New OECD Guidance on the Transfer Pricing Implications of the COVID-19 Pandemic
21 December 2020
Can groups reduce the profit margins of their subsidiaries to zero? Can subsidiaries demonstrate losses?
The unique economic conditions arising from COVID-19 and government responses to the pandemic have led to practical challenges for the application of the arm’s length principle. For taxpayers applying transfer pricing rules for the financial years impacted by the COVID-19 pandemic and for tax administrations that will be evaluating this application, there is an urgent need to address these challenges.
Accordingly, the OECD published a guide that focuses on how the arm’s length principle and the OECD transfer pricing guidelines (“TPG”) apply to issues that may arise or be exacerbated in the context of the COVID-19 pandemic. This guidance focuses on four priority issues: (i) comparability analysis; (ii) losses and the allocation of COVID-19 specific costs; (iii) government assistance programs; and (iv) advance pricing agreements (“APAs”).
During the pandemic period, many enterprises have faced or continue to face significant cash flow constraints, requiring them to develop and implement strategies to conserve and generate cash. Enterprises have seen wide swings in profitability, both upward and downward. Enterprises across a variety of industries have faced disruption to their supply chains, including the curtailment of their operations and corresponding reductions in output, and have been forced to change how their business is conducted (e.g. working from home). In many jurisdictions, hotels, factories, mines, shops and restaurants have been forced to close, at least temporarily. In some industries, demand has completely collapsed, while in others it has merely shifted channels or even increased (e.g. the market for online videoconferencing services).
The COVID-19 pandemic, which constitutes a hazard risk, has led to unusual outcomes of other risks for some taxpayers, including: (i) marketplace risk, as demand for some products and services has collapsed; (ii) operational risk, as the pandemic has disrupted supply chains and inhibited production; and (iii) financial risks, as borrowing costs for some industries have spiked and customers have delayed or defaulted on payments. The following is a short summary of the guidance, available at the OECD website.
Guidance on Comparability Analysis
Among other factors, the following sources of information may support the view that a comparability analysis is justified, generally by estimating the effect of the COVID-19 pandemic on the controlled transactions under review:
- An analysis of how sales volumes have changed during COVID-19, including whether the change is due to the use of other sales channels, and specifically compared to sales generated in pre-COVID years;
- Specific information relative to incremental or exceptional costs borne by parties to the controlled transaction (either with associated or unrelated parties) or by the MNE group as a whole;
- The extent to which government assistance has been received and, if so, quantifying the effect and identifying the type of the assistance and its accounting treatment;
- Macroeconomic information like country specific GDP data or industry indicators from central banks, government agencies, industry or trade associations to the extent useful in understanding the context of the controlled transaction;
- A comparison of internal budgeted/forecasted data relating to sales, costs and profitability, compared to actual results; and
- An analysis of the effects on profitability or on third party behavior observed in previous recessionary periods or using any data available in the current year, even if partial.
The guidance additionally states that another potential approach would be to utilize budgeted or forecast financial results to those actually achieved, to approximate the specific effects of COVID-19 on revenues, costs and margins. The financial outcomes that taxpayers within a controlled transaction would have achieved ‘but for’ the impact of COVID-19 may provide useful information, particularly when assessing the financial impacts from COVID-19 on the group.
Since comparable data from independent comparable transactions or companies from other time periods, such as average returns in preceding years, may not provide a sufficiently reliable benchmark for the current period, the guidance suggests several approaches to assist in determining the applicable transfer price, such as the use of reasonable commercial judgement supplemented by contemporaneous information on the market; the use of more than one transfer pricing method; utilization of data from other crises may be used to support price setting; and where applicable, recommends that the tax authorities will allow tax payers to make amendments to FY 2020 tax returns such that transfer prices are set on an arm’s length basis and using comparable information which will only become available on a later stage. The guidance also suggests considering including loss making comparables in the benchmark, subject to applicability.
Losses and the Allocation of COVID-19 Specific Costs
During the COVID-19 pandemic, many MNE groups have incurred losses due to a decrease in demand, inability to obtain or supply products or services or as a result of exceptional, non-recurring operating costs. The allocation of losses between associated entities can give rise to dispute and hence is an issue that requires consideration given the probable increase in the frequency and magnitude of losses in the current economic environment. When considering the issue of losses and the allocation of COVID-19 specific costs, three issues warrant specific discussion:
- First, it is important to emphasize that the allocation of risks between the parties to an arrangement affects how profits or losses resulting from the transaction are allocated at arm’s length through the pricing of the transaction;
- Second, it is necessary to consider how exceptional, non-recurring operating costs arising as a result of COVID-19 should be allocated between related parties. These costs should be allocated based on an assessment of how independent enterprises under comparable circumstances operate.
- Third, the option to apply force majeure clauses, revoke or otherwise revise the intercompany agreements are to be considered and not automatically be applies.
It will be necessary to consider the specific facts and circumstances of each intercompany transaction when determining whether a so-called “limited-risk” entity (such as an LRD or a service provider) could incur losses at arm’s length. In determining this, the risks assumed by an entity will be particularly important. This reflects the fact that at arm’s length, the allocation of risks between the parties to an arrangement affects how profits or losses resulting from the transaction are allocated. The extent of the loss that may be earned at arm’s length will be determined by the conditions and the economically relevant characteristics of transaction, compared to those of comparable uncontrolled transactions, including application of the most appropriate transfer pricing method.
Allocation of operating or exceptional costs would also follow risk assumption and how third parties would treat such costs. Some costs, may be deemed as pass through, for example. Amendments to intercompany agreements may also be considered, under the same rules.
Government Assistance Programs
Governments may directly subsidize the labor costs incurred in undertaking certain activities or may indirectly support businesses through the provision of local infrastructure, or other benefits. Governments have also provided broader financial and liquidity supports to ensure enterprises can continue to operate through the period of reduction in business activity. The terms and conditions of government assistance programs related to COVID-19 need to be considered when determining the potential impact of these programs on controlled transactions. If the government assistance is an economically relevant characteristic, this information should be included as a part of the documentation to support the transfer pricing analysis.
The economic circumstances of the market in which the party receiving government assistance operates could also influence the pricing of the controlled transaction. Thus, the analysis of the effect of government assistance on the price of a controlled transaction should take into account the allocation of the economically significant risks under the controlled transaction, the impact of the pandemic on the outcome of the economically significant risks, and the linkage between the type of government assistance and those risks. Caution should be exercised in assessing whether a purported sharing of government assistance represents an arm’s length outcome.
Advance Pricing Agreements (“APAs”)
COVID-19 has led to material changes in economic conditions that were not anticipated when many APAs covering FY2020 and potentially future financial years affected by COVID-19 were agreed. Given this situation, it is important to determine to what extent, if any, the change in economic conditions affects the application of existing APAs.
Some taxpayers may face challenges applying existing APAs under the economic conditions resulting from the COVID-19 pandemic. In those instances, taxpayers are encouraged to adopt a collaborative and transparent approach by raising these issues with the relevant tax administrations in a timely manner. Tax authorities are also urged to consider which action is best suited for each APA: a revision of the APA, a cancellation, or a revocation. The guidance continues to describe which action would fit under which circumstances.
The guidance published by the OECD, in most aspects, repeats the principles adopted by the OECD under the TPG. Thus, incurring losses (or the non-generation of profits) in a limited risk (or no-risk) subsidiary is not trivial and should be carefully documented, in what we internally refer to as a “Corona File”, when prepared by us.
Groups that wish to amend the intercompany pricing due to the COVID-19 effects, must document the effects on the group and support its amendments with data such as published by third parties and budget vs. actual results.
The above is general information only and does not constitute legal consultation. Our firm assists in preparing the relevant documentation and represents MNEs in APA and MAP proceedings. We encourage you to address any question to one of our partners listed below.