Guidance on the implications for transfer prices of the COVID-19 pandemic

An OECD policy responses to the Coronavirus (COVID-19) was published on 18 December 2020, called:

“Guidance on the implications for transfer prices of the COVID-19 pandemic”

In view of the current nature of this topic, companies that must comply with the obligations related to “transfer pricing” should pay attention to these new guidelines.

February/2021

 

We now transcribe an extract from this document.

 

Executive summary 

 

The “Guidance on the transfer pricing implications of the COVID-19 pandemic” represents the consensus view of the 137 members of the Inclusive Framework on BEPS regarding the application of the arm’s length principle and the OECD Transfer Pricing Guidelines to issues that may arise or be exacerbated in the context of the COVID-19 pandemic.

The unique economic conditions arising from COVID-19 and government responses to the pandemic have led to practical challenges for the application of the arm’s length principle. For taxpayers applying transfer pricing rules for the financial years impacted by the COVID-19 pandemic and for tax administrations that will be evaluating this application, there is an urgent need to address these practical questions.

The OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations 2017 (“OECD TPG”) are intended to help tax administrations and multinational enterprises (“MNEs”) find mutually satisfactory solutions to transfer pricing cases and should continue to be relied upon when performing a transfer pricing analysis, including under the possibly unique circumstances introduced by the pandemic. Accordingly, this 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 the COVID-19 pandemic, rather than on developing specialised guidance beyond what is currently addressed in the OECD TPG.

 

This guidance focuses on four priority issues where it is recognised that the additional practical challenges posed by COVID-19 are most significant:

  1. comparability analysis;
  2. losses and the allocation of COVID-19 specific costs;
  3. government assistance programmes; and
  4. advance pricing agreements (“APAs”).

 

In view of the interest and timeliness of these new OECD guidelines on the issue of transfer pricing, we have transcribed some points on the first issue “Comparability analysis”

 

1. Introduction 

 

9. The unprecedented change in the economic environment following the outbreak of COVID-19 creates unique challenges for performing comparability analysis. The pandemic may have a significant impact on the pricing of some transactions between independent enterprises and may reduce the reliance that can be placed on historical data when performing comparability analyses. This may require taxpayers and tax administrations to consider practical approaches that can be adopted to address information deficiencies, such as comparability adjustments. Such practical approaches regarding the performance of comparability analyses should be consistent with the transfer pricing policy of the taxpayer over time.

 

10. The challenges associated with performing a comparability analysis may vary depending on the impact of the COVID-19 pandemic on the economically relevant characteristics of the accurately delineated transaction. For example, if a controlled transaction is covered by a pre-existing intercompany agreement (for example, if in 2018 it was determined that at arm’s length a party should receive an agreed fixed return for five years, and that parties at arm’s length would remain bound by that agreement), there may be no need to perform a comparability analysis for Financial Year (“FY”) 2020 provided that the facts and circumstances of the accurately delineated controlled transaction have not changed. In reaching this conclusion, it is important to consider any changes in the economically relevant characteristics, including the terms and conditions of the agreement, and whether at arm’s length, unrelated parties would have tried to renegotiate those terms and conditions. In contrast, where the arm’s length price of a controlled transaction is determined on an annual basis, it will be necessary to perform a comparability analysis for FY 2020.

 

2. What sources of contemporaneous information may be used to support the performance of a comparability analysis applicable for FY 2020?

 

11. In principle, any form of publicly available information regarding the effect of COVID-19 on the business, industry and controlled transaction may be relevant in ascertaining the arm’s length nature of an enterprise’s transfer pricing policy implemented for FY 2020. The following sources of information may support that determination through the comparability analysis, generally by estimating the effect of the COVID-19 pandemic on the controlled transactions under review:

 

  •   An analysis of how sales volumes have changed during COVID-19, including whether the change is due to the use of other sales channels, and specifically compared to sales generated in pre-COVID years;

 

  • An analysis of the change in capacity utilisation relevant for the MNE group and the controlled transaction, and/or transactions with independent parties;

 

  • Specific information relative to incremental or exceptional costs borne by parties to the controlled transaction (either with associated or unrelated parties) or by the MNE group as a whole;

 

  • The extent to which government assistance has been received and, if so, quantifying the effect and identifying the type of the assistance and its accounting treatment;

 

  • Details regarding government interventions that have affected the pricing and performance of controlled transactions;

 

  • Information from interim financial statements such as quarterly SEC filings or earnings releases;

 

  • Macroeconomic information like country specific GDP data or industry indicators from central banks, government agencies, industry or trade associations to the extent useful in understanding the context of the controlled transaction;

 

  • Statistical methods such as regression analysis or variance analysis that are used to predict the extent to which a certain variable will vary with reference to other variables under certain specific conditions (e.g. the response of corporate profits in certain industries to GDP movements);

 

  • A comparison of internal budgeted/forecasted data relating to sales, costs and profitability, compared to actual results; and

 

  • An analysis of the effects on profitability or on third party behaviour observed in previous recessionary periods or using any data available in the current year, even if partial.

 

3. Can budgeted financial information be used to support the setting of arm’s length prices?

 

12. Another potential approach to utilise 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. The financial outcomes that taxpayers within a controlled transaction would have achieved ‘but for’ the impact of COVID-19 may provide useful information, particularly when assessing the financial impacts from COVID-19 (e.g. reduced sales volume or increased operating expenses) and determining, in light of contractual terms and risk assumption of the parties, any appropriate resulting impact on intercompany prices. This analysis may include:

  • The preparation of a detailed profit and loss analysis showing changes in revenue and expenses, with an explanation for variances resulting from COVID-19 – this may include a variance analysis of budgeted (pre-COVID) versus actual results;

 

  •  Details of profitability, adjusted to where the outcome would have been if COVID-19 had not occurred – this should consider all factors that have a positive or negative impact on the profits of the taxpayer to a controlled transaction and should be supported by evidence;

 

  • The rationale and evidence for any increased allocation of costs or a reduction of sales (and subsequent changes in operating margins) to the tested party in the controlled transaction, taking into consideration its function, asset and risk profile; and

 

  • Any evidence of any government assistance provided or affecting the tested party in the controlled transaction, its effect and its accounting treatment.

 

13. Such a review may be performed as part of a more general set of approaches utilised to evaluate the context and the factors that may impact the arm’s length nature of prices. 

 4. Under what circumstances are timing issues most pronounced?

 

14. Information relating to the conditions of comparable uncontrolled transactions undertaken during the same period as the controlled transaction (“contemporaneous uncontrolled transactions”) is the most reliable information to use in a comparability analysis. Such information reflects how independent parties behave in an economic environment that is the same as or substantially similar to the economic environment of the controlled transaction.

 

 15. In some instances, comparability analysis can be performed using contemporaneous (or near contemporaneous) uncontrolled transactions. For example, publicly available commercial databases typically have current or recent information on financial transactions between unrelated parties, which may provide reliable information on which to base comparability analyses under current economic conditions. Similarly, taxpayers are more likely to have current information on potential internal comparables, where these can be used to price related party transactions.

 

16. In other instances, it may be more challenging to use contemporaneous uncontrolled transactions as part of a comparability analysis, notably in the application of the transactional net margin method (“TNMM”). 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 because commercial databases use publicly available information derived from financial statements and these financial statements tend to be lodged only after several months after the period to which they relate. This suggests that in these circumstances taxpayers will need to perform a comparability analysis based on available prior year financial information and, depending on the facts and circumstances of the case, utilising whatever current year information is available to support their transfer prices.

 

 

17. However, not every application of the TNMM will in principle require contemporaneous information for FY 2020. For example, a long term arrangement covering FY 2019 through FY 2022 may be in place, including an arm’s length price based on comparables contemporaneous with the negotiation of the arrangement, that insulates the tested party from risks that the tested party does not assume like those that play out during the pandemic. See also paragraph 10.

 

5. What practical approaches may be available to address information deficiencies?

 

18. As the economic circumstances caused by the pandemic are continuing and evolving over time, taxpayers may encounter difficulties in determining arm’s length conditions due to the lag in time between the occurrence of controlled transactions and the availability of information regarding contemporaneous uncontrolled transactions.

 

19. Data from independent comparable transactions or companies from other time periods, such as average returns in preceding years, may not provide a sufficiently reliable benchmark for the current period without considering the specific impact of the pandemic on the controlled transactions under review.

 

 20. The discussion below provides several pragmatic approaches to this issue. Tax administrations could consider these pragmatic approaches in an attempt to minimise disputes where taxpayers are making good faith efforts to determine arm’s length prices in the context of the information deficiencies associated with the COVID-19 pandemic. However, these approaches would not be appropriate in cases where taxpayers seek to use the circumstances attached to the COVID-19 pandemic to manipulate their pricing strategies in a way that is inconsistent with the arm’s length principle.

 

 5.1. Allow for the use of reasonable commercial judgement supplemented by contemporaneous information to set a reasonable estimate of the arm’s length price

 21. The difficulty posed by the delayed availability of contemporaneous data on comparable companies or transactions may have been exacerbated by the COVID-19 pandemic. Taxpayers and tax administrations should be mindful that determining a reliable arm’s length outcome requires flexibility and the exercise of good judgment.10 Difficult transfer pricing issues that arise as a result of the COVID-19 pandemic could give rise to a large number of mutual agreement procedure (“MAP”) disputes that could severely strain the resources of tax administrations. As such, tax administrations are encouraged to keep these complexities in mind when performing risk assessments, evaluating transfer pricing positions on audits and considering the support and documentation taxpayers provide that might demonstrate reasonable efforts and care when trying to comply with the arm’s length principle. Taxpayers should undertake reasonable and appropriate due diligence in evaluating the likely effects of the COVID-19 pandemic and in implementing appropriate changes in their transfer prices. MNE groups should document the best available market evidence currently available, which may be in the form of internal comparables, external comparables, or other relevant evidence of the economic impact of the COVID-19 pandemic (see paragraph 11), including its effects on the level of demand for goods and services, and on production and supply chains in particular sectors of the economy.

 

5.2. Where feasible, allow for an arm’s length outcome testing approach

 

 22. The OECD TPG describe two approaches to identify and collect data required to undertake a transfer pricing analysis. The first is a “price-setting,” i.e. an ex-ante approach, which uses historical data updated to reflect any change in economic conditions through the date of the contract. The second is an “outcome-testing” approach, which may incorporate information that becomes available after the close of the taxable year to determine arm’s length conditions and report results on the tax return. According to the OECD TPG, both approaches, or a combination of these approaches, are found among OECD member countries.

 

 23. 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). Tax administrations could provide flexibility to allow amendments to FY 2020 tax returns such that transfer prices are set on an arm’s length basis and using available information. Also given the potential for double taxation that may arise as a result of unilateral adjustments, consideration may be given by tax administrations to:

 

  •  Provide for flexibility in the allowance of “compensating adjustments” to be made before the tax return is filed, where it is legally permissible, in order to allow for any available contemporaneous information to be better evaluated by taxpayers and tax administrations such that arm’s length prices can be reliably established; or

 

  • Ensure access to the MAP, or to some alternative applicable procedure, where the issue could be addressed between the respective tax administrations and early certainty could be obtained, to avoid double taxation, noting that through MAP or alternative procedures tax administrations can address issues in a non-adversarial proceeding, often achieving a negotiated settlement in the interests of all parties.

 

 5.3. Use of more than one transfer pricing method

 

 24. In the specific circumstances of the COVID-19 pandemic, the application of more than one transfer pricing method may be useful to corroborate the arm’s length price of a controlled transaction. In this context, it is important to note that the arm’s length principle does not require the application of more than one method and that the use of more than one method should follow the guidance in paragraphs 2.2 and 2.12 of the OECD TPG.

 

 6. Can data from other crises be used to support price setting?

 

 25. A comparability analysis that is solely based on financial information from the global financial crisis 2008/2009 would raise significant concerns (despite the obvious superficial similarities between that crisis and the current pandemic), given the unique and unprecedented nature of the COVID-19 pandemic and its effect on economic conditions, as well as the variability of the impact by business sector of the 2008/2009 crisis. In all cases, a comparability analysis should be performed by reference to the specific delineation of the controlled transaction, including its actual economic circumstances.

 

 7. How might the period of data used to evaluate arm’s length pricing be established to support a comparability analysis?

 

 26. The principles outlined in Section B.5 of Chapter III of the OECD TPG regarding the use of multiple year data and averages remain applicable. In ordinary circumstances, the use of multiple year data and multiple year averages for comparability analyses may have certain advantages. For example, it can be used as a means to mitigate the impact of accounting differences, appropriately measure the effects on profitability for the tested party based on its business and product life cycles, and to evaluate the same for the comparables, such that the reliability of the comparison is increased.

 

 27. 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. This may be appropriate, so long as the data from independent comparables can be measured over a similar period in a consistent manner. Care should be taken to ensure the financial data of years affected by the pandemic do not unduly distort results from pre- or post-pandemic periods.

 

 In addition, government intervention in a market may materially affect the performance of activities. For example, in certain situations, the activities that otherwise normally would have occurred absent the pandemic may not occur in the same manner (or at all) during the period that the government intervention is in place. Also, in some cases a government intervention may permit activities to proceed that otherwise would have been curtailed or stopped by the pandemic. The accurate delineation of a controlled transaction will determine the effect, if any, of such intervention on the price or form of any controlled transaction associated with such activities.

 

28. This aspect is also relevant in performing the comparability analysis. For instance, assume government intervention forces a taxpayer to close its distribution facilities for three months. In undertaking a benchmark analysis, care should be taken in verifying that comparable enterprises have faced similar restrictions or conditions. Otherwise, it might be necessary to adjust the period over which the comparison is performed (e.g. excluding the economic data corresponding to the three months where the taxpayer was unable to operate). Taxpayers and tax administrations should determine on a case-by-case basis the extent to which these adjustments are necessary in circumstances where the potential differences may not have a material impact on the comparability. In this respect, the guidance in paragraphs 3.50 to 3.52 of the OECD TPG is relevant.

 

29. As with other analyses under the OECD TPG, numerous considerations may come into play, including the availability and choice of potential transfer pricing methods and comparables, and the interrelationship among them and the parameters of the testing periods (e.g. a transaction-based method may have a different time frame from a profit-based method). Just as it may improve reliability to use separate or more carefully circumscribed testing periods (or price setting periods) in some fact patterns (see paragraph 27), in other fact patterns the use of combined periods (that include both years that are impacted by the pandemic and years that are not impacted) may improve reliability. This approach would aggregate the financial results of FY2020, which may be exceptional, with the more normal results of prior years in order to test the arm’s length nature of the transfer pricing policy applied in FY2020.

 

8. Would price adjustment mechanisms be appropriate?

 

30. 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. This may provide for flexibility while maintaining an arm’s length outcome. In particular, this approach to the extent permissible by domestic law would allow the adjustment of prices relevant for FY2020 through adjusted invoicing or intercompany payments effectuated in a later period (likely FY2021), when more accurate information to establish the arm’s length transfer price becomes available. In jurisdictions that use the outcome-testing approach (see question 5.2 above), price adjustment mechanisms to reflect updated information relevant to determining an arm’s length price are often used. A jurisdiction that temporarily allows the outcometesting approach (see question 5.2 above) could also temporarily allow the use of price adjustment mechanisms for that purpose and the taxpayer would be expected to describe the application of the price adjustment mechanism in its transfer pricing documentation. Such price adjustment mechanisms (provided that they are consistent with the arm’s length principle in the particular facts and circumstances) would address the issue of the lack of contemporaneous information on comparables or other direct evidence of arm’s length behaviour in response to the pandemic. This would give flexibility to taxpayers and tax administrations while also ensuring ultimate compliance with the arm’s length principle; however, given the scope of the potential adjustments, care would need to be taken with their appropriate characterisation, any effects that the payment may have on the comparability analysis for FY2021, and their potential resultant VAT/GST and customs duty implications (which are not the subject of this chapter or guidance).

 

9. What actions may be taken to evaluate the set of comparable companies or transactions used?

 

31. The COVID-19 pandemic has created economic conditions that often differ from those of previous years. In these circumstances, where a taxpayer rolls forward an existing set of comparables to cover FY2020, it may be necessary to review the suitability of these existing comparables and potentially in some cases, it may be useful to revise the set, based on updated search criteria.

 

32. For example, assume that geographic comparability is deemed as the most relevant comparability factor given the nature of the effects of COVID-19 in a particular market. In these circumstances, in order to obtain reliable data from a particular market it may potentially be necessary to relax other comparability criteria, and then refine the sample.

 

10. Can loss making comparables be used?

 

 33. In general, there is no overriding rule on the inclusion or exclusion of loss making comparables in the OECD TPG. Accordingly, 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. Consequently, when performing a comparability analysis for FY 2020, it may be appropriate to include loss-making comparables when the accurate delineation of the transaction indicates that those comparables are reliable (e.g. the comparables assume similar levels of risk and that have been similarly impacted by the pandemic).

 

This communication is of a general nature and is merely informative, not intended for any particular entity or situation, and does not replace professional advice appropriate to the specific case. Vitis will not be responsible for any damage or loss arising from decisions made based on the generic and synthetic information described here.

The text was prepared based on the best information available at the time of its edition

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