On 18th December 2020, the OECD released transfer pricing guidance in the context of COVID-19, covering issues such as comparability analyses, the allocation of losses/costs between group entities, and the termination or renegotiation of existing intercompany agreements. Given the onset of year-end closing for many companies, it will be important to proactively assess the impact of COVID-19, any adjustments required for this fiscal year, and determine appropriate support for transfer pricing compliance and a sustainable approach going forward.
The unprecedented economic impact of COVID-19 has led to practical challenges for many companies. During this period, many multinational enterprises (“MNEs”) have faced disruption to their supply chains, undergone changes to their business models, and have been required to scale down or close their operations during lockdown periods. This has resulted in reduced output and revenues, constraints in cash flow, and volatile profitability for many companies.
MNEs applying transfer pricing rules for the financial years impacted by the COVID-19 pandemic will need to allocate profits (or losses) in accordance with the arm’s length principle, and to anticipate potential questions and challenges from the tax administrations which will evaluate their submissions.
On 18th December 2020, the OECD released a paper on “Guidance on the transfer pricing implications of the COVID-19 pandemic” (“OECD Guidance”), focusing on how the arm’s length principle and the OECD Transfer Pricing Guidelines released in 2017 (“OECD TPG”) apply to issues arising in the context of the COVID-19 pandemic. These include comparability analyses, the allocation of losses and COVID-19 specific costs between entities in a group, and direction on how to manage existing intercompany and Advanced Pricing Agreements (“APAs”).
This article aims to place this guidance in the context of the practical questions being asked by many companies, including:
During the COVID-19 pandemic, many MNEs will have incurred losses due to a decrease in demand, inability to obtain or supply products or services or as a result of exceptional costs such as the requirement to temporarily close their operations. The OECD Guidance covers the treatment of profits or losses, as well as exceptional costs, with reference to the allocation of risks between the parties to an arrangement.
How can profits/losses be allocated?
The COVID-19 pandemic has led to heightened risks for some taxpayers, in particular:
In order to support the allocation of costs or losses, companies will need to determine how the entities in the group respond to the manifestation of these risks, and its subsequent effects on the controlled transaction. Key considerations include:
How should exceptional costs be allocated?
In order to determine which entities should bear exceptional costs, companies should indicate who has the responsibility for performing activities related to the relevant costs, and who assumes risks related to these activities. For this, the OECD Guidance sets out some key principles:
Can companies modify intercompany agreements or invoke a force majeure clause?
In response to the COVID-19 pandemic, independent parties could seek to renegotiate certain terms in their existing agreements, in order to support the financial survival of the transactional counterparties (given the potential costs or disruptions required to enforce the contractual obligations), or in view of anticipated increased future business with the counterparty.
Associated parties may therefore also consider the option to apply force majeure clauses, revoke, or revise their intercompany agreements. This may impact the allocation of losses and COVID-19 specific costs between associated parties. Associated parties may also consider revising their intercompany agreements and/or their conduct in their commercial relationships.
Renegotiation of the intercompany agreement could, for example, allow the consideration of a “hardship” clause to cover cases in which unforeseen events occur that fundamentally alter the equilibrium of a contract resulting in an excessive burden being placed on one of the parties involved, for instance:
Where one party to a controlled transaction seeks to invoke force majeure or to renegotiate the contract, the agreement and underlying legal framework should form the starting point of the transfer pricing analysis. An assessment of the economic circumstances surrounding the commercial arrangement is also relevant to determine whether an independent party would decide to invoke a force majeure clause. Commercial considerations may include the level, length of time, and impact of the disruption to the relevant company, as to whether this clause could be legally invoked and to review the force majeure clause in the context of the overall relationship and contractual agreement.
How should APAs be treated?
The terms of the agreement are also to be considered for the review of terms of existing APAs. Generally, the OECD Guidance states that existing APAs and their terms should be respected, maintained and upheld, unless a condition leading to the cancellation or revision of the APA (e.g. breach of critical assumptions) has occurred.
An assessment of a potential breach should be analysed on a case-by-case basis, considering the individual circumstances of the taxpayer and its commercial environment. If a breach has occurred, in determining an appropriate response, a tax administration would carefully consider the extent of the divergence between the agreed parameters in the APA and the new parameters under the COVID-19 economic circumstances; as well as the ability of the agreed transfer pricing methodology to reliably reflect arm’s length pricing of a controlled transaction under the new situation.
Where tax administrations establish that the critical assumptions of an APA have not been breached, the existing APA, as agreed, should continue to be respected, maintained and upheld. If a taxpayer believes that the terms of the APA are no longer appropriate, it should approach the relevant tax administration in a transparent way to discuss their concerns.
What are the challenges of performing comparability analyses?
Taxpayers typically rely on historical information from commercial databases in order to set and test intercompany prices. For example, financial data pertaining to 2020 will typically not be available until mid-2021, since financial statements tend to be lodged only several months after the period to which they relate.
In these circumstances, taxpayers will need to perform comparability analyses based on available prior year financial information and, depending on the facts and circumstances of the case, utilize whatever current year information is available to support their transfer prices. This will be difficult to justify, given the volatile environment and challenging market in 2020 compared to prior years.
What internal and external data can be used to make qualitative statements or adjustments?
The OECD Guidance sets out examples of data points which can be used to explain or adjust the comparability analysis by estimating the effect of the COVID-19 pandemic on the controlled transactions.
Assessment of the taxpayer’s financial and operational data includes:
Assessment of external market data includes:
Based on the above analysis, MNE groups should aim to set the intercompany pricing, and subsequently, test and document the transactions, using the best available market evidence currently available. This may be in the form of internal or external comparables, or other relevant evidence of the economic impact of the COVID-19 pandemic, including its effects on the level of demand for goods and services, and on production and supply chains sectors of the economy.
How can lossmaking entities be benchmarked?
In a typical year, it is common practice for taxpayers to apply some type of loss screening to benchmark routine companies. However, there is no overriding rule on the inclusion or exclusion of loss-making comparables in the OECD TPG. As stated in the OECD Guidance, “loss-making comparables that satisfy the comparability criteria should not be rejected on the sole basis that they suffer losses in periods affected by the COVID-19 pandemic.” Consequently, taxpayers performing a comparability analysis for 2020, even for routine entities, may find it appropriate to include loss-making comparables, where the comparables assume similar levels of risk and that have been similarly impacted by the pandemic.
In the instance where there are no transactions through which an appropriate adjustment can be made (i.e. remuneration for the provision of goods or services, or in the case that the tested party is typically risk-bearing), companies may also face challenges in finding appropriate mechanisms to support loss-making companies. However, as well as reaching an arm’s length outcome, managing losses can be important to manage local tax risk, for instance, or to avoid companies falling into a negative capital situation.
Appropriate support depends on the nature of the existing relationship between the entities, and as mentioned above, the contractual allocation of risk. Several options exist, ranging from income to capital contributions, in order to support local operations. These include:
Income-based contributions have the advantage of impacting the operating profit of the entity, potentially decreasing the risk of losses and challenge from the local tax authorities. However, the taxpayer would need to justify the arm’s length nature for the contribution, demonstrating that a third party would also have acted in this way under similar circumstances, in order also to justify deductibility of the contribution for the payer.
Conversely, whilst loans and capital contributions would also improve the cash balance and working capital of the tested party, a loan would require the payment of interest expense by the tested party, further reducing its profitability. There are also instances where a third party would refuse to grant a loan under similar terms (or at all) to a group entity on a standalone basis. The taxpayer would additionally need to justify the arm’s length nature of the loan transaction. Therefore, in cases where the result of the tested party is likely to be subject already to challenge by the tax authorities, it may preferable to rely on income-based contributions and find market-based justifications for the payment.
The considerations above primarily cover support for the short term but given the longer-term impact of COVID-19, companies may wish to consider the extent to which their operating models and transfer pricing policies are still appropriate. This can be in response to changes in the business operations (i.e. increased digitalization or changes to working locations), amendments to supply chains, differing business channels (online vs. retail), or alternatively, a differential in the risks the business is bearing.
Given the potential functional changes within the group, and to support the linkage between value creation and remuneration, it would be a good opportunity to review the location of key value drivers of each Group with a focus on the allocation of their functions, risks and assets. By performing a Value Chain Analysis (“VCA”), Groups will understand the location of their profit creation and allocate the Group’s profits accordingly between the entities. This requires a review of:
This exercise is crucial during a global crisis in order to determine the functional profile of each entity and therefore decide on the envisaged actions to be taken. The two options are typically: