By Randall Fox, Head, International Transfer Pricing, and Shee Boon Law, Director, International Tax, DLA Piper, London
The OECD published its long-awaited guidance on transfer pricing implications of the COVID-19 pandemic just before Christmas, in a still-uncertain landscape: vaccines were starting to be approved; a new variant of the virus emerged; and many countries began dealing with a fresh wave of infections.
Because COVID-19 uncertainty will continue to dominate the economic outlook in 2021, the new OECD guidance will be important to businesses that are examining how best to address the impact of the pandemic on their transfer pricing arrangements.
The OECD guidance covers the impact of COVID-19 on comparability analyses, treatment of losses and allocation of specific costs arising from COVID-19 and advance pricing agreements (APAs).
Businesses that have received government assistance are also advised to consider the transfer pricing implications of that assistance.
In this article, we summarise our observations on the new OECD guidelines.
Legal agreements are the starting point
Legal agreements are the starting point when examining the impact of the COVID-19 pandemic.
Independent parties may seek to renegotiate certain terms in their existing agreements in response to the pandemic. OECD guidelines require tax authorities to review these agreements and the conduct of associated enterprises to ascertain whether any such renegotiation should be respected, or whether indemnification of the harmed party may be required.
On the other hand, it cannot be presumed that the pandemic would change the pricing in a controlled transaction. The OECD guidance suggests there may be no need to perform a comparability analysis for the specific year(s) affected by the pandemic where, at arm’s length, unrelated parties would not have tried to renegotiate terms and conditions covered by a pre-existing intercompany agreement.
In contrast, where the arm’s length price is determined on an annual basis, it will be necessary to perform a comparability analysis for the specific years affected by the pandemic. In this context, the pandemic may have a significant impact on pricing between unrelated parties and may reduce the reliance that can be placed on historical data (and increase the use of comparability adjustments).
Adopt a practical approach to contemporaneous documentation
Assuming that the COVID-19 pandemic will persist well into 2021, at this point, it is expected to affect businesses only for a specific year or 2. The pandemic’s impact has to be clearly documented, focusing in particular on the realisation of a hazard risk that has led to unusual outcomes on marketplace risk (ie, the impact on demand for goods and services), operational risk (ie, the impact on supply chains and production) and financial risk (ie, the impact on borrowing costs and credit), as well as the impact on other economically significant risks identified in a controlled transaction.
Any renegotiation of related party arrangements should be well supported by documentation outlining how the modification is in line with the arm’s length principle. The contemporaneous documentation can include any form of publicly available information as well as internal budgeted/forecasted data. The OECD guidelines also set out several practical approaches to address information deficiency caused by the timing of available data reflecting the impact of COVID-19 pandemic.
Documentation should be taxpayer and transaction specific
The OECD guidance recognises that COVID-19 has had particular impacts on different types of businesses. This means it is important to provide evidence of the impact on the specific controlled transaction within a specific business. A general observation of the widespread effects of the COVID-19 pandemic in an industry or within a multinational group is not sufficient – the evidence must be specific to how a member of the group bears the realisation of economically significant risks it controls in related party transactions as a consequence of the pandemic.
Limited risk entities may incur certain COVID-19 losses and bear specific pandemic costs
The OECD guidelines do not prohibit limited risk entities from incurring losses caused by the pandemic or being allocated specific pandemic costs, as long as these approaches are supported by an accurate delineation of the controlled transaction and a robust comparability analysis. To the extent that the risk assumed by a limited risk entity is consistent with the realisation of a hazard risk caused by the pandemic (such as the marketplace risk), the limited risk entity may be allocated a loss associated with the playing out of this risk.
However, if before the pandemic, a limited risk entity did not assume any credit risk, it may not be appropriate for it to bear the realisation of such a risk during the pandemic. Doing so may lead tax authorities to question the original pre-pandemic characterisation, or to treat the change as a business restructuring.
Impact of government assistance should be analysed
Government assistance during the pandemic comes in different forms and is likely to impact transfer pricing in different ways. The receipt of government assistance in itself cannot be presumed to have an impact on the price of controlled transactions – a comparability analysis needs to be performed, taking into account economically relevant characteristics and the conditions imposed by the government assistance, among other factors.
The receipt of government assistance is unlikely to impact the allocation of risk in related party transactions, although it reduces the negative impact of the realisation of a particular risk. Furthermore, government assistance may affect the comparables and the arm’s length prices of uncontrolled transactions in different ways. The impact of government assistance should be identified and considered when reviewing potential comparables.
Engage proactively with tax authorities on existing APAs and ongoing APA negotiations
The pandemic has led to changes in economic conditions that underpin existing APAs and those under negotiation. Engaging with the tax authorities proactively, supported by well documented evidence on the impact of COVID-19, would be important not only in terms of assessing whether critical assumptions have been violated but also in determining whether a revision, cancellation or revocation is the appropriate response. In negotiating APAs that will cover the years affected by COVID-19, a flexible and collaborative approach would ensure outcomes that are practical and workable for taxpayers and tax administrations alike.
COVID-19 has caused all manner of uncertainty. The transfer pricing implications of the pandemic are not immune from that uncertainty but at least the OECD’s guidance is a genuine and welcome attempt to ease some of that uncertainty. Some prudent thought and analysis can be beneficial.
This article was originally published in Thomson Reuters’ Weekly Tax Bulletin.