On 18 December 2020, the Organisation for Economic Co-operation and Development (OECD) issued the much-awaited guidance on Transfer Pricing implications of Covid-19 pandemic that provides broad principles for taxpayers in reporting the financial periods affected by the pandemic and for tax administrations in evaluating the implementation of taxpayers’ Transfer Pricing policies.
Primarily, the guidance focuses on the following 4 significant challenges that businesses across the world might or would face in complying with their local Transfer Pricing compliance requirements because of the ongoing pandemic:
The extraordinary changes in the economic environment following the outbreak of Covid-19 have created certain unique issues while performing comparability analysis, especially, reducing the reliance that could be placed on historical comparable data as the same would be highly distorted due to significant changes in the operations, profitability, and pricing policies of most of the companies.
As a result, taxpayers and tax administrations may have to work out different practical approaches that can be adopted to ensure a robust comparability analysis that is compliant and consistent with the Transfer Pricing principles and regulations of the local tax jurisdiction. Some of such approaches addressed by the OECD in its guidance cover the following:
Various sources of information to support the comparability analysis
Practical approaches for addressing information deficiencies including:
Use of reasonable commercial judgement supplemented by contemporaneous information
Arm’s length outcome testing approach
Use of more than one Transfer Pricing method
Separate testing periods of data could be used for determining arm’s length price and proper treatment of government intervention schemes/aids
Inclusion of price adjustment mechanisms in controlled transactions
Use of loss making comparables
Losses and allocation of Covid-19 specific costs
Due to the pandemic, many Multinational Enterprise (MNE) groups incurred losses due to a decrease in demand, disruptions in supply chain or operations, inability to obtain or supply products or services or due to exceptional, non-recurring operating costs. As a result, the allocation of losses between associated entities could give rise to potential tax disputes.
The OECD in its guidance has addressed the above in the following 3 aspects:
Allocation of losses to limited risk entities – The OECD guidance provides that while considering the risks that should be assumed by a party to a controlled transaction, tax administrations should carefully consider the commercial rationale for any purported change in the risks assumed by a party before and after the outbreak of the pandemic (and taking into consideration the accurate delineation of such purported change).
Modification of existing intercompany agreements – The OECD is of the view that related parties may also consider revising their intercompany agreements and/or their conduct in their commercial relationships. The same seems relevant as the accurate delineation of the controlled transaction will determine whether the revision of intercompany agreements is consistent with the behaviour of unrelated parties operating under comparable circumstances.
Allocation of operational/exceptional costs between related parties – The guidance provides that in order to determine which associated enterprise should bear exceptional costs, it would 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.
Impact of force majeure clause on the allocation of losses
Due to the ongoing pandemic, some taxpayers may seek to assert force majeure in situations where it is not contained within the relevant intercompany agreement or may seek to change an existing intercompany agreement to insert a force majeure clause or may seek to assert that a renegotiation at arm’s length would have similar economic outcomes. Thus, in such situations, the OECD guidance suggests that tax administrations should carefully review such assertions in light of the accurately delineated transaction (including consideration of the conduct of the parties, both past and present) and the economically relevant circumstances of the transaction.
Government Assistance Programmes
The OECD guidance propagates that the terms and conditions of government assistance programmes related to Covid-19 need to be considered when determining the potential impact of these programmes on controlled transactions and when comparing their effects with those of other pre-existing assistance programmes. Moreover, the analysis required on the specific characteristics of the government assistance should take into account the economic impact of the assistance on the accurately delineated transaction.
Thus, the determination of the economic relevance of government support will have an impact on the accurate delineation of the controlled transaction and performing the comparability analysis. If the government assistance is an economically relevant characteristic, this information should be included as a part of the documentation to support the transfer pricing analysis.
The OECD also suggests that if the taxpayer is applying a one-sided method such as the resale price method, the cost-plus method, or 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.
Advance Pricing Arrangements (APA)
The OECD suggests that taxpayers who may face challenges applying existing APAs under the present economic conditions should adopt a collaborative and transparent approach by raising these issues with the relevant tax administrations in a timely manner. Taxpayers should not seek to resolve them unilaterally without consulting with the relevant tax administrations.
Moreover, most APAs include critical assumptions about the operational and economic conditions that will affect the transactions covered by the APA. The pandemic and the response of governments have dramatically affected the economic and market conditions and are likely to qualify as a breach of the critical assumptions. However, the OECD is of the view that a mere change in business results during the period affected by the pandemic would not, however, result in a breach of a critical assumption (unless the particular APA had a critical assumption regarding changes in business results). Thus, if tax administrations establish that the critical assumptions of an APA have not been breached, the existing APA, as agreed, must continue to be respected, maintained and upheld.
To conclude, taxpayers and tax administrations negotiating APAs that are intended to cover Financial Year 2020 are encouraged to adopt a flexible and collaborative approach to determine how to take into account the current economic conditions, and the various options available in relation to the revision of existing APAs.