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:

1. Which entities should bear the costs/losses incurred as a result of COVID-19?
2. How should companies manage existing agreements?
3. In both setting and testing prices, what are the challenges around comparability, and what are the options to address this?
4. What other options are tactically available in the short term to manage capital requirements and tax risk?
5. Is there a need for a longer-term policy adjustment, or restructuring?
6. What are the next steps to implement this in a sustainable way?

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:

• Market risk due to the collapse in demand for some products and services;
• Operational risk due to the disruption to supply chains; and 
• Financial risks due to increased borrowing costs for some industries, and increased risk of customers defaulting on payments.

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:

• Is it possible for a “limited risk” entity to make a loss? The OECD Guidance states that “simple or low risk functions in particular are not expected to generate losses for a long period of time”. While it is generally accepted that a “limited risk” entity would not typically have volatile profitability or bear ongoing losses, it allows the possibility that routine functions may incur losses in the short run.
• From what risk factors can the loss arise? In determining whether a “limited-risk” entity may incur losses, the risks assumed by an entity will be particularly important and need to be linked to the risks it bears and can conceivably manage. For example, where there is a significant decline in demand due to COVID-19, a “limited-risk” distributor (“LRD”), with limited inventory ownership via the use of “flash title” may still assume some market risk due to lower demand, and may at arm’s length earn a loss associated crystallization of this risk. Conversely, an LRD that does not assume credit risk from defaulting customers should not bear associated losses resulting from the write-off of bad debt.
• Does the entity contractually bearing these risks bearing the corresponding loss, does it have the financial capacity to bear the risk, and is this in line with third party comparables? The extent of the loss that may crystallize at arm’s length will be determined by the conditions and the economically relevant characteristics of the tested transaction compared to those of comparable uncontrolled transactions. It will be important to assess the contractual arrangements, observe the LRD’s financial capacity to bear these losses, and assess the nature of third party comparables used to support the arm’s length nature of the transaction.

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:

• Exceptional costs should generally be excluded from the net profit indicator except when those costs relate to the controlled transaction. 
• The exclusion of exceptional costs must be performed consistently at the level of the tested party and the comparables to ensure a reliable result, for example, both realized above EBIT level.
• When determining the cost basis of a charge, it will be important to consider whether the basis should:
  • ­ Include exceptional costs: This would be selected in the case that the counterparty (i.e. service recipient) was managing and bearing the risks associated with that cost, in which case the costs would be transferred to the counterparty; or
  • Exclude exceptional costs: This would be selected in the case that the tested party (i.e. service provider) managed and bore the risks, in which case the costs would be retained in the tested party.
• Adjustments for accounting may be used to improve comparability, and to eliminate the effect of differing accounting practices between the controlled and uncontrolled transactions. For example, exceptional costs arising from COVID-19 may be accounted for as either operating or non-operating items in different jurisdictions.

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:

• Claw back of losses: This allows the renegotiation of contracts in order to ensure future compensation to the routine entities which contributed during the downturn period. More specifically, in the case where the economic conditions have improved, the LRD could be paid a higher than routine margin to compensate for its contribution in the crisis period; or
• Minimum operating margin: This would ensure a minimum targeted operating margin in the case an LRD is expected to make losses, including a stop gap mechanism, if the strategy decided by the group assumes that LRDs should not be affected by the poor economic conditions.

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:

• Sales volumes and channels: 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-19 years; 
• Capacity utilization: An analysis of the change in capacity utilisation relevant for the MNE group and the controlled transaction, and/or transactions with independent parties; 
• Exceptional costs: Specific information relating 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;
• Budget vs. actual data: A comparison of internal budgeted/forecasted data relating to sales, costs and profitability, compared to actual results, with an explanation of the variance due to COVID-19.

Assessment of external market data includes:

• Government assistance: 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, and the extent to which it may have affected the pricing and performance of controlled transactions;
• Interim financial statements: Information from interim financial statements such as quarterly SEC filings or earnings releases, in order to benchmark a comparison with the prior year. This will, however, only cover a limited number of companies and will not provide a view of the whole year;
• Macroeconomic information: This includes country-specific Gross Domestic Product (“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, especially when coupled with statistical methods such as regression analysis or variance analysis; and
• Historical information: An analysis of the effects on profitability or on third party behaviour observed in previous recessionary periods or using any data available in the current year, even if partial. The OECD Guidance notes, however, state that it will be difficult to fully replicate the unique economic circumstances of the pandemic with historical information, and that this analysis should be used with caution.

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: This includes, for example, a one-off COVID-19 hardship contribution for 2020, rent contribution, or marketing subsidy, and are typically treated as part of the entity’s operating income; or
• Capital-based contributions: Examples include a loan or capital injection.

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:

• Functional profile: Reviewing the functional profile of each entity of the group to determine any changes to the entities which perform key value contributing functions, assume the significant risks and hold/use the key assets.
• Remuneration: Based on the functional profile, determine whether the remuneration of each entity of the group is still consistent with its value contribution. Entrepreneurial or risk-bearing entities, which both manage and have the financial capacity to bear risk, should receive the residual profit or support the losses relating to the concerned intragroup transactions, with routine entities maintaining more stable returns.

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:

• Consider the business and value drivers as fundamentally different from pre-crisis, recognize the adjustment of functions, assets and risks across the group, and amend the transfer pricing policy accordingly; or
• Consider the business insufficiently impacted, or impacted only to a temporary degree, ensure the current transfer pricing policy can be supported (if needed with comparability adjustments or explanations of the exceptional circumstances for the period) and continue with the existing policy.

• Assess the impact of COVID-19: Review the impact of COVID-19, including any exceptional losses, and document the internal reasons for any exceptional costs or losses.
• Consider the need for pricing adjustments: Assess the current transactions, including contractual arrangements, delineation of functions, assets and risks, and determine where pricing adjustments need to be made based on existing policies.
• Collate internal and external comparability data: In the case that comparability analyses are performed, i.e. benchmarking studies to support the returns, collect external market data on the impact of COVID-19 on similar industries and products to augment the internal data collated for comparability adjustments.
• Review intercompany contracts and APAs: Review intercompany agreements and determine if any adjustments are needed, and whether the use of force majeure or renegotiations are appropriate. Likewise, in the case that an APA has been agreed, review the terms to assess if a critical assumption has been breached, and if so, contact the relevant tax administration.
• Manage short term losses and liquidity risk: Where existing transactions do not allow for an arm’s length result to be achieved, or negative capital is an issue, consider alternative income or capital contributions to manage local operating profit.
• Assess the need for restructuring or policy changes: Determine the need for a longer-term change in transfer pricing model or pricing policy based on business changes.