaching the Tax authority.

The Corona crisis has both short-term and intermediate to long-terms impacts. In the short-term, the Virus' direct impact, the restrictions that it has created and the unexpected costs on at least some of the companies in the Group require adjustments and changes in the transfer pricing policy. In the intermediate to long-term, the impact of the crisis will be examined in the coming years and it is possible that it will lead to a change in the transfer pricing policy, which will find expression in different terms in inter-company transactions and in re-arrangements in international companies, including an expansion in relation to exceptional events and the impact thereof.

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