On 18 December 2020, the OECD published Guidance on the transfer pricing implications of the COVID-19 pandemic (OECD Guidance) providing guidance to taxpayers when applying the arm's length principle and applying the OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations 2017 (OECD TPG) for periods impacted by the COVID-19 pandemic.
This guidance emphasizes the use of the existing OECD TPG and the arm’s length principle to tackle difficulties caused or aggravated by the COVID-19 pandemic. It focuses upon transfer pricing and operating transactions but notably does not deal with transfer pricing of financial transactions such as interest on intragroup debt, other important intracompany transactions, such as management fees, are also not dealt with in the OECD Guidance.
The OECD Guidance should not be viewed as an extension nor as a modification of the OECD TPG.
The OECD Guidance is divided into these four sections to highlight challenges multinational enterprises (MNE) may encounter in complying with transfer pricing regulations as a result of COVID-19:
- Comparability analysis
- Losses and the allocation of COVID-19 specific costs
- Government assistance programs
- Advance pricing agreements (APAs)
1. Comparability analysis
COVID-19 has created challenges in the execution of comparability analyses, particularly because sole reliance on historical data to determine transfer pricing in the very unique economic situation encountered in 2020 ("FY20") has in many cases become unreliable.1 Taxpayers and tax administrations therefore need to adopt a practical approach to address these timing issues and other related information deficiencies. The first section of the OECD Guidance outlines several possible approaches and considerations that may support the preparation of comparability analyses for FY20:
- Use publicly available information documenting the effect of the pandemic on the economically relevant characteristics of the controlled transaction, and analyze financial information of the MNE group and/or parties to the transaction (e.g., sales volume, capacity utilization, costs, government assistance or intervention, interim financial statements, macroeconomic and industry specific indicators, statistical analysis). It is important to recognize that where interim (e.g., quarterly) financial information for independent firms is evaluated, there may be significant variability among companies regarding the impacts of COVID-19.
- The use of taxpayer financial forecasts and/or budgets to support the manner in which arm's length prices were set and subsequently to compute adjustments to actual results may be an appropriate way to address the impacts of COVID-19, where P&L variances attributed to COVID-19 can be demonstrated. Companies with a record of establishing periodic budgets for their operations should be prepared to demonstrate the historic reliability of those budgets in order to enhance the basis for attributing changes in financial outcomes to COVID-19.
- In line with the OECD TPG, contemporaneous uncontrolled transactions are considered the most reliable information for comparability and may be publicly or internally available reflecting the unusual economic outcomes of the pandemic. When contemporaneous information is not available (e.g., when using the TNMM), the OECD Guidance prescribes to use “whatever current year information is available” to support the transfer prices.
- Tax authorities should be flexible and taxpayers should use reasonable commercial judgement supplemented by contemporaneous information. The OECD Guidance also discusses the advantages of using the outcome-testing approach2 (as opposed to the price-setting approach3 used by some tax authorities), such as providing for flexibility to taxpayers, as well as the option of using more than one transfer pricing method for corroborative purposes. The timing of available information can impact the usefulness of this approach if, for example, transfer pricing adjustment after the close of the financial period are barred or limited by local legislation (e.g., post-closing changes that reduce taxable income are not allowed).
- It may be possible to include price adjustment mechanisms in controlled transactions combined with the outcome-testing approach. These adjustments should be formalized in intercompany agreements, if possible.
- Comparability analyses should include the actual economic circumstances of the controlled transaction. Hence, sole reliance on precedents such as financial outcomes contemporaneous to the global financial crisis 2008/2009 would be viewed as inadequate because the impacts of the COVID-19 crisis may differ significantly to those of the 2008/2009 global financial crisis.
- The selection of the period of data used to evaluate arm's length price may include the use of separate testing periods or combined testing periods (i.e., including years impacted by the pandemic and years not impacted). Care should be exercised to assess the relative impact of COVID-19 on the comparable firms' data, their industries, etc.
- The use of loss making comparable companies may be appropriate where reliability can be demonstrated (i.e., the comparable companies should assume similar levels of risk and be similarly impacted by the pandemic). In these cases, outcomes such as similar revenue declines as well as characteristics, such as similar industries and similar supply chains, are critical components of the analysis. Modeling may help illustrate these outcomes.
Baker McKenzie comments:
The OECD outlines several possible approaches to adjust comparability analysis for 2020. These approaches may be appropriate as well as other pragmatic approaches depending on the specific facts and circumstances of a taxpayer.
2. Losses and the allocation of COVID-19 specific costs
During the COVID-19 pandemic, many MNE groups have incurred losses due to challenges including reduced demand, difficulty in obtaining supply of goods or services, or exceptional and non-recurring operating costs (e.g., expenditure on personal protective equipment, reconfiguration of workspaces to enable physical distancing, specific IT infrastructure). The allocation of these losses or COVID-19 specific costs between related entities increases the complexity of applying the arm's length principle and the risk of disputes with tax authorities. The OECD Guidance outlines three main issues for consideration to mitigate this risk:
The allocation of profits or losses between related parties to an arrangement should follow the allocation of risks as described in Chapter I of the OECD TPG,4 to be consistent with an arm's-length arrangement. The OECD Guidance specifically addresses the case of entities operating under limited-risk arrangements and emphasizes the following points:
- Though the term “limited-risk” is commonly used in transfer pricing, it is not defined in the OECD TPG and the functions performed, assets used and risks assumed by “limited-risk” entities may vary. It is impossible to establish as a general rule that these entities should or should not incur losses; rather, the facts, circumstances and contractual provisions need to be analyzed on a case-by-case basis. This statement may provide some relief to taxpayers with limited-risk entities bearing losses as a result of COVID-19, provided these losses can be further supported as arm’s length.
- According to the OECD TPG, limited or low-risk enterprises are typically not expected to generate losses for a long period of time.5 It is thus possible for the limited risk enterprises to generate losses, albeit for a limited time, provided these losses are supported by a robust comparability analysis and contractual provisions.
- Whether a limited-risk enterprise can incur a loss will be largely informed by the risks (albeit limited) that the enterprise generally assumes. For example, a limited-risk distributor that assumes some marketplace risks may, at arm's length, earn a loss due to the decline in demand as a result of COVID-19. Conversely, it will not be appropriate to allocate losses associated with the decline in demand if the limited-risk entity does not bear these risks. Ultimately, the determination of the extent of an arm's-length loss should be based upon a comparability analysis, following the most appropriate transfer pricing method to the circumstances.
- The OECD Guidance advises that any changes to the risks assumed by a party before and after COVID-19, and to the allocation of losses, are likely to come under scrutiny of tax administrations. Consideration should be given to re-examining whether, prior to the outbreak of COVID-19, the accurate delineation of the transaction and resulting allocation of risks was supportable. If a prior risk allocation is recognized under an accurate delineation for a reallocation of that risk to be accepted, it must be supported by an updated facts-and-circumstances analysis, along with evidence of similar commercial arrangements between independent parties under comparable circumstances. In this respect, the guidance in Chapter IX of the OECD TPG in relation to business restructurings may be relevant.
- Based on this OECD Guidance, MNEs looking to allocate or share the burden of losses with limited-risk entities should ensure that its approach (1) reflects an accurate allocation of risks between entities prior to COVID-19, or can be substantiated by an updated facts-and-circumstances analysis reflecting any new risks borne or activities performed by the entity, and (2) be supported by an appropriate comparability analysis.
- The allocation of exceptional, non-recurring operating costs, as a result of COVID-19 should be based on an assessment of how they would have been allocated between independent parties under comparable circumstances.
- The arm's-length allocation of these costs should align with the delineation of the controlled transaction i.e., the party responsible for performing the activities and assuming the risks associated with such costs would typically bear such costs. If, however, these exceptional costs are centrally borne by one entity of the MNE group, it may be appropriate to charge out those costs to the other parties benefiting from them.
- Companies should be mindful of these exceptional costs as the OECD Guidance clarifies that certain operating costs resulting from COVID-19 (e.g. teleworking costs) may not be exceptional or non-recurring if they become permanent or long-term.
- Reference should also be made to market conditions, such as the competitiveness of the industry, for the allocation of exceptional costs. For instance, one entity may not be able to pass on these costs to its customers without impacting the demand for its products or services, while another entity may be able to pass on these costs to its customers without a similar drop in demand. These circumstances should be part of the comparability analysis prior to allocating these extraordinary costs.
- When performing a comparability analysis, exceptional costs need to be considered carefully in three main instances. First, they should generally be excluded from the net profit indicator of the tested party and comparables, unless they are associated with the accurately delineated controlled transaction. Second, it is important to consider whether these costs should be included in the cost basis of the controlled transaction and, when included, whether to be passed through at cost or with a profit element. Third, adjustments for accounting inconsistency between the controlled and uncontrolled transactions may be required to improve comparability (e.g., when exceptional costs are accounted for as operating items in one jurisdiction and as non-operating items in another).
- Intercompany agreements may be appropriately revised, modified, or revoked as a result of the COVID-19 pandemic, including through the invocation of force majeure clauses, though caution should be taken with any such approach.
- MNEs should carefully approach renegotiating the terms of intercompany agreements, including pricing terms, as a result of COVID-19 as the OECD Guidance recommends changes to be well-documented and substantiated by evidence of similar unrelated-party behavior operating under comparable circumstances.
- In renegotiating the terms of an intercompany agreement, the OECD Guidance advises that consideration about the options realistically available to the parties and the long-term effects on the profit potential of the parties should be made to assess whether the new terms of the agreement (including the revised pricing and any potential compensation for the renegotiation itself) represent the best interest of the parties. The parties should likewise consider whether indemnification to the “harmed” party is required as a result of a renegotiation.
Where one party to a controlled transaction seeks to invoke force majeure, the agreement and underlying legal framework should form the starting point of the transfer pricing analysis. The OECD Guidance does not define force majeure in the context of the pandemic and instead defers to the contractual definition of force majeure and the conduct of the parties to determine whether the invocation of the force majeure clause is permissible under applicable law. The OECD Guidance further notes that the companies should consider the long-term nature of the relationships and short-term nature of any related disruption before invoking the force majeure clause. Where the agreement does not contain such a clause, companies may seek to assert that a renegotiation would have occurred at arm’s length based on a similar basis; however, tax administrations are advised to carefully review these assertions, given the transaction and economically relevant circumstances.
Baker McKenzie comments:
A review of existing contractual arrangements and past year transfer pricing documentation will most often be the starting point for determining and supporting the allocation of risks and losses among related parties. That being said, the COVID-19 situation has created circumstances that often exceed what was reasonably anticipated in intragroup arrangements and these circumstances need to be identified and quantified. Further, many groups have adapted their governance and decision-making processes to cope with this unique environment.
3. Government assistance programs
Due to COVID-19, many governments have provided grants, subsidies, and/or loans, they have also initiated job retention programs or introduced additional tax incentives to eligible taxpayers to mitigate the decline in business activity due to COVID-19. The OECD Guidance provides that these programs potentially have transfer pricing implications, as they may be provided to a member of an MNE group (i.e., the tested party) directly or made available to independent parties within the market so that the behavior and financial results of enterprises engaged in comparable transactions are altered. Due consideration must be given to the terms and conditions of these government assistance programs (such as the availability, substance, duration and take-up).
The OECD states that the extent to which the receipt of government assistance is an economically relevant characteristic may vary. The OECD refers to the provision of a wage subsidy, a government debt guarantee or short-term liquidity support as examples that may be more economically relevant as it may directly affect the controlled transaction and comparable transactions between independent parties. If the government assistance can be considered an economically relevant characteristic, the OECD Guidance directs taxpayers to evaluate and note the impact thereof on accurately delineating the controlled transaction and performing the comparability analysis (as outlined in paragraph 1.33 of the OECD TPG) and to include this assessment as a part of the documentation to support the transfer pricing analysis.
As part of this analysis, taxpayers can rely on existing guidance under the OECD TPG on other local market features by analogy,6 which provides that government interventions should generally be treated as conditions of the market and be considered in evaluating the taxpayer’s transfer price in that market. The analysis of receiving government assistance as a local market feature (including the nature of assistance) may help determine not only whether its receipt affects the price of a controlled transaction, but also how it affects the comparables and the arm’s length prices of uncontrolled transactions.
The potential effect of the receipt of government assistance on the pricing of a controlled transaction will depend on economically relevant characteristics thereof such as the availability, purpose, duration or other conditions imposed by the government; and the allocation of the economically significant risks. In addition, the OECD Guidance indicates that the economic circumstances of the market in which the party receiving government assistance operates could influence the pricing. For example, factors such as the level of competition, the elasticity of the demand, or the availability of the benefits to competitors in the market could be relevant factors in determining whether receiving government assistance would be translated into an entity’s pricing strategy. Furthermore, the impact of price change on taxpayer’s sales to third party customers would also be relevant to determine the impact of the government subsidy on the controlled transaction.
The OECD Guidance recognizes that the impact of different government assistance available in a market may impose additional challenges to the comparability analysis, as government assistance and the specific circumstances of the COVID-19 pandemic may vary across different markets, and hence may impact the arm's length prices of uncontrolled transactions in different ways. Here, the OECD indicates that, when using one-sided methods, adopting a mechanical approach without further analysis (e.g., recognizing the government assistance as an extraordinary income, offsetting the government assistance against the party's cost base) should be avoided. Moreover, when identifying comparables, taxpayers are urged to consider not only the availability, the duration, and the purpose of the government programs, but also the divergence in accounting treatment of the subsidies under different accounting standards, which may impact different levels of profitability. For example, the accounting treatment of a conditional loan differs from that of an outright grant.
Absent reliable local market comparables, adjustments may be required to account for the impact of government assistance on the arm’s length prices of goods transferred or services provided between uncontrolled taxpayers. However, one challenge that the OECD Guidance does not address is the lack of detail in, and the availability of, publicly available data on comparables to conduct this level of analysis. This is particularly so when using European or Asian databases. This level of information is also not available in the United States as there is no explicit GAAP accounting standard for the accounting for government assistance. FASB is developing rules that will require public companies to disclose the amount of their government subsidies.
The OECD Guidance also discusses the impact of receipt of government assistance on the allocation of risk in a controlled transaction. Referring to the existing guidance of Chapter I of the OECD TPG, the OECD Guidance provides that the provision of government assistance to an associated party will not change the allocation of risk in a controlled transaction for transfer pricing purposes as the contractual arrangements, the entity’s capability and actual performance of decision-making functions remain unchanged.
The OECD Guidance does not address the allocation of risk where a limited risk entity that has contractually transferred all its risks to a related counterparty in exchange for a guaranteed return receives a government subsidy. Would this subsidy offset the transfer pricing adjustment due from the counterparty? One argument could be that an independent enterprise in a similar circumstance would have insisted on payment from the counterparty despite receiving the government subsidy. In analyzing this type of situation, consideration should be given to local legislation that might prohibit the direct or indirect transfer of government grants or subsidies to other parties.
The OECD Guidance also does not address unilateral directions from individual jurisdictions as to how any government assistance should factor into determining transfer prices, which may create challenges for taxpayers where such local direction may run counter to the OECD Guidance or be contrary to the views of other jurisdictions and complicate any potential resolution of disputes through the Mutual Agreement Procedure.
Baker McKenzie comments:
The transfer pricing treatment of government assistance can have a very significant impact on entities that are remunerated using a targeted return approach (e.g., a cost-based method or a targeted operating margin). Of course, the application of this assistance may vary from jurisdiction to jurisdiction.
4. Advance pricing agreements (APAs)
The OECD maintains that even in times of a pandemic, APAs remain a compelling instrument to achieve tax certainty and prevent tax disputes. However, taxpayers and tax administrations can only rely on the agreements in APAs if the critical assumptions on which the APA is agreed remain valid. It is likely that the COVID-19 pandemic and the response of governments have dramatically affected the economic and market conditions, which may lead to a breach of the critical assumptions, or cause the need for a revision to the critical assumptions.
For existing APAs, tax administrations should consider case by case whether a breach in critical assumptions should lead to either a revision, cancellation or revocation of the APA. The OECD Guidance states that a mere change in business results during the pandemic would likely not result in a breach of a critical assumption. The assessment depends both on the extent to which critical assumptions have been affected, and on the conduct of the taxpayer. Taxpayers should promptly contact the tax administration to begin the dialogue instead of delaying and then having the approach look like an afterthought. The OECD points out that drastic steps, such as cancellation or revocation, should not be triggered automatically.
Instead, both for existing and new APAs, the OECD calls on tax administrations to apply a flexible and collaborative approach in dealing with the unusual circumstances caused by the pandemic. Many tax administrations have set up COVID-19 teams to address these issues, e.g., the US APMA team. The OECD Guidance correctly suggests that tax administrations can consider several approaches to mitigate a breach of critical assumptions or failure to adhere to the agreed transfer pricing system, such as:
- Separating an APA into distinct phases to address: (1) the period affected by the pandemic; and (2) the post-COVID-19 period. This has the attractiveness of simply focusing on the COVID-19 year(s) as an aberration.
- Incorporating provisions in the APA that the impact of COVID-19 will be analyzed separately, including an agreement on a mechanism for potential adjustments. In this instance, adjustments will be deferred until data relevant to COVID-19 is available for some comparison. A review of the specific impact upon the taxpayer's industry would be most helpful.
- Extending the period of the APA to mitigate the short-term impact of the APA, in particular when the extension is combined with testing the transfer pricing on a multi-period basis.
- Applying a multi-period term-test to assess whether the transfer pricing complies with the APA provisions, rather than evaluating the transfer pricing for each separate financial year. Here multi-year averaging may smooth over the results of COVID-19. In addition, evaluating the arm’s length nature of the transfer pricing based on a targeted range rather than a fixed target may give taxpayers some flexibility to address the impact of COVID-19.
The OECD emphasizes taxpayers needing to provide tax administrations with transparency regarding the impact of COVID-19 on their operations. Taxpayers are expected to inform tax authorities proactively when they foresee that the critical assumptions of an APA may be impacted by the pandemic. The OECD lists various examples of sources of information that taxpayers can use to document the impact of the pandemic, such as segmented P&L data, updated budgetary/revenue projections and modifications to legal agreements or information about third-party behavior. An interesting approach would attempt be to normalize or model the taxpayer's P&L statement for the specific impact of COVID-19 on its results. This can be done by estimating lost revenues and fluctuations to variable costs to show to which extent COVID-19 has created a gap between a taxpayer’s expectations and the actual operating results. This modeling can be most helpful as it would depict the situation that is unique to the taxpayer, which may not be the same as some of the comparable firms used in the APA Request. It is stressed that all parts of the respective documentation should contain a clear assessment that the perceived impact is attributable to the pandemic.In a transfer pricing analysis which considers the impact of COVID-19, the four priority topics discussed above may be interrelated and should be considered together alongside the OECD TPG.
When considering the implications of COVID-19 for a transfer pricing analysis, taxpayers should document their specific information relating to how and the extent to which they have been impacted, and the measures they took to minimize the impact. This, with the financial modeling noted above, should be quite helpful in any future discussions and negotiations with the respective tax administration(s).
Baker McKenzie comments:
Taxpayers who have entered into APAs that contain guaranteed profit margins for low risk entities may be willing to rediscuss the application of the APA conditions to 2020. This can prove a difficult exercise in practice. APAs in the US where COVID-19 has an impact will be reviewed and considered by a special COVID-19 committee. Each jurisdiction may take different approaches to this issue so it is important to consult with the local team to understand that local criteria.
1 The misalignment or lag of publicly available data (comparables' financial and pricing information) to assess contemporaneous transfer prices creates the situation where historical data is commonly the best and most reliable third party information available for transfer pricing analyses.
2 Outcome-testing is an ex-post approach, which may incorporate information that becomes available after the close of the taxable year.
3 Price-setting is an ex-ante approach, which uses historical data updated to reflect any change in economic conditions through the date of the contract.
4 Paragraphs 1.56 -1.106 of Chapter I of the OECD TPG.
5 Paragraph 3.64 of Chapter III of the OECD TPG.
6 See Section D.4 and D6.2 of Chapter I of the OECD TPG.