COVID-19 has forced many multinational enterprises (MNEs) to change the way business is conducted, due to significant disruption and change. Some industries have enjoyed a boom since early 2020, with a sudden influx of revenue and an increased workforce. Others have had to re-engineer service offerings and workplace environments, against the backdrop of weakening consumer demand and confidence, global supply chain disruptions, and a compromised workforce.
The long-term impact of COVID-19 on the global economy is unlikely to be known for some time, however real gross domestic product (GDP) in the OECD area showed an unprecedented fall of 4.9% for 2020, the largest fall ever recorded in over 50 years.
In a transfer pricing (TP) context, this has meant that some MNEs are experiencing losses across the value chain. Several new and unanticipated risks have also materialised in an unforeseeable and unprecedented way. However, for those sectors experiencing unprecedented growth and increased revenue, there are now additional profits in the chain that need to be properly allocated.
COVID-19 provides an opportunity for MNEs to revisit international related party dealings (including contracts and TP models between related parties), just as independent companies are doing, to help their businesses survive the pandemic and its aftermath.
As governments come under increased and sustained fiscal pressure, tax administrations are also likely to expand TP reviews and audit activity. MNEs will need to present clear evidence of the impact of COVID-19 on business and TP positions.
This article considers the impact of COVID-19 across the various stages of the TP lifecycle and provides practical guidance on steps MNEs can take to help ensure that TP policies and filing positions remain defensible in the light of commercial changes necessitated by COVID-19.
OECD guidance and revenue authority responses
In December 2020, the OECD released guidance which clarifies and illustrates the practical application of the arm’s-length principle to some of the unique fact patterns and specific challenges associated with the COVID-19 pandemic. The guidance was developed and approved by the 137 members of the OECD/G20 Inclusive Framework on BEPS (Inclusive Framework).
Four priority issues were identified and are covered in the OECD guidance:
The guidance emphasises the importance of a comparability analysis which specifically delineates the related party transaction, including its actual economic circumstances. It also recognises that the reliability of historical data used in comparability analyses may be reduced, and that if the arm’s-length price of a controlled transaction is determined annually, a comparability analysis will be required for the 2020 financial year.
Losses and the allocation of COVID-19 specific costs
In relation to losses, Chapter I of the OECD TP Guidelines is particularly relevant. It is noted that exceptional, non-recurring operating costs should be allocated based on an assessment of how independent parties operate. Further, the commercial rationale for any change in the risks assumed before and after the outbreak of COVID-19, must be considered.
Government assistance programmes
The OECD view is that government assistance may mitigate the quantifiable negative impact of a risk. It should therefore be taken into account when reviewing potential comparables (given that it may be relevant to how the parties establish commercial or financial relations, and how transactions are priced).
Advance pricing agreements
For MNEs with unilateral, bilateral or multilateral advance pricing agreements (APAs) in place, certain critical assumptions may have been breached depending on the impact of COVID-19. For non-material breaches, the business and tax authority may agree to keep the APA on foot. For material breaches, the APA may be revised, cancelled or revoked.
The OECD encourages businesses and tax authorities to adopt a flexible and collaborative approach to minimise delays in concluding APAs under negotiation.
Though tax authorities are cognisant of the impact COVID-19 is having on MNEs globally, challenges will inevitably arise for those multinational groups financially impacted, whether positively or negatively.
The Australian Taxation Office (ATO) released guidance on:
- How taxpayers should account for COVID-19 economic impacts on TP arrangements; and
- Concerns the ATO have with taxpayers changing related party agreements in the COVID-19 environment.
It is clear from the guidance issued that the impact of COVID-19 on TP positions is likely to be a key area of focus for the ATO (and other tax authorities globally) for the foreseeable future.
What should MNEs be considering in light of COVID-19?
Against this backdrop, now is the time for MNEs to consider the following (non-exhaustively) in relation to 2020 and beyond:
- Whether triggering of force majeure clauses, or revisions to key terms and conditions, in existing inter-company agreements is necessary;
- Whether penalty or termination clauses should be invoked;
- Whether covenant holidays or payment deferrals could be negotiated, or credit terms restructured;
- Whether parental guarantees are required in order to secure third party funding in the current economic circumstances;
- The impact of strengthened or weakening consumer demand and confidence on revenue and in turn, profitability forecasts;
- The materialisation of unexpected risks and the impact on functional, asset and risk profiles;
- Whether any of the above changes warrant a change in the TP method(s) applied or policies, or profit level indicators used;
- Whether new related party agreements are required depending on any changes in counterparties across the global value chain;
- Global supply chain interruptions including changes to the location and scale of key activities;
- How to reflect COVID-19 in benchmarking studies and economic analysis;
- The justification for (potential) profitability decreases or losses; and
- The allocation of additional profits that may have accrued to the MNE if in an industry or sector that has in fact been buoyed by COVID-19.
Impact of COVID-19 across the TP lifecycle: A holistic approach
There are four main stages to the TP lifecycle – plan, implement, manage and resolve. Together these steps help MNEs to proactively manage their day-to-day operational TP and documentation processes, prevent and resolve disputes.
Plan: Revisit pricing policies and anticipated results instead of waiting for year-end surprises
As mentioned above, COVID-19 has impacted the level of profits across the supply chain for many MNEs, thereby distorting the allocations of profits and losses between group companies.
Businesses are encouraged to proactively review and, where necessary, adjust TP policies and inter-company agreements, just as they would renegotiate third party contracts. It is critical to consider consistency, long-term relevance and flexibility; the commercial justification for any changes; and how independent companies and industry peers are reacting to COVID-19.
MNEs are strongly encouraged to develop a strategy based on anticipated results instead of waiting for year-end surprises. During this stage of the TP lifecycle, some of the practical and more granular considerations for MNEs may include:
- Which entities have historically been bearing the key risks in respect of inter-company transactions? Have these entities maintained this risk profile throughout COVID-19?
- Have new key risks materialised as a result of COVID-19 and who is responsible for managing these new risks?
- Are entities which have been previously characterised as limited risk distributors, breaking even, in fact incurring losses, in 2020 or are they insulated?
- Who is truly responsible for the development, enhancement, maintenance, protection and exploitation (DEMPE) of existing or new IP?
- Is there a need for additional funding to support cash flows during the period given reduced revenue (noting the credit rating may be impaired)?
- Alternatively, how can any excess cash be best used to reduce debt, invest in new businesses or product offerings?
- Where should additional profits sit, commensurate with the functional, asset and risk profiles of the entities in the value chain?
As part of the planning phase, it may become evident that the MNE’s operating model and global tax structure needs to be better aligned and integrated. Hence this planning phase is critical, bearing in mind the short-term impact felt by COVID-19, and the likely continued impact of the pandemic.
Implement: Build robust mechanisms to collate operational and financial data
This phase of the TP lifecycle involves implementing the right systems, for example building mechanisms to collect and collate relevant operational and financial data.
The current global environment is forcing many tax teams to do more with less, with a focus on preserving cash, reducing costs and providing increased value in a difficult business environment. Other tax teams are grappling with the effects of a sharp and sudden increase in demand, revenue and profits across the value chain. Ensuring that efficient and appropriate operational TP processes are in place, is critical.
MNEs should consider:
- Are the right systems in place to set prices as well as test outcomes?
- Can TP policies be effectively and efficiently tested, and how regularly?
- Are there specific shareholder, chargeable, or other types of costs which need to be identified and isolated/tracked?
- Is it a challenge to collect the relevant data for reporting deadlines/filings?
- Is there a more effective way of keeping track of new costs or expenses, or new transactions?
- Could the process for true-up adjustments be streamlined?
- Are local results consistent with new group policies (if any)?
- Can profit and loss segmentation, transaction data capture, etc. be automated?
- Is valuable data being appropriately leveraged and used effectively?
These short-term responses and more longer-term changes can help mitigate the potential financial and operational impacts of COVID-19.
Manage: Revisit inter-company agreements vis-à-vis actual conduct and prepare contemporaneous documentation to prevent disputes
Preparing contemporaneous documentation and audit defense files is the best way to successfully navigate any inquiries. Businesses are under increasing pressure to find efficient ways of managing TP documentation. The OECD recommendations are being expanded with additional local requirements, and tax authorities expect significant levels of detail and exactness from MNEs in their documentation.
Businesses must therefore analyse, document and keep evidence of business changes and the impacts of COVID-19 and address it explicitly and in detail in the TP documentation. MNEs, whether negatively or positively financially impacted by COVID-19, should gather comprehensive evidence to help explain and defend the TP position in the event of a tax authority review. Such evidence may include:
- From a benchmarking perspective, how have third party comparable companies fared during COVID-19? What year(s) will benchmarking studies cover? Is a special factor analysis required? Can loss-making comparables be included or a lower point in the range selected?
- For MNEs operating in an industry that has fared well (e.g. online retail, workplace solutions, cleaning products and supermarkets), how have competitors fared during COVID-19 (as the tax authorities would do the comparison)?
- Can ‘but for COVID-19’ results be prepared/provided to help illustrate how TP and financial outcomes were impacted by COVID-19?
- The justification for (potential) reductions in revenues, profitability decreases or losses, including any significantly impacted profit and loss items.
- Conversely, the rationale for increased revenue, additional profits and an explanation of how these have been allocated across the group.
- Commentary on how the taxpayer is controlling the impact of COVID-19 on performance and who within the MNE is controlling the major risks faced by the business.
- Board minutes, emails, presentations, TP documentation, news reports, competitor results or industry-specific information highlighting the impact of COVID-19 on financial results to support TP positions taken in 2020 with granular detail in case of tax authority enquiries.
The focus of this stage of the lifecycle is on contemporaneous TP documentation that tells a well-developed and coherent ‘story’ and demonstrates alignment between substance and form.
MNEs are also encouraged to monitor whether local tax authorities have issued temporary concessions or guidelines to support businesses in applying alternative TP methodologies during the pandemic. For certainty, MNEs may wish to proactively engage with revenue authorities in relation to any APAs in place for which critical assumptions and conditions are at risk of being breached as a result of the impact of COVID-19.
Resolve: Settle disputes with real-time evidence of the impact of COVID-19 and commercial drivers for change
In this last stage of the TP lifecycle, MNEs must consider past and future interactions with tax authorities and develop a resilient controversy strategy. To defend the existence/pricing of particular transactions, particularly if faced with delineation or reconstruction challenges, MNEs should play devil’s advocate and prepare for inevitable queries from the tax authorities.
APAs may help achieve certainty in this uncertain environment. The mutual agreement procedure (MAP) process may also be beneficial in resolving disputes. Looking at tax audits through a pre-, during, and post-COVID lens including any historic tax/TP audits and reviews, will help MNEs’ audit-readiness. This may involve defending profitability or results in the context of wider group margins; reviewing the appropriateness of critical assumptions in existing APAs given the pandemic was not foreseeable; or exploring new APAs where restructuring has occurred.
COVID-19 has undoubtedly led to unchartered waters for MNEs in managing complex supply chain, workforce and other key operational elements. Despite the well-documented predicament of certain industries, other sectors have better weathered the storm, with some even experiencing a surge in growth and profits.
Tax authorities are likely to be more investigative in this COVID-19 context, whether MNEs have been positively or negatively financially impacted. It is therefore imperative that MNEs collect and present the right quantitative and qualitative evidence to be able to demonstrate to tax authorities, down the track, the real impact of COVID-19 on business.
Across all stages of the TP lifecycle, MNEs must have a forward looking, comprehensive strategy for tackling the impact of COVID-19. Real-time evidence of the impact of COVID-19 and commercial drivers for change, robust documentation of the factual position and economic analysis to support arm’s-length outcomes, and bridging the gap between the tax authority’s understanding of the facts and reality, are more important now than ever to best prepare for inevitable inquiries.