Transfer Pricing documentation relating to FY 2020 will need to be prepared and filed this year. TP and the arm’s length principle are tricky enough concept but adding COVID-19 and its implications into the mix will give any head of tax, grey hair.
Typical questions we have heard clients asking include:
- How will we demonstrate in future that losses or low profits were not due to any transfer mispricing but rather as a result of the pandemic?
- How do we justify in future that we put interest charges in relation to the intercompany loan to our related party, on hold?
- Should we be renegotiating our intercompany related party arrangements based on current circumstances?
Fortunately, in December 2020, the OECD provided some guidance in this regard in its report titled “Guidance on the transfer pricing implications of the COVID-19 pandemic”. The stated purpose of the report was to provide both taxpayers and tax authorities with guidance regarding the application of the arm’s length principle and the OECD transfer pricing guidelines, to issues that may arise, or be exacerbated, in the context of the COVID-19 pandemic.
Four priority issues were identified in the report, namely:
- comparability analysis
- losses and the allocation of COVID-19 specific costs
- government assistance programs
- advanced pricing agreements or APAs.
The full report is available on the OECD website, on the following link: https://doi.org/10.1787/731a59b0-en.
The OECD clarifies in the report that this COVID-specific guidance does not replace or expand on the OECD’s transfer pricing guidelines. And, in fact, the OECD has reiterated, through this report, that the arm’s length principle remains the correct standard to evaluate controlled transactions, even in relation to the impact of COVID. Throughout the report, significance continues to be given by the OECD to consideration of the specific facts and circumstances, which should include “accurate delineation” of the controlled transaction.
Tax administrations are advised in this guidance to consider a pragmatic approach where it is clear that taxpayers are making bona fide efforts to determine arm’s length prices in the context of a lack of available information associated with the pandemic. It is therefore important for taxpayers to make reasonable effort to do this, while remaining flexible and using reasonable commercial judgment, supplemented, as far as possible, with contemporary information.
The first issue highlighted by the OECD: Comparability
How are we supposed to perform a comparability analysis when, often, particularly when applying the transactional net margin method, we are relying on historical data to do these analyses? Financial data from 2017 –2019 would not reflect the drastically different financial environment in 2020.
Well, given that contemporaneous uncontrolled information reflects how independent parties are being affected in a substantially similar economic environment, the OECD proposes that, ideally, businesses should seek to contemporaneously document how, and to what extent, they have been impacted by the pandemic. Sources of information which the OECD says could be used include, amongst others,
- an analysis of changes in sales volumes
- an analysis of changes in capacity utilization
- quantification of the effects of any government assistance received
- macro-economic information like country-specific GDP data
- a comparison of budgeted and actual costs and results-in other words, what would the financial outcomes have been but for COVID’s impact?
Obviously, the idea here would be for the taxpayer to be able to prove that the negative financial impact in 2020 was snot due to Transfer mispricing but rather as a consequence of the pandemic.
The guidance also proposes that tax administrations be flexible and pragmatic in their consideration of the approach followed by a taxpayer to collect data and information for a TP analysis and should, as far as possible, ensure access to mutual agreement procedure, or MAP, for taxpayers.
Regarding the period of data used to evaluate arm’s length pricing, it is suggested that separate testing periods be used for the duration of the period in which the material effects of the pandemic were most evident. But, as with all TP comparability analyses, the type, and the extent to which, adjustments to a comparability analysis are relevant and required, should be determined on a case-by-case basis. Accurate delineation of the controlled transactions remains as relevant, and as important, as ever.
The second issue highlighted by the OECD: TP guidance on losses and the allocation of COVID-19 specific costs
The pandemic, classified by the OECD as a “hazard risk” (which is an external risk which causes damage or harm if it materializes), has resulted in the materialization of many other risks, such as market risk and financial risk.
As we know, the allocation of risks between parties is a determining factor in how profits or losses associated with that specific transaction, are allocated at arm’s length.
In answer to the question “Should a limited risk entity incur losses?”, yes -they can, but -per the OECD TP guidelines, “simple or low-risk functions are not expected to generate losses for a long period of time”.
When performing a comparability analysis, comparables selected should be suitable, taking the risks assumed by the parties to the control transaction into account. Obviously, a Limited Risk Distributor (“LRD”)that does not assume, for example, credit risk, should not bear the losses derived from the realization of that credit risk.
As regards the question of whether an entity should be re-negotiating its intercompany related party arrangements…It is important for that entity to consider factors such as:
- the options realistically available
- the long-term effects on the profit potential of the parties
- whether any party should be indemnified against any harm which could result from the renegotiation
- would independent parties, acting at arm’s length and under comparable circumstances, consider re-negotiation of contracts.
An interesting point is made in the guidance around the incurrable operating costs due to the pandemic-such as expenditure on personal protective equipment and expenses spent on the reconfiguration of workspaces to enable physical distancing.
For those costs that are deemed to be “exceptional” or “non-recurring”, they would generally be excluded from the net profit indicator relating to the controlled transaction. However, the point made by the OECD in this regard is that certain of these costs may not be viewed as “exceptional” or “non-recurring” if those costs relate to long-term or permanent changes in the business operations.
The third issue highlighted: TP guidance on government assistance programs
What is “government assistance” in this context? The guidance states that government assistance is a monetary or non-monetary program in terms of which a government provides a direct or indirect economic benefit to eligible taxpayers. This can be in the form of grants, tax deductions, etc.
To be considered in the context of COVID, and specifically -whether the receipt of such government assistance would be translated into an entity’s pricing strategy-is the extent to which the receipt of such government assistance is an economically relevant characteristic with respect to the control transaction. Obviously, if it is determined to be an economically relevant characteristic, this information should be included in the documentation prepared to support the TP analysis.
Also important to consider would be –
- which party is allocated the economically significant risks
- the impact of the pandemic on the outcome of that economically significant risks and
- the impact of any government assistance on the mitigation of the risks materializing.
Further, the receipt of government assistance may be seen to be a local market feature-in which case the current OECD guidance regarding local market features would remain applicable.
The fourth issue highlighted: APA’s
The final issue addressed in the guidance by the OECD relates to advance pricing agreements, APA’s. TheGuidance reaffirms that APA’s are useful instruments to ensure tax certainty. It goes on to say that existing APA’scannot be automatically disregarded based on changes in economic circumstances-and this is true for both taxpayers as well as tax authorities. Any determination of a breach in a critical assumption should be analyzed on a case-by-case basis. In the absence of applicable domestic law in this regard, such a breach is a critical assumption could have three potential outcomes, namely, revision of the APA, cancellation of the APA, or revocation of the APA in cases where a taxpayer’s neglect, carelessness or wilful default results in a misrepresentation, mistake or omission, or where a taxpayer fails to comply with a material term or condition of the APA.
Taxpayers and tax authorities alike need to be innovative and flexible to ensure collaborative working when it comes to negotiating APA’s.
The key takeaways from this report
In my view, the key takeaway is that companies will need to put in a substantial amount of effort into documenting the effect of the pandemic on their operations, documenting their Transfer Pricing policies applied in 2020 –including changes to those policies, and why they believe that their actions in 2020 were warranted and in accordance with the arm’s length principle.
