On 18 December 2020, the OECD released guidance on the transfer pricing implications of the Covid-19 pandemic (hereafter, the “guidance”). The guidance represents the consensus view of the 137 members of the inclusive framework and provides clarifying comments on the practical application of the arm’s length principle regarding four priority issues. A detailed and KPMG Global view of the guidance can be found in the following link: OECD guidance on the transfer pricing implications - KPMG United States (home.kpmg)
This alert focuses on the Middle East market. It specifically considers how the guidance for each priority area may practically affect groups operating in some of the most impacted sectors in the region, being retail, manufacturing, construction and the sovereign wealth fund (SWF) sectors.
Please note that all examples included are for illustrative purposes only and are not based on any actual group fact pattern or operating structure.
The guidance recognizes that challenges associated with performing a comparability analysis may vary depending on the impact of the pandemic on the economic characteristics of the controlled transaction. The guidance gives an example of a controlled transaction being covered by a pre-existing inter-company agreement (for example, if in 2018 it was determined that at arm’s length a party should receive an agreed fixed return for five years, and that parties at arm’s length would remain bound by that agreement). The guidance proceeds to state that there is unlikely to be a need to perform a comparability analysis for FY20 provided that the facts and circumstances of the accurately delineated controlled transaction have not changed. In contrast, the guidance also states that where the arm’s length price of a controlled transaction is determined on an annual basis, it will be necessary to perform a comparability analysis. The guidance stresses the importance of the use of publicly available information regarding the effect of the pandemic on the business, industry and controlled transaction that may be relevant and should be documented as part of the transfer pricing documentation in ascertaining the arm’s length nature of an enterprise’s TP policy implemented for FY20.
Practical example: comparability adjustment
Case study: Family owned UAE headquartered retail group that uses the external Comparable Uncontrolled Price (“CUP”) method to reward its distributors in the KSA and Qatar.
Analysis: Based on the guidance issued, if the pricing has been set to cover a fixed number of years and there is no change in the facts and circumstances of the controlled transaction, it would be appropriate to continue to apply the same pricing policy as per the CUP benchmarking performed in previous years. If however, the pricing policy is set annually or the pandemic has significantly impacted the facts and circumstances of the controlled transaction, then a change in methodology or adjustment may well be justified. In this case, the group may well decide to move away from the CUP methodology and apply a Transactional Net Margin Method (“TNMM”) methodology as the CUP may no longer be considered comparable to the market conditions suffered by the business in 2020.
Due to the “short” tax return filing period in the certain jurisdictions within the Middle East (in this case, 30 April for KSA and Qatar), the group may well face timing issues, both in terms of TNMM comparable data availability and finding local comparables (which is preferred by the KSA General Authority of Tax and Zakat (“GAZT”) , as well as the time necessary to perform comparability adjustment analyses. In addition, tax authorities across the GCC have historically adopted a conservative approach on loss making entities in comparable sets (most notably KSA in this example). As a result, and where relevant, the inclusion of such loss-making companies in the new TNMM methodology proposed should be clearly articulated as part of the analysis and reference made to this new OECD guidance issued
Recommendations: In order to avoid tax authority challenge by GAZT or Qatar’s General Tax Authority (“GTA”), the rationale (and in the case of Qatar, approval from the GTA) of the change in pricing policy should be documented on a timely basis and publicly available contemporaneous information, for example, using an analysis of sales volumes or capacity utilization (to include lockdown impact) should be included as part of the transfer pricing documentation to justify any move away from a local comparable, adjustment or change in pricing proposed.
Losses and allocation of Covid-19 specific costs
The guidance recognizes that during the 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. It further acknowledges that the allocation of losses between associated entities can give rise to dispute. When considering the issue of losses and the allocation of Covid-19 specific costs, the guidance states that three issues warrant specific discussion, firstly, the allocation of risks between the related parties, secondly, how exceptional, non-recurring operating costs arising as a result of Covid-19 should be allocated between the associated parties and finally the conditions in which associated parties may consider whether they have the option to apply force majeure clauses, revoke or revise their intercompany agreements.
Practical example: losses and allocation of Covid-19 specific costs
Case study: KSA FMCG group with manufacturing operations in the UAE and Egypt
Prior to the pandemic the group entered into an intercompany agreement between its head office in KSA and its toll manufacturing entities in the UAE and Egypt to reward them on a TNMM cost plus 10% basis.
As a result of the pandemic, the toll manufacturing entities have had to endure forced closures and even when operations restarted, they have since been operating at limited capacity and have incurred significant exceptional costs in relation to meeting PPE and socially distance operation requirements. Given the costs incurred and exceptional losses suffered the group would like to invoke a force majeure clause in the contract to close several manufacturing entities in the UAE and Egypt permanently without liability.
Analysis: In such situations, the guidance, highlights that tax administrations should review the agreements and/or the conduct of the associated enterprises, in light of the guidance in Chapter I and IX of the 2017 OECD Transfer Pricing Guidelines (“TPG”), together with observations of relevant behavior of independent parties, in order to ascertain whether any such assertion, revision or negotiation should be respected under the OECD TPG, and that the TP outcomes are appropriate in light of the accurate delineation of the transaction.
Recommendations: The rationale and basis for invoking such force majeures must be carefully considered and any business restructurings should be thoroughly documented and contemporaneously included as part of the group’s transfer pricing documentation with specific reference to Chapter IX of the TPG.
Government assistance programs
Governments across the region have provided broad financial and liquidity support to ensure enterprises may continue to operate through the period of reduction in business activity. This includes job retention programs, subsidy of employee salaries, loan guarantees, direct financing to business on preferential terms, loan deferrals, specific grants and tax relief. The guidance recognizes that the terms and conditions of government assistance programs related to the pandemic need to be considered when determining the potential impact of these programs on controlled transactions and when comparing their effects with those of other pre-existing assistance programs.
Case study: Omani construction group providing loan financing to its UAE subsidiary
Analysis: An Omani head quartered construction group provides fixed and variable rate loans to a number of regional subsidiaries and itself enjoyed a reduction on interest rates on borrowing obtained centrally by way of Oman’s Central Bank economic stimulus package announced in March 2020.
From a transfer pricing perspective, such measures would raise questions around whether such benefits (in this case a reduction in the interest rate borne centrally) can be passed on to group subsidiaries who may also be experiencing cash flow issues arising from the pandemic.
Recommendations: The guidance supports a flexible approach in assessing whether prices can be adjusted in the case of such government support programs. Whilst it may be easier to make an adjustment in the case of where variable rates are charged, if it can be demonstrated that fixed rates would also be renegotiated by independent third parties then this should be documented. In either case, a thorough analysis of the loan agreements and any supporting evidence for an adjustment should be performed and retained as part of the group’s overall transfer pricing documentation.
Advance pricing arrangements
The pandemic has led to material changes in economic conditions that were not anticipated when many Advance Pricing Agreements (“APA”s) covering FY20 and potentially future financial years, affected by the pandemic were agreed. Some taxpayers may face challenges applying existing APAs under the economic conditions resulting from the 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. The guidance states that taxpayers should not seek to resolve them unilaterally without consulting with the relevant tax administrations.
Case study: GCC headquartered SWF with unilateral APA in the UK
Analysis: For groups with APAs in other jurisdictions, the guidance makes it clear that unless a critical assumption is breached or the taxpayer has failed to materially comply with any term or condition of the APA, the APA will still be expected to remain in force. Where a group is concerned that the pricing agreed per the APA is no longer sustainable, they should approach the relevant tax administration in a transparent manner to discuss their concerns.
Recommendations: Such discussions are likely to be relevant for a number of SWFs who may now be in the process of restructuring and streamlining their investments and operations in response to some of the pandemic’s long term consequences on their supply chain and portfolio investment objectives. In this example, it would be advisable for the group to proactively approach HMRC to consider such conversations, and where relevant, this dialogue should be entered into sooner rather than later. Furthermore, given the unpresented circumstances and guidance issued, now may be an opportunity for the group to explore or reconsider the possibility of entering into APAs or rulings regionally (for example, with the Egyptian Tax Authority or GAZT ) in order to prevent future challenges both within the Middle East and globally.
Overall, the guidance reaffirms the arm’s length principle and reiterates that the Transfer Pricing Guidelines are still considered the primary reference for guidance with no new approaches being proposed. The pandemic is considered a hazard risk and the risk framework of the TPG continues to apply. Functional analyses and comparability analyses are key in documenting and explaining the rationale for any change in transfer pricing policy applied for FY20 and any future adjustments proposed.
We note that regulators and tax authorities across the Middle East are yet to provide detailed Covid-19 guidance on TP matters and thus a more proactive approach (for example, engaging with tax authority contacts in advance of filings) may be advised to obtain more clarity and certainty where possible, on the best way to proceed in these extraordinary times. This is considered particularly pertinent given the ever evolving regional tax landscape as demonstrated by the recent implementation of substance reporting requirements (for example, Bahrain’s and the UAE’s Economic Substance Regulations) which are closely linked to transfer pricing and highlight the need for transfer pricing consistency and supporting documentation in this new era of international tax reporting in the Middle East.
For further information or to discuss any of the issues raised in this alert, please do not hesitate to reach out to our contacts noted below.