KPMG report: OECD guidance on the transfer pricing implications of the COVID-19 pandemic
OECD guidance on the transfer pricing implications
The Organisation for Economic Co-operation and Development (“OECD”) released guidance on the application of the arm’s length principle in the context of the coronavirus (COVID-19).
The OECD report is titled Guidance on the transfer pricing implications of the COVID-19 pandemic (18 December 2020).
The following discussion provides impressions about the OECD Guidance.
The unique economic conditions arising from COVID-19 and government responses to it have resulted in challenges for the application of the arm’s length principle. In order to enhance tax certainty in the face of such challenges, the Guidance attempts to clarify and illustrate the practical application of the arm’s length principle in the context of COVID-19.
The Guidance emphasizes that the OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations 2017 (“OECD TPG”) should continue to be relied upon when performing a transfer pricing analysis, including under the possibly unique circumstances introduced by the pandemic. Accordingly, the Guidance focuses on how the arm’s length principle and the OECD TPG apply to issues that may arise or be exacerbated in the context of COVID-19, rather than on developing specialized guidance beyond what is currently addressed in the OECD TPG. The Guidance represents the consensus view of the 137 members of the Inclusive Framework.
Overview of the Guidance
The Guidance focuses on four priority issues where the additional practical challenges posed by COVID-19 are considered most significant:
- Comparability analysis
- Losses and the allocation of COVID-19 specific costs
- Government assistance programs
- Advance pricing agreements (APAs)
The Guidance emphasizes that while the four issues have been presented as discrete topics for ease of presentation, these topics may be interrelated and therefore need to be considered together and within the analytical framework of the OECD TPG. Within each of the four priority issues, the Guidance addresses several questions.
The Guidance addresses many of the most challenging issues raised by COVID-19 for transfer pricing analyses. A common theme of the Guidance is that an appropriate arm’s length response to any issue will depend upon the facts and circumstances of the transaction under consideration. Unsurprisingly, given the range of facts and circumstances encountered by taxpayers and the need for consensus from 137 countries, the Guidance provides general principles for evaluating the arm’s length response without providing specific solutions. Nevertheless, the Guidance is seen by tax professionals as being helpful in that it provides useful discussion of the various factors that should be considered in making arm’s length pricing determinations under conditions impacted by COVID-19. Additionally, the Guidance’s encouragement of pragmatism and flexibility provides a welcome practicality to addressing some challenging transfer pricing issues. It remains to be seen how different tax authorities incorporate the suggestions in the Guidance in their dealings with taxpayers.
The Guidance related to each of the four priority areas is summarized below.
I. Comparability analysis
The Guidance acknowledges that COVID-19 has created unique challenges for performing comparability analyses. Taxpayers and tax administrations may be required to consider practical approaches, consistent with the transfer pricing policy of the taxpayer over time, to address such challenges. The Guidance addresses comparability analyses in a series of nine questions, as described below.
1. What sources of contemporaneous information may be used to support the performance of a comparability analysis applicable for 2020? The Guidance notes that, in principle, any form of publicly available information regarding the effect of COVID-19 on the business, industry and controlled transaction may be relevant in ascertaining the arm’s length nature of an enterprise’s transfer pricing policy implemented for 2020. It lists several possible sources of information, such as an analysis of how sales volumes have changed during COVID-19, exceptional costs, etc.
2. Can budgeted financial information be used to support the setting of arm’s length prices? The Guidance notes that financial outcomes that taxpayers within a controlled transaction would have achieved “but for” the impact of COVID-19 may provide useful information for assessing the financial impacts from COVID-19 and determining any appropriate resulting impact on intercompany prices.
3. Under what circumstances are timing issues most pronounced? According to the Guidance, timing issues may be most notable in the application of the transactional net margin method (TNMM) since 2020 information will typically not be available until mid-2021 at the earliest. However, not every application of the TNMM will in principle require contemporaneous information for 2020, such as when a long-term arrangement that insulates the tested party from risks related to the pandemic is in place.
4. What practical approaches may be available to address information deficiencies? The Guidance encourages tax administrations to consider pragmatic approaches for addressing the paucity of reliable benchmarks in order to minimize disputes where taxpayers are making good faith efforts to determine arm’s length prices. These pragmatic approaches include:
- Allowing for the use of reasonable commercial judgement supplemented by contemporaneous information to set a reasonable estimate of the arm’s length price
- Where feasible, instead of a “price-setting” or ex ante approach, allowing for an arm’s length outcome testing approach, which may incorporate information that becomes available after the close of the tax year in reporting results on the tax return. Given the potential for double taxation that may arise as a result of post-close adjustments, tax administrations could consider:
- Allowing “compensating adjustments” to be made before the tax return is filed
- Ensuring access to the MAP, or an alternative procedure, to avoid double taxation
- Using more than one transfer pricing method in order to corroborate the arm’s length price
5. Can data from other crises be used to support price setting? The Guidance notes that a comparability analysis should be performed by reference to the specific delineation of the controlled transaction, including its actual economic circumstances. A comparability analysis that is solely based on financial information from the global financial crisis of 2008 / 2009 would raise significant concerns given the unique and unprecedented nature of the COVID-19 pandemic.
6. How might the period of data used to evaluate arm’s length pricing be established to support a comparability analysis? The Guidance notes that the principles outlined in the OECD TPG regarding the use of multiple year data and averages remain applicable. As a pragmatic approach, in some fact patterns it may be appropriate to have separate testing (or price setting) for periods most impacted by the pandemic. In other fact patterns, the use of combined periods (that include both years that are impacted by the pandemic and years that are not impacted) may improve reliability.
7. Would price adjustment mechanisms be appropriate? Per the Guidance, price adjustment mechanisms that allow the adjustment of prices relevant for 2020 in a later period, to the extent permissible by domestic law, may provide for flexibility while maintaining an arm’s length outcome. However, care would need to be taken with their appropriate characterization, any effects that the payment may have on the comparability analysis for 2021, and their potential resultant VAT/GST and customs duty implications.
8. What actions may be taken to evaluate the set of comparable companies or transactions used? When a taxpayer rolls forward an existing set of comparables to cover 2020, it may be necessary to review and revise the set based on updated search criteria. For example, if geography is considered the most relevant comparability factor given the effects of COVID-19, it may potentially be necessary to relax other comparability criteria to obtain reliable data from the selected market.
9. Can loss-making comparables be used? In general, there is no overriding rule on the inclusion or exclusion of loss-making comparables in the OECD TPG. Accordingly, the Guidance notes that loss-making comparables that satisfy the comparability criteria in a particular case should not be rejected on the sole basis that they suffer losses in periods affected by the COVID-19 pandemic.
II. Losses and allocation of COVID-19-specific costs
The Guidance provides three general principles on the allocation of losses between associated entities.
- First, the allocation of risks between the parties to a transaction affects how profits or losses resulting from the transaction are allocated at arm’s length.
- Second, exceptional, non-recurring operating costs arising as a result of COVID-19 should be allocated based on an assessment of how independent enterprises under comparable circumstances operate.
- Finally, associated parties may consider whether they have the option to apply force majeure clauses, revoke or otherwise revise their intercompany agreements.
The Guidance then addresses a series of five questions related to losses and the allocation of Covid-19 specific costs.
1. Can entities operating under limited-risk arrangements incur losses? The Guidance emphasizes that it will be necessary to consider the specific facts and circumstances when determining whether a so-called “limited-risk” entity could incur losses at arm’s length. The OECD TPG, which states that “simple or low risk functions in particular are not expected to generate losses for a long period of time,” holds open the possibility that simple or low-risk functions may incur losses in the short run. In determining whether a “limited-risk” entity may incur losses, the risks assumed by the entity will be particularly important. For example, a “limited-risk” distributor that assumes some marketplace risk may at arm’s length earn a loss associated with the playing out of this risk. However, it will not be appropriate for a “limited-risk” distributor that does not assume any marketplace risk or another specific risk to bear a portion of the loss associated with the playing out of that risk. Additionally, according to the Guidance, consideration should be given to whether a taxpayer is taking inconsistent positions pre- and post-pandemic and, if so, whether either position is consistent with the accurate delineation of the transaction.
2. Under what circumstances may arrangements be modified to address the consequences of COVID-19? The Guidance notes that the determination of whether a renegotiation is arm’s length should be based on what independent parties would do under comparable circumstances. Determining whether a renegotiation represents the best interests of the parties to a transaction requires careful consideration of their options realistically available and the long-run effects on the profit potential of the parties. Consideration should also be given to whether the economic impact resulting from the renegotiation may require indemnification. The Guidance emphasizes that in the absence of clear evidence that independent parties in comparable circumstances would have revised their existing agreements or commercial relations, the modification of existing intercompany arrangements should be treated with caution and well-supported by documentation outlining how the modification is in line with the arm’s length principle.
3. How should operational or exceptional costs arising from COVID-19 be allocated between related parties? Per the Guidance, it would first be necessary to accurately delineate the controlled transaction, which would indicate who has the responsibility for performing activities related to the relevant costs and who assumes risks related to these activities. Allocation of operating or exceptional costs between related parties should follow risk assumption and how third parties would treat such costs. The Guidance notes that certain operating costs may not be viewed as exceptional or nonrecurring in circumstances when the costs relate to long-term or permanent changes in the manner in which businesses operate.
4. How should exceptional costs arising from COVID-19 be taken into account in a comparability analysis? The Guidance provides three principles for considering how exceptional costs arising from COVID-19 should be taken into account in a comparability analysis.
- First, exceptional costs should generally be excluded, consistently at the level of the tested party and the comparables, from the net profit indicator except when those costs relate to the controlled transaction as accurately delineated.
- Second, given the accurate delineation of the transaction, if exceptional costs are included in the cost basis, it is important to consider whether such costs should be treated as pass-through costs.
- Third, adjustments for accounting consistency may be required to improve comparability when exceptional costs arising from COVID-19 may be accounted for as either operating or non-operating items by different taxpayers in different transactions.
5. How may force majeure affect the allocation of losses derived from the COVID-19 pandemic? Force majeure clauses may be invoked in order to suspend, defer or release an enterprise from its contractual duties without liability in certain situations. Per the Guidance, it cannot be automatically assumed that when a relevant intercompany contract contains a force majeure clause that the COVID-19 pandemic is sufficient for a party to that contract to invoke force majeure, nor can it be automatically assumed in the absence of such a clause in the intercompany contract that a renegotiation with a potentially similar outcome at arm’s length would be inappropriate. The Guidance encourages tax administrations to carefully review assertions of force majeure or renegotiation in light of the accurately delineated transaction and the economically relevant circumstances of the transaction.
III. Government assistance programs
According to the Guidance, the economic impact of government assistance programs related to COVID-19—such as grants, subsidies, forgivable loans, tax deductions, or investment allowances—on the accurately delineated transaction needs to be considered in a transfer pricing analysis. The Guidance addresses a series of five questions on government assistance programs.
1. Is the receipt of government assistance an economically relevant characteristic? The Guidance notes that extent to which the receipt of government assistance is an economically relevant characteristic may vary. Examples of government assistance that may be more economically relevant include the provision of a wage subsidy, a government debt guarantee or short-term liquidity support, when government assistance may have a direct impact on the controlled and comparable transactions. In comparison, assistance such as the provision of local infrastructure may be less economically relevant.
2. Is guidance on other local market features relevant when analyzing the transfer pricing implications of government assistance? As a general rule, government interventions should be treated as conditions of the market, per the OECD TPG. The Guidance notes that the analysis should consider whether the government assistance provides a market advantage to the recipient; the amount of any increase in revenues or decrease in costs that are attributable to the government assistance, and the duration of the assistance; the degree to which benefits of government assistance are passed on to independent customers or suppliers; and the manner in which independent enterprises operating under similar circumstances would allocate any benefits that are not passed on between them.
3. Does the receipt of government assistance affect the price of controlled transactions? According to the Guidance, the potential effect on the pricing will depend on the economically relevant characteristics of the transaction, an accurate delineation of the controlled transaction, and the performance of a comparability analysis. Some of the aspects to consider in analyzing the impact of government assistance on the price of a controlled transaction include the characteristics of the government assistance; the allocation of the economically significant risks; and the level of competition and demand within the relevant markets. The Guidance provides a discussion of each of these aspects. It also notes that in the absence of reliable information regarding how independent parties would allocate government assistance, caution should be exercised in assessing whether a purported sharing of government assistance represents an arm’s length outcome.
4. Does the receipt of government assistance modify the allocation of risk in a controlled transaction? The Guidance notes that while the receipt of government assistance may reduce the quantitative negative impact of a risk, this aspect must be distinguished from the allocation of risk under the guidance of Chapter I of the OECD TPG. Under that guidance, the provision of government assistance to an associated party will not change the allocation of risk in a controlled transaction for transfer pricing purposes.
5. Does the receipt of government assistance affect the comparability analysis? Per the Guidance, the receipt of government assistance may affect both how the parties establish their commercial or financial relations and how they price their transactions. Since government assistance and the specific circumstances of the COVID-19 pandemic may vary across different markets, it may affect the comparables and the arm’s length prices of uncontrolled transactions in different ways. Further, when applying a one-sided method such as the TNMM, the accounting treatment of the government assistance in both the tested party and any comparable may need to be specifically identified, especially when the tested party and the comparables apply different accounting standards.
The Guidance encourages taxpayers to adopt a collaborative and transparent approach by raising COVID-19-related issues with the relevant tax administrations in a timely manner. The Guidance separately addresses issues related to existing APAs and APAs under negotiation.
What impact does COVID-19 have on existing APAs?
1. Are taxpayers and tax administrations still bound by existing APAs in light of the changes in economic conditions? The Guidance notes 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.
2. Does the change in economic conditions constitute a breach of a critical assumption? Per the Guidance, whether there has been a breach in a critical assumption should be analyzed on a case-by-case basis. Where tax administrations establish that the critical assumptions of an APA have not been breached, the existing APA, as agreed, must continue to be respected. If a taxpayer believes that the terms of the APA are no longer appropriate, they should approach the relevant tax administration in a transparent way to discuss their concerns.
3. How should tax administrations respond to the failure to meet critical assumptions? Tax administrations and taxpayers should consider the (i) terms of the APA; (ii) any agreement between relevant tax administrations as to how to deal with the failure; and (iii) any applicable domestic law or procedural provisions. A breach of critical assumption with the APA could have three potential outcomes:
- Revision: The APA still applies for the whole of the proposed period, although different terms apply before and after the revision date. Revision would be the appropriate response when there has been a material change in conditions noted in a critical assumption in the APA and the tax administration and the taxpayer agree on how to revise the APA.
- Cancellation: The APA is in effect only up to the cancellation date. In the context of the COVID-19 pandemic, an APA may be cancelled if: (i) there is a material breach in an APA’s critical assumption; or (ii) the taxpayer failed to materially comply with any term of the APA. However, the tax administration may waive cancellation under certain circumstances.
- Revocation: The APA is treated as having never been entered into. Revocation may be considered when: (i) there is a misrepresentation, mistake or omission attributable to the neglect, carelessness, or willful default of a taxpayer; or (ii) the taxpayer fails to materially comply with a fundamental term or condition of the APA.
4. When should taxpayers notify tax administrations of the failure to meet critical assumptions? The Guidance encourages early notification when material changes in economic conditions lead to the breach of one or more of the critical assumptions—as soon as practicable after the change occurs, or the taxpayer becomes aware of the change.
5. How should taxpayers document the failure to meet critical assumptions? The Guidance provides a list of items that taxpayers should collect and provide tax administrations when the critical assumptions of an APA are breached. These include a description of the relevant taxpayer business segment; forecast and actual business segment profits; copies of modifications to pre-existing agreements or of new intercompany contracts; a narrative explaining the anticipated effects of the current economic conditions on an agreed transfer pricing methodology; a detailed profit and loss statement; and information about third-party behavior.
6. How should tax administrations respond to non-compliance with an existing APA? The Guidance suggests that tax administrations should approach the evaluation of non-compliance similarly to a situation involving a potential breach of a critical assumption. However, tax administrations are likely to respond differently to the failure to comply with the terms of an APA than to the failure to meet critical assumptions in terms of whether they cancel, revoke, revise or enforce an APA.
What impact does COVID-19 have on APAs under negotiation?
The Guidance encourages all parties to adopt a flexible and collaborative approach to determine how to account for the current economic conditions. For example, they could consider a short-period APA for the period affected by COVID-19 and a separate APA for the post-COVID period, consider certain retrospective amendments to the APA, extend the period of the APA, or use a cumulative or term test throughout the APA period. The Guidance notes that despite potential challenges, the value of achieving advanced certainty and effective dispute prevention through APAs remains compelling. Further, a range of reliable technological solutions are available to replace and/or complement traditional methods of communication.
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