The unique economic conditions arising from COVID-19 have seriously impacted financial performance raising the question of how these impacts should be shared. There is an urgent need to address these practical questions and this is the purpose of the Attached Report issued on 18 December 2020 by the OECD as “Guidance on the transfer pricing implications of the COVID-19 pandemic” (“The Guidance”).
The Guidance emphasizes that the OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations 2017 (“OECD TPG”) should continue to be relied upon when performing a transfer pricing analysis. Accordingly, the Guidance focuses on how the arm’s length principle and the OECD TPG apply to issues that may arise or be exacerbated in the context of COVID-19, rather than on developing specialized guidance beyond what is currently addressed in the OECD TPG. The Guidance represents the consensus view of the 137 members of the Inclusive Framework.
Although overly generic, the Guidance can be quite helpful for those Taxpayers who want a roadmap on how to use COVID-19 to justify reducing their taxable profits in 2020.
Four Areas Covered by the Guidance
The Guidance focuses on four priority issues where the additional practical challenges posed by COVID-19 are considered most significant:
- Comparability analysis
- Losses and the allocation of COVID-19 specific costs
- Government assistance programs
- Advance pricing agreements (APAs)
Is the Guidance relevant to your company?
For many MNCs, the Guidance may be irrelevant because they are unaffected by COVID-19 or because even if there has been an impact there is no intention to pass those costs to offshore subsidiaries.
The Guidance is relevant in particular for MNCs who need insights on how to
- Lower profit for Single-Function Entities: Typically, a simple-function, low-risk entity (such as a contract manufacturer or distributor) receives a guaranteed profit. However, the Guidance provides a way to reduce the guaranteed profit rate for 2020 below the normal rate
- Defend Selective Royalty Waivers: The COVID-19 has impacted countries in a widely different way. So MNCs may have waived royalties or service fees for some countries but not others. This would need to be documented.
- Allocate COVID-19 costs: Companies who want to push COVID-19 costs to the subsidiaries will need a policy to classify and allocate COVID-19 between the Principal and the local subsidiary and the Guidance is useful in this regard.
- Invoke Force Majeure: The Guidance discusses using COVID-19 as a Force Majeure event to amend the intercompany agreement.
- Amend APA: The Guidance explains whether COVID-19 is a “breach of critical assumptions” and if so how to amend APA accordingly
- Document COVID-19 Losses: Traditional approach such as using 3-years of comparable data may not be effective in explaining the poor financial results due to COVID-19.
How to conduct 2020 comparables analysis?
The Guidance acknowledges that COVID-19 has created unique challenges for performing comparability analyses due to focus on historical data. The Guidance notes in this regard that “When applying the TNMM, taxpayers and tax administrations typically rely on historical information from commercial databases in order to set and test prices. FY 2020 information will typically not be available until mid FY 2021 at the earliest”.
The Guidance then offers the Taxpayers wide latitude in trying to resolve this roadblock:
Selectively Use 2020 information: COVID impacted information can be extracted from interim financial statements such as quarterly SEC filings or earnings releases.
Separate testing periods: As a pragmatic means of addressing divergent economic conditions in the pre- or post-pandemic period, and when the pandemic was in effect, it may be appropriate to have separate testing periods (and periods considered for price setting) for the duration of the pandemic
Include loss-making comparables: The Guidance notes that loss-making comparables that satisfy the comparability criteria in a particular case should not be rejected on the sole basis that they suffer losses in periods affected by the COVID-19 pandemic.
Supplement with commercial factor analysis: The Guidance discusses use of commercial factors such as “An analysis of how sales volumes and capacity utilization and other variables have changed during COVID-19 compared to pre-COVID years”.
Supplement with budgeting vs. actual simulations: The Guidance states that “Another potential approach to utilize in setting transfer prices is to compare budgeted or forecast financial results to those actually achieved, to approximate the specific effects of COVID-19 on revenues, costs and margins.”
Can Entities operating under limited risk arrangements incur losses?
This is a very important question, but the Guidance only offers generalities. The Guidance states that “In all circumstances it will be necessary to consider the specific facts and circumstances when determining whether a so-called "limited-risk" entity could incur losses at arm's length. This is reflected in the OECD TPG which states that "simple or low risk functions in particular are not expected to generate losses for a long period of time" and therefore holds open the possibility that simple or low risk functions may incur losses in the short-run.
For example, where there is a significant decline in demand due to COVID-19, a "limited-risk" distributor that assumes some marketplace risk may at arm's length earn a loss associated with the playing out of this risk. The extent of the loss that may be earned at arm's length will be determined by the conditions and the economically relevant characteristics of the accurately delineated transaction compared to those of comparable uncontrolled transactions.”
How should Operational or exceptional costs arising from COVID-19 be allocated between related parties?
The Guidance introduces the concept of “exceptional and non-recurring operating costs” and
states that “As a result of the COVID-19 pandemic, many enterprises have incurred exceptional, non-recurring operating costs relevant to differing operating conditions for the pandemic period. These include expenditure on Personal Protective Equipment (PPE), reconfiguration of workspaces to enable physical distancing, IT infrastructure expenses relating to test, track and trace obligations and to implement teleworking arrangements.” Unfortunately, the Guidance does not discuss indirect costs such as cost of excess capacity and costs associated with forced shutdowns.
The Guidance provides three general principles on the allocation of losses between associated entities.
- First, the allocation of risks between the parties to a transaction affects how profits or losses resulting from the transaction are allocated at arm’s length.
- Second, exceptional, non-recurring operating costs arising as a result of COVID-19 should be allocated based on an assessment of how independent enterprises under comparable circumstances operate.
- Finally, associated parties may consider whether they have the option to apply force majeure clauses, revoke or otherwise revise their intercompany agreements.
How may Force majeure affect the allocation of losses derived from the COVID-19 pandemic?
Force majeure clauses may be invoked in order to suspend, defer or release an enterprise from its contractual duties without liability in certain situations. Per the Guidance, it cannot be automatically assumed that when a relevant intercompany contract contains a force majeure clause that the COVID-19 pandemic is sufficient for a party to that contract to invoke force majeure, nor can it be automatically assumed in the absence of such a clause in the intercompany contract that a renegotiation with a potentially similar outcome at arm’s length would be inappropriate.
Under what circumstances may arrangements be modified to address the consequences of COVID-19?
The Guidance notes that the determination of whether a renegotiation is arm’s length should be based on what independent parties would do under comparable circumstances. In the absence of clear evidence that independent parties in comparable circumstances would have revised their existing agreements or commercial relations, the modification of existing intercompany arrangements should be treated with caution and well-supported by documentation outlining how the modification is in line with the arm’s length principle.
What Impact does COVID-19 have on 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 and tax administrations cannot automatically disregard or alter the terms of existing APAs due to the change in economic circumstances.
Most APAs include critical assumptions about the operational and economic conditions that will affect the transactions covered by the APA. The 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. Whether there has been a breach in a critical assumption should be analysed on a case-by-case basis, and it should take into account the individual circumstances of the taxpayer and commercial environment.
What Impact does COVID-19 have on APAs under negotiation?
In the current environment, taxpayers may be reluctant about continuing or initiating new APA applications. Where taxpayers and tax administrations are negotiating APAs that are intended to cover FY2020, all parties are encouraged to adopt a flexible and collaborative approach to determine how to take into account the current economic conditions, and the various options discussed above in relation to the revision of existing APAs will be relevant. For example, consideration could be given to agreeing a short period APA covering the period affected by the COVID-19 pandemic and a separate APA covering the post-COVID period.
Covid-19 - The Impacts Vary Enormously
While many countries are still reeling from COVID-19, China - where the virus was first identified - has become one of the safest places in the world. The country reported fewer than 100,000 infections (and less than 5,000 deaths) for all of 2020. The United States has reporting more than that every day since early November. Nor is the USA alone in facing a tsunami of infections, Europe (especially the United Kingdom) and India are also hit by rolling waves of COVID-19.
The statistical differences are astounding. The number of deaths in China at 4,791 is far below that of USA at 347,555 or UK at 75,024 by January 4th, 2021.
There is a strong correlation between COVID-19 control and economic performance. In 2020, China was the only major economy to record a positive growth. China GDP growth for 2020 is estimated at 1.9% versus -4.3% in USA, -10.3% in India and -9.8% in UK.
The Guidance is a fairly generic document and it adds nothing new to the TPG but merely suggests creative ways in which the TPG can be used to deal with the COVID-19 impacts. It provides support to those MNCS who wish to push COVID-19 costs down to the subsidiaries.
A common theme of the Guidance is that an appropriate arm’s length response to any issue will depend upon the facts and circumstances of the transaction under consideration. Unsurprisingly, given the need for consensus from 137 countries, the Guidance provides general principles for evaluating the arm’s length response without providing specific solutions. Nevertheless, the Guidance is helpful in that it provides useful discussion of the various factors that should be considered in making arm’s length pricing determinations under conditions impacted by COVID-19. Additionally, the Guidance’s encouragement of pragmatism and flexibility provides a welcome practicality to addressing some challenging transfer pricing issues.
However, taxpayers should be warned that despite the so-called 137-country consensus, the OECD operates in an advisory capacity and many nations will choose their own paths and ignore the OECD views when they conflict with their self-interest.
Finally with regard to China, COVID-19 has had minimal impact on US MNCs with regard to their China operations. But some MNCS have been hit and in this context the Guidance provides some support for them to lower their 2020 reported profit.