It seems like an eternity ago since the World Health Organisation declared a pandemic on 11 March 2020. Governments around the world have responded to the pandemic in different ways, including various degrees of lockdowns, travel restrictions and fiscal and monetary support for some of the most affected industries. This has led to unprecedented disruptions of the global economy and affected business models of many multinational enterprises ("MNEs"). It has had a profound impact on how we work and live our lives.
What was initially seen as a global crisis with a high impact on a short term basis, has now become a recurring theme as various regions around the globe are affected differently when new variants of the COVID-19 virus are detected. This means that businesses are required to constantly re-assess the impact of the pandemic on their business and transfer pricing models. Businesses have to critically test whether decisions taken and adjustments made to controlled transactions (if any) in response to the pandemic, are still defendable as being consistent with the arm's length principle in light of the prolonged pandemic.
From a transfer pricing perspective, the question as to whether any adjustments to controlled transactions are required, have to be asked at certain particular points in time, being:
- the moment when the decision has to be made from a business/commercial perspective;
- at financial year-end, when it has to be determined whether any year-end adjustments are required and
- at the time of the submission of the income tax return, when a decision has to be made whether any transfer pricing adjustments in terms of section 31(2) of the Income Tax Act, 1962 are required.
economically relevant characteristics
Although the questions to be asked are very similar, the relevant information available at each point in time, might be different. The focus should be to get a thorough understanding of the impact of the pandemic on the economically relevant characteristics of the accurately delineated transactions and then to consider how independent third parties would have acted in comparable transactions under comparable circumstances.
The OECD has issued some guidance which clarifies the practical application of the arm's length principle as articulated in the OECD Transfer Pricing Guidelines to the unique fact patterns and specific challenges implied by the COVID-19 pandemic. It is important to keep in mind that the economically relevant characteristics to be taken into account in accurately delineating a controlled transaction in the context of the pandemic are the same as for any transfer pricing analysis. The only difference is that the pandemic has created some unprecedented economic circumstances for the parties and the market in which the parties operate, which now need to be considered.
immediate reaction from a business perspective
The commercial decisions taken by MNEs as an immediate reaction to the pandemic were and are still taken under unprecedented circumstances and often under immense time pressure. Applying the information available at the time in trying to make an arm's length decision, the MNE has to first identify the impact of the pandemic on its business with specificity. This could be a direct impact in the form of government intervention (lockdown), or a more indirect impact due to supply chain interruptions or the collapse of market demand.
Once the impact on the business is clear, the question, how would independent third parties, acting at arm's length, have reacted to this event, has to be asked. The starting point to this analysis would typically be the legal agreements in place (if any) and whether, for example, there are any force majeure clauses that could apply in the specific circumstances.
Ultimately, however, the characterisation of the parties, based on the accurately delineated transactions would be the most important factor.
Consider, for example, the distributor of an MNE, whose sales and corresponding revenues decreased significantly due to a drop in demand. The question whether the resulting unintended transfer pricing outcome (in the form of a decrease in profit or the incurral of a loss) is still consistent with the arm's length principle or requires an adjustment to the MNE's transfer pricing policy, depends on the characterisation of the distributor. The distributor could have a functional and risk profile similar to that of a profit centre and is remunerated not only for the distribution functions performed, but also for managing risks. A distributor could also assume limited risk and is remunerated for its functions performed only with a small, but stable return and as result would generally not be expected to share in the losses as a result of the pandemic.
It is important that the characterisation of the relevant entities in the MNE are carefully considered before making any adjustments to the transfer prices to ensure a consistent approach. Deviations should only take place in exceptional circumstances, when it can be shown that third parties in comparable circumstances would have been willing to renegotiate the arrangement and, for example, agree to share the market risk with its limited risk distributor where the existence of the supplier is at risk (ie to "defend the centre").
at financial year-end
This analysis might look different at year-end, when the taxpayer has to evaluate whether the commercial decision taken at the time resulted in an arm's length outcome. Consider, for example, a limited risk distributor where the initial impact on the industry appeared very strong, supporting the arm's length nature of a decision by the supplier to steer the profits of the distributor through price reductions. If the market picks up again, with a substantial recovery in sales before year-end, the limited risk distributor might end up with profits that are far above what would constitute an arm's length remuneration for performing what is essentially a routine function.
At year-end, taking into account the economically relevant factors, the MNE would therefore have to assess whether the initial decision to reduce prices can still be justified. If the outcome of this analysis is that the decision taken at the start of the pandemic resulted in a non-arm's length outcome, it should be considered whether third parties would have rectified this and, if so, whether adjustments can be made before year-end to ensure an arm's length result.
This is of particular importance as any adjustments made after year-end would result in a secondary adjustment and trigger additional tax costs in the form of dividends tax. In this context, potential exchange control, indirect tax and customs issues should also be considered.
at the time of submission of the tax return
Tax returns in respect of certain 2020 financial year-ends will already include the impact of the pandemic on the MNE's business, albeit mostly for a limited period of time only. Taxpayers might also have to submit transfer pricing documentation in the form of a local file and master file.
This is when SARS expects the taxpayer to test the arm's length nature of their controlled transactions. The arm's length nature of the commercial decisions taken at the start of the pandemic and reviewed at year-end may have to be justified, should the economic conditions prevalent at the time when submitting the tax return have changed considerably. This is also the time when SARS will be assessing these decisions and the taxpayer will have to explain any inconsistencies or contradictions as a result of subsequent developments.
the importance of documentation
In light of substantially increased audit activity by tax authorities, trying to make up for the loss of tax revenue as a result of the pandemic, the importance of contemporaneously documenting each decision taken by a MNE should not be underestimated. Especially considering the difficulties expected to "reconstruct" the specific economic circumstances at the time when the taxpayer had to make decisions regarding how to deal with the impact of the pandemic on its business and transfer pricing model.
In practice, this has to happen at different levels:
- The first and immediate step has to be to ensure that any decision taken by the taxpayer is either catered for in the legal agreements or, if required, the legal agreements are updated to ensure that the commercial and legal realities are aligned. Documentation supporting the decision to change the terms of the legal agreements, such as budgets, forecasts etc. should be retained.
- In a second step, taxpayers will have to carefully consider the disclosure of the pandemic related economic circumstances and how these affected the business and the transfer pricing model in the master file and local file transfer pricing documentation. This will be the taxpayer's first line of defence against scrutiny by the tax authorities.
In addition, taxpayers are advised to prepare an extra COVID-19 defence file. This defence file could be used to:
- document timelines specific to the MNE
- track the relevant changes to the business of the MNE,
- document who is responsible for taking the decisions relevant for control over risks materialising as a result of the pandemic, and
- document as much information as possible concerning uncontrolled transactions and behaviour in the same industry during these periods.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.