News Update Transfer Pricing

23 December 2020

On 18 December 2020, the OECD released its Guidance on the transfer pricing implications of the COVID-19 pandemic (the "Guidance"). This document provides guidance on the application of the arm's length principle and the OECD Transfer Pricing Guidelines (the "TP Guidelines") for four transfer pricing issues in the context of the COVID-19 pandemic: i) comparability analysis; ii) losses and the allocation of COVID-19 specific costs; iii) government assistance programmes; and iv) advance pricing agreements. Our transfer pricing experts summarise the main practical aspects of the Guidance for you below.

1. Comparability analysis

The Guidance acknowledges the challenges that the COVID-19 pandemic creates for performing comparability analyses. In this respect, significant impact on pricing between independent parties may reduce the reliability of historical comparability data. Challenges may especially arise for intercompany transactions for which the arm's length price is determined annually, and therefore requires performing a comparability analysis for the fiscal year 2020 ("FY2020").

Sources of information
The Guidance contains a list of information sources which can be used in comparability analyses to support the determination of the effect of COVID-19 on intercompany pricing. The list includes: i) an analysis of changes in sales volume and capacity utilisation during COVID-19; ii) specific information on incremental or exceptional costs; iii) the effect of government assistance and interventions; iv) statistical methods such as regression analysis to predict the effect of COVID-19 on certain variables; v) a comparison of internal budgeted data to actual results; and vi) an analysis of the effect on third party profitability during previous recessions.

The OECD does not believe that a comparability analysis exclusively based on information from the 2008/2009 financial crisis adequately reflects the unique nature of the COVID-19 pandemic.

Timing issues and information deficiencies
Due to the time lag between the intercompany transaction and the availability of contemporaneous information on transactions between independent parties, timing difficulties might arise when trying to adequately reflect the effect of the pandemic on arm's length price setting. Therefore, tax authorities could consider taking into account information which becomes available after the close of the fiscal year (i.e. an arm's length outcome testing approach). This requires some flexibility to allow amendments to FY2020 tax returns to make sure that transfer prices are set in accordance with the arm's length principle using available information. Another potential solution for the uncertainty caused by the pandemic would be allowing price adjustment mechanisms to be included in intercompany agreements.

The Guidance also considers using more than one transfer pricing method useful to corroborate the arm's length price in the specific circumstances of the pandemic, following the guidelines in paragraphs 2.2 and 2.12 of the TP Guidelines.

Period of data used
According to the Guidance, the reliability of comparability analyses might improve when using circumscribed price setting periods when certain material effects of the pandemic were most evident. However, using separate price setting periods should be in line with the facts of the intercompany transaction, as other fact patterns might require the inclusion of both pandemic and non-pandemic years to aggregate the exceptional financial results of FY2020.

Care should be taken when considering using an existing set of comparables to cover FY2020, since the pandemic has caused extraordinary economic conditions which require a review of the suitability of these comparables. This may include a revision based on updated search criteria (i.e. by shifting the focus to the most relevant comparability criteria). Furthermore, the Guidance stipulates that loss-making comparables which meet the comparability criteria should not be rejected solely because they are loss-making due to the pandemic, which is in line with paragraphs 3.64-3.65 of the TP Guidelines.

2. Losses and the allocation of COVID-19 specific costs

The OECD provides guidance on allocation of losses and exceptional costs arising as a result of COVID-19. The Guidance emphasises that the existing guidelines on analysing risks will be particularly relevant for determining how COVID-19 related losses are allocated between related entities. Furthermore, consideration must be given to the option of applying force majeure clauses.

Limited risk arrangements
The Guidance emphasises that it is not possible to develop a general rule on the basis of which limited risk entities should or should not incur losses. This determination can be done based on a risk analysis and there is a possibility that limited risk entities can incur losses if the facts and circumstances of the case justify that.

The Guidance provides an example of a limited risk distributor which assumes some marketplace risk and faces a substantial decline in demand due to the pandemic. In this case, earning a loss which is related to the materialisation of the marketplace risk might be in accordance with the arm's length principle. Taxpayers should consider the framework set out in paragraphs 1.56-1.106 of the TP Guidelines, as allocating losses highly depends on the analysis of risks assumed in commercial or financial relations.

Modifying arrangements
Third parties may renegotiate terms of existing agreements in response to the pandemic. Accurately delineating intercompany transactions will decide whether modifying intercompany agreements can be considered to be in line with the behaviour of unrelated parties under comparable circumstances. Taxpayers might be reasonably justified in revising intra-group agreements where there are comparable uncontrolled transactions in which contractual terms have been amended. The options realistically available should be carefully considered (e.g. terminating an agreement if there is no possibility to modify).

Dealing with operational or exceptional costs
Allocating operational or exceptional costs between related parties should match the assumption of risks and how third parties would treat these costs. Parties should carefully analyse whether specific operating costs can be considered as exceptional in circumstances where the costs arise due to permanent changes. The Guidance provides an example of costs related to teleworking arrangements, which may be considered permanent if working from home became more common because of the COVID-19 pandemic.

The Guidance recommends a three-step approach for allocating exceptional costs. First, in line with paragraph 2.86 of the TP Guidelines, exceptional costs should generally be excluded from the net profit indicator, except when the costs relate to the accurately delineated controlled transaction. Second, if the exceptional costs are deemed to relate to the intercompany transaction, it is important to determine whether these costs should be treated as pass-through costs to which no profit element should be attributed, in line with paragraph 2.99 of the TP Guidelines. Third, comparability adjustments might be necessary if exceptional costs may be accounted for as either operating or non-operating costs by different taxpayers, based on differences in accounting standards.

Force majeure
Due to the pandemic, parties may justify failing to perform an agreement by invoking a force majeure clause. As in any transfer pricing analysis, the underlying agreement under which a party may invoke force majeure should form the starting point of the analysis. Analysing the economic circumstances of the relevant arrangement is necessary to determine whether a party would seek to invoke a force majeure clause in accordance with the arm's length principle.

3. Government assistance programmes

The terms and conditions of government assistance programmes related to the pandemic need to be taken into account when determining the potential implications of these programmes for intercompany transactions. The Guidance provides a list of non-exhaustive characteristics which should be analysed from a transfer pricing perspective.

An economically relevant characteristic?
The extent to which the receipt of government assistance should be regarded as an economically relevant characteristic varies. According to the Guidance, government assistance may be more economically relevant (i.e. likely to have a direct impact on the intercompany transaction, including its price) when it is provided by wage subsidies, short-term liquidity support, or a government debt guarantee.

Effect on pricing and risks
According to the Guidance, the assumption that merely receiving government assistance affects the price cannot be considered to be in line with the arm's length principle, without performing a careful comparability analysis.

The receipt of government assistance may reduce the quantitative negative impact of certain risks. According to the Guidance, this reduction in the negative impact of risk should be distinguished from the allocation of risks under the guidelines in section D.1.2.1 of the TP Guidelines, i.e. the receipt of government assistance by a related party should not alter the allocation of risk in an intercompany transaction for transfer pricing purposes.

Comparability analysis
A transaction between independent parties which might be considered comparable to an intercompany transaction under non-pandemic circumstances might not be considered comparable because one of the transactions is subject to government assistance, while the other is not or is subject to different assistance. As explained above, a revised search strategy and a corroborating transfer pricing methodology may need to be applied to take account of these differences. The OECD acknowledges the difficulty of making adjustments for different levels of government assistance and thus considers using local or regional comparables as the most reliable approach to overcome this issue.

Careful consideration should be given to the qualification of government subsidies under different accounting standards, possibly requiring comparability adjustments.

4. Advance Pricing Agreements

It is important to assess whether and, if so, to what extent, existing advance pricing agreements ("APAs") and APAs under negotiation are affected by a change in economic conditions due to COVID-19.

Existing APAs
Existing APAs should be respected and maintained, unless a breach of critical assumptions has occurred. The Guidance confirms that the impact of the COVID-19 pandemic is likely to qualify as a breach of the critical assumptions. However, it recommends a case-by-case analysis taking into account the individual circumstances of the taxpayer and the commercial environment to reach any conclusions. When considering the consequences of a breach of the critical assumptions, tax authorities and taxpayers should consider:

i) the terms of the APA;
ii) any agreement between relevant tax authorities as to how to deal with the failure; and
(iii) any applicable domestic law or procedural provisions.

In the absence of other rules and procedures prescribed by domestic law, a breach of critical assumptions could have three potential outcomes as provided in section E.3 Annex II to Chapter IV of the TP Guidelines:

i) Revision (i.e. different terms apply before and after the revision date);
ii) Cancellation (i.e. APA is effective only up to the cancellation date); and
iii) Revocation (i.e. the APA is treated as never entered into).

APAs under negotiation
The Guidance encourages taxpayers and tax authorities to adopt a flexible approach when negotiating APAs which are intended to cover FY2020. For example, consideration could be given to agreeing a short period APA covering the pandemic period and a separate APA which covers the post-pandemic period. Another suggested solution is concluding an APA for the whole period, with a condition that the possible impacts of COVID-19 are analysed and reported on an annual basis, allowing for retrospective amendments to the APA.

Conclusion

The COVID-19 pandemic causes many transfer pricing challenges for taxpayers. The newly issued Guidance addresses the main issues, and welcomely advises on applying the arm's length principle and the TP Guidelines to these issues. When setting their intercompany pricing, taxpayers should accurately deal with the possible impacts of the COVID-19 pandemic and, more than ever, make sure to carefully document the considerations they make. If you have any further questions, please contact the Houthoff Transfer Pricing team.