Just in time for the holidays, the OECD has published detailed guidance about the impact of the COVID-19 pandemic on transfer pricing. The guidance has useful information for taxpayers and tax administrations alike. It contains general advice on the application of basic transfer pricing principles during the pandemic, as well as specific advice on four issues: (i) comparability analyses, (ii) allocating losses, (iii) government-assistance programs, and (iv) advance pricing arrangements ("APAs"). The OECD guidance is broadly consistent with comments we made in a prior post about the impact of the pandemic on transfer pricing.
Basic Principles. The guidance confirms that the arm's length principle controls during the pandemic. According to the OECD, "[t]he arm's length principle has been found to work effectively in the vast majority of cases, and this principle-based approach to assessing intercompany prices is equally robust for evaluating controlled transactions in the face of the COVID-19 pandemic."
The guidance recognizes that "unique and almost unprecedented economic conditions" arising from the pandemic have led to difficulty in applying the arm's length principle. But the guidance suggests that taxpayers and tax administrations don't "lose sight of the objective to find a reasonable estimate of an arm's length outcome." And it suggests that taxpayers would be well advised to carefully document how the pandemic is impacting their transfer pricing.
Comparability. The guidance makes the unsurprising point that historic data—particularly as to profitability—might be less valuable in a comparability analysis during the pandemic. Further, as we explained previously, documenting the comparability analysis might be more difficult during the pandemic. In light of these problems, the guidance suggests that taxpayers and taxing authorities will need to be flexible and creative in finding workarounds.
Beyond that generic advice, the guidance provides specific advice about how the pandemic might impact comparability. The following points seemed especially relevant:
- "Where possible, and on a temporary basis during the pandemic, tax authorities that otherwise use the price-setting approach could consider allowing taxpayers, for those controlled transactions affected by the pandemic, to take into account information that becomes available after the close of the taxable year in filing their returns (where legally permissible and properly described in the transfer pricing documentation)."
- The guidance suggests that taxpayers could use more than one transfer pricing method for the year if that reaches a more accurate result.
- Data from other crises might be helpful. But "[a] comparability analysis that is solely based on financial information from the global financial crisis 2008/2009 would raise significant concerns."
- "As a pragmatic means of addressing divergent economic conditions in the pre- or post-pandemic period, and when the pandemic was in effect and its effects on economic conditions were material, it may be appropriate to have separate testing periods (and periods considered for price setting) for the duration of the pandemic or for the period when certain material effects of the pandemic were most evident."
- "One potential solution to the uncertainty caused by the COVID-19 pandemic would be to allow for the inclusion of price adjustment mechanisms in controlled transactions."
Allocation of Losses. According to the guidance, "[t]he allocation of losses between associated entities can give rise to dispute and hence is an issue that requires consideration given the probable increase in the frequency and magnitude of losses in the current economic environment."
The guidance confirms that limited-risk entities can experience losses in the short term, such as during the pandemic. But it suggests that taxing authorities will look suspiciously on taxpayers who claim that an entity was a limited-risk entity before the pandemic, but a risk bearing entity during 2020 so that it may be allocated a greater share of losses.
The guidance also suggests that "it is possible that independent parties may not strictly hold another party to their contractual obligations, particularly if it is in the interest of both parties to renegotiate the contract or to amend certain aspects of their behaviour. For example, unrelated enterprises may opt to renegotiate a contract to support the financial survival of any of the transactional counterparties given the potential costs or business disruptions of enforcing the contractual obligations, or in view of anticipated increased future business with the counterparty." We discussed this concept in a prior blog post. Further, in a different post, we cautioned that support payments may be considered a cross-border transfer of value requiring compensation from a transfer pricing standpoint and may also give rise to tax consequences associated with an outbound transfer of IP or "business restructuring" in the context of the OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations.
Government assistance. The guidance suggests that government-assistance programs will pose particular challenges for transfer pricing analyses in 2020. "[T]he receipt of government assistance may be part of the economic circumstances of the parties and a feature of the market in which the parties operate."
The guidance sets out the following factors to consider when evaluating the impact of government assistance on transfer pricing:
- whether the receipt of government assistance provides a market advantage to the recipient;
- the amount of any increase in revenues, decrease in costs, vis-à-vis those of reliable comparables, that are attributable to the government assistance received, and the duration of the assistance;
- the degree to which benefits of government assistance, at arm's length, are passed on to independent customers or suppliers; and,
- where benefits attributable to government assistance exist and are not fully passed on to independent customers or suppliers, the manner in which independent enterprises operating under similar circumstances would allocate such benefits between them.
Advance Pricing Arrangements. According to the guidance, "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 and tax administrations cannot automatically disregard or alter the terms of existing APAs due to the change in economic circumstances." At the same time, according to the guidance, "[t]he COVID-19 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."
When documenting a failure to meet a critical assumption, the guidance suggests the following:
- A description of the narrowest relevant taxpayer business segment tracked by management that encompasses the entities and covered transactions involved in the APA.
- Forecast and actual business segment profits for the financial years ending with or within financial years affected by COVID-19.
- Copies showing any proposed or implemented modifications to pre-existing agreements or of new intercompany contracts among the controlled parties affecting the covered transactions.
- A narrative explaining the anticipated effects of the current economic conditions on an agreed transfer pricing methodology during the financial years affected by COVID-19 including whether it caused restructuring of its operations and/or changes in its risks and responsibilities, and any mitigation of the impact of the current economic conditions on the tested party by government actions or other mechanisms such as business interruption insurance.
- A detailed profit and loss statement ("P&L") with a breakdown of cost of goods sold ("COGS") and selling, general and administrative expenses ("SG&A") and other non-interest expenses for financial years affected by COVID-19 that include the covered transactions subject to the APA.
- Information about third party behavior.
While this guidance is primarily intended to assist taxpayers in documenting potential critical assumption failures in existing APAs, it seems that this guidance may be equally helpful to new APAs that include tax years adversely impacted by COVID-19. This is because the same documentation that the OECD recommends to substantiate critical assumption failures is likely to be equally relevant and helpful to a tax administration evaluating the impact of COVID-19 on a pending APA.
Finally, we would note that some tax administrations have previously issued their own guidance on the impact of the COVID-19 pandemic on APAs, including the US Internal Revenue Service ("IRS") and the Inland Revenue Authority of Singapore ("IRAS"). The IRS's guidance and IRAS's guidance were the subject of prior posts.
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