The Organisation for Economic Co-operation and Development (OECD) issued a paper in December 2020 providing guidance on the application of the arm’s-length principle and the OECD Transfer Pricing Guidelines (TPG) to issues that arise or are exacerbated by COVID-19.
The guidance makes clarifying comments on the practical application of the arm’s-length principle in the context of four priority issues: 1) comparability analysis, 2) losses and the allocation of pandemic-specific costs, 3) government assistance programs, and 4) advance pricing agreements. These issues are discussed as discrete topics, but, in practice, these topics are likely to be interrelated and should be considered together in performing transfer pricing analysis.
The paper represents the consensus view of the 137 countries that form the OECD “Inclusive Framework” and may assist taxpayers in reporting transfer pricing determinations in periods affected by the pandemic.
COVID-19 may have a significant impact on the pricing of some transactions between independent enterprises and may reduce the reliance that can be placed on historical data when performing comparability analyses. This may require taxpayers and tax administrations to consider practical approaches to address information deficiencies, such as comparability adjustments.
Publicly available information regarding the effect of the pandemic on businesses, industries and controlled transactions may be relevant in FY 2020. The guidance provides that the following sources of information may help estimate the effect of the pandemic on the controlled transactions under review:
- Sales volumes during the pandemic
- Change in capacity utilization
- Information regarding exceptional costs borne by parties to the controlled transaction
- Receipt of government assistance
- Government interventions that affect the pricing
- Interim financial statements
- Macroeconomic information, such as country-specific GDP data or industry indicators from central banks, government agencies, industry or trade associations
- Statistical methods such as regression analysis or variance analysis
- Internal budgeted or forecasted data relating to sales, costs and profitability, compared to actual results
- Analysis of the effects on profitability or on third-party behavior observed in previous recessionary periods
Similarly, budgeted financial information may be used to support the setting of arm’s-length prices. In addition, the following practical approaches may be available to address information deficiencies:
- Allowing for the use of reasonable commercial judgment supplemented by contemporaneous information to set a reasonable estimate of the arm’s-length price
- Allowing for an arm’s-length outcome testing approach
- Using more than one transfer pricing method
- Using data from other crises to support price setting
The remainder of this section addresses further comparability issues, such as:
- Practical approaches to address information deficiencies
- Pricing adjustment mechanisms
- Ability to use loss-making comparables
During the pandemic, many multinational enterprise (MNE) groups have incurred losses due to a decrease in demand, inability to obtain or supply products or services or as a result of extraordinary operating costs. Because the allocation of losses between associated entities can result in transfer pricing disputes, the allocation of losses may require consideration.
When considering losses and the allocation of pandemic-specific costs, the guidance highlights three issues that warrant specific discussion. First, the allocation of risks between the parties affects how profits or losses are allocated at arm’s length. Thus, existing guidance on the analysis of risks in commercial relations will be particularly relevant for determining how losses are allocated between associated parties. Second, exceptional, non-recurring operating costs of the pandemic should be allocated between associated parties consistent with the way independent enterprises operate under comparable circumstances. Separately, as extraordinary costs may be either operating or non-operating items, comparability adjustments may be necessary to improve reliability. Finally, the pandemic has created conditions in which associated parties may consider whether they have the option to apply force majeure clauses to revoke or otherwise revise their intercompany transactions. As the effects of pandemic vary by industry, business model or market, it is likely that this question can only be answered through a careful analysis of the specific costs under consideration. Many companies experiencing losses this year are concerned about an increased risk of disputes with tax authorities over how to allocate those losses among their entities.
The significance of certain risks is particularly relevant in the current economic climate: 1) marketplace risk, as demand for some products and services has collapsed, 2) operational risk, as the pandemic has disrupted supply chains and inhibited production, and 3) financial risks, as borrowing costs for some industries have spiked and customers have delayed or defaulted on payments.
Taxpayers should follow the guidance in Chapter 1 of the TPG to specifically identify the economically significant risks and determine the specific risks assumed by each party to a controlled transaction. The analysis may determine that a party cannot influence the hazard risk associated with the pandemic, but assumes other risks produced by the pandemic. Taxpayers must also determine how the associated enterprises and the group as a whole respond to the manifestation of hazard risks and its subsequent effects on the other economically significant risks identified in the controlled transaction. In particular, the widespread effects of the pandemic in an industry or within an MNE group do not suffice to claim that a member of an MNE group has to bear the consequences of risks materializing as a result of the pandemic without analysis how the outcome of the economically significant risks controlled by the member of the group has been affected by the pandemic.
The guidance defines government assistance as a program whereby a government provides grants, subsidies, forgivable loans, tax deductions or investment allowances to eligible enterprises. During the pandemic, governments’ overriding concern has been public health and controlling the spread of the COVID-19 while at the same time trying to help enterprises manage the impact of the decline of business activity and workers facing a decline in employment opportunities and income. Job retention programs have been used in many jurisdictions. The availability, substance, duration and make-up of these programs have potential transfer pricing implications, whether the government assistance is provided to a member of an MNE group directly or made available to independent parties within the market where an MNE group operates.
The terms and conditions of government assistance program need to be considered when determining the potential impact of these programs on controlled transactions and when comparing their effects with those of other pre-existing assistance programs. The guidance deals with government assistance programs, but does not discuss the effects of other government interventions, including interventions that prevent or limit a party’s ability to fulfil an existing intercompany agreement.
Specifically, the guidance addresses:
- The extent to which the receipt of government assistance is economically relevant
- Whether other local market features are relevant when analyzing the transfer pricing implications of government assistance
- The potential effect of the receipt of government assistance on pricing of a controlled transaction
- How government assistance could modify the allocation of risk in a controlled transaction
- The effect of government assistance on the comparability analysis
Tax certainty is the primary benefit of an advance pricing agreement (APA) to taxpayers and tax administrations. The pandemic has produced material changes in economic conditions not anticipated when many APAs covering FY 2020 and future years were negotiated. Thus, it is important to determine to what extent, if any, the change in economic conditions affects the application of existing APAs. Taxpayers and tax administrations negotiating APAs that apply to FY 2020 may also face questions about how the economic conditions arising from the pandemic should be taken into account. Therefore, the guidance addresses the possible impact of the pandemic on existing unilateral, bilateral and multilateral APAs and APAs under negotiation.
Taxpayers facing challenges to apply existing APAs under the economic conditions resulting from the pandemic are encouraged to 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. Taxpayers and tax administrations are still bound by existing APAs; 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. Taxpayers cannot automatically disregard or alter the terms of existing APAs due to the change in economic circumstances. Generally, the APA itself will explicitly describe what constitutes non-compliance or failure to meet a critical assumption and the consequences of that failure. It will also be important for taxpayers with APAs under negotiation to engage proactively with the tax authorities.
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