Allocation of Catastrophic Costs
COVID-19 has placed unforeseen stress on the distribution structures of Multinational Enterprises (“MNE”) due to catastrophic losses and costs from supply chain interruptions and plummeting demand. Existing intercompany agreements most likely do not cover the allocation of catastrophic costs or losses and several questions may need to be addressed. For example, should catastrophic costs be shared among group members, and if the answer is yes, then how?
The starting point for any transfer pricing analysis is generally an MNE’s existing intercompany agreements. However, MNEs may find that their existing agreements do not directly address how costs of an unanticipated catastrophic nature should be taken into account.
For example, a typical limited risk distributor (“LRD”) agreement may provide for an LRD to earn a predictable, fixed margin and for all residual profit or loss to inure to the principal. While such LRD agreements may provide for most operating costs incurred in the ordinary course of business and any resulting losses 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 or losses of a catastrophic nature should be allocated between the parties. In any event, limited risk does not necessarily mean no risk in this particular context. Even if the operative provisions of an LRD agreement allocate a particular catastrophic cost or a loss to the principal, consideration should be given to the impact of any actual or implied force majeure, hardship, or other similar provisions.
A difficult judgement call may also arise in the case of a “routine” or “full-fledged” distribution agreement in which the distributor has no contractual guarantee of profitability. Although “routine” or “full-fledged” distributors bear more risk than LRDs, such distributors are ordinarily intended to bear only the routine risks associated with marketing and distributing products. Accordingly, questions may still arise as to the extent such distributors should share in costs or losses of a catastrophic or exceptional nature.
In order to address these uncertain issues, MNEs should be prepared to provide transfer pricing documentation that thoroughly explains how unforeseen business circumstances caused unexpected financial results and why such losses were not caused by intercompany pricing. In addition, MNEs should consider taking a fresh look at their existing intercompany arrangements and may consider making exceptions to longstanding transfer pricing and benchmarking practices.
In certain circumstances, MNEs trying to support allocation of COVID-19 costs or losses among group members may be better served by amending existing arrangements or introducing new intercompany agreements that explicitly address the relevant issues related to such costs or losses. Such a new agreement or amendment, combined with transfer pricing documentation containing a robust discussion of the facts and circumstances and qualitative arguments supporting the introduction of these provisions, may ultimately provide a better line of defense than trying to justify how catastrophic costs or losses should be allocated under outdated structures or agreements. This may be the case even if the new agreements or amendments entered into after the relevant costs or losses are incurred are viewed by tax authorities as carrying less persuasive weight than an existing, contemporaneous agreement.
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