COVID-19 impact on transfer pricing

Every company affected by COVID-19 has encountered (some of) the following experiences:

• Lockdowns and employees all having to work virtually from home;
• Cash flow management concerns leading to extended credit lines, trying to manage and reduce cost and reconsidering payment terms where possible;
• Pressure on corporate supply chains and logistics due to lack of people or lack of resources or border closings. This may result in temporary relocation of functions to other entities that (still) can perform, but as a result lead to extra costs, or if more permanent, a deemed business reorganization;
• Assessment of available stimulus measures and review of whether and how to apply for them;
• Permanent establishment exposure due to decision-makers or sales staff being locked down or situated in other countries longer than expected and intended due to COVID-19.

Multi National Enterprises (MNEs) face additional challenges, namely making sure that they translate the COVID-19 effects properly into their tax and transfer pricing policies.

Transfer pricing challenges

While independent enterprises can act swiftly to reduce costs, revise the terms of their agreements with third parties to adjust for the impact of COVID-19 and reframe their supply chains to cater to possible new opportunities, MNEs find themselves caught in a tight net of corporate tax rules that govern the allocation of global income to the separate enterprises that make up the MNE: transfer pricing rules and regulations. Their global income allocation is determined by an analysis of functions performed, assets used and risks assumed by the separate enterprises and should be consistent with the arm’s length principle (i.e. by reference to what independent enterprises would do). Changes to the characterization of the separate enterprises, as to how intercompany agreements are executed and to the income allocation determined by tax and transfer pricing policies are generally scrutinized, considered to be exclusively for tax optimization purposes and often challenged by tax authorities upon audit.

OECD guidance

Based on public request for guidance, the OECD published guidance on the transfer pricing implications of the COVID-19 pandemic for MNEs on December 18, 2020. This Insights briefing discusses the guidance issued and provides some suggestions that can help improve your transfer pricing position in case of a tax audit.

Issues of particular concern to business addressed by the OECD are:

• the third party comparability analysis that is used to benchmark what profit margin or return qualifies as being at arm’s length for associated enterprises;
• when will the incurrence and allocation of losses within an MNE group and the allocation of COVID-19 specific costs qualify as being at arm’s length;
• what is the impact of government stimulus programs for the intercompany transaction and transfer price as seen from an arm’s length perspective; and
• what to do with previously agreed profit margins in so-called Advance Pricing Agreements (APAs) when the economic circumstances change as much as they do in the COVID-19 situation.

Comparability analysis aspects

The comparability analysis forms the basis for applying the arm's length principle to inter-company transactions. In issue now is if (and how) you can adjust previously benchmarked margins that reflect historical data to anticipate (2020 and) 2021 results that may show lower margins than benchmarked earlier or even losses. Accurate delineation (i.e. considering the economically relevant characteristics of an inter-company transaction) and comparing the related party transaction with similar transactions between unrelated parties remains the rule. However, the OECD Guidance does offer some pointers: 

1. As comparable information may not be available, to substantiate lower margins a robust set of data and information will be required to support the COVID-19 impact (the OECD Guidance provides some examples) and importantly, that similar impact was observed at unrelated third parties. The guidance on comparables explicitly provides that loss making comparables may be used as long as the loss-making comparables meet the comparability criteria;

2. A variance analysis that considers financial results that were expected to be achieved "but for" Covid-19 as compared to actuals may also help;

3. Transactions undertaken by comparables during the same period as the controlled transactions are considered most reliable for a comparability analysis and to assess the COVID-19 impact on controlled transactions. Internal comparables (transactions of the MNE group with unrelated parties) are a good source of information, assuming those transactions indeed qualify as comparable transactions;

4. Tax administrations are encouraged to consider the complexities of obtaining contemporaneous data on comparables when performing risk assessments, evaluating transfer pricing positions during audits and considering the documentation that taxpayers prepared;

5. It is suggested that taxpayers are allowed (if need be temporarily) to use an outcome-testing approach, using information that becomes available after the close of the taxable year to determine arm's length conditions and report results on the tax return. Considering that transfer pricing usually affects more than one entity in more than one jurisdiction, this would require flexible use of compensating adjustments before the tax return is filed, to avoid double taxation;

6. It is suggested that on occasion, more than one transfer pricing method may be used to help- corroborate the arm's length price of a controlled transaction; and

7. Applying price adjustment mechanisms could be based on the use of force majeure or changed circumstances clauses in (intercompany) contracts, or even temporarily be allowed. However, allowing taxpayers to do so is conditioned upon the taxpayer describing the use of such clauses in their transfer pricing documentation and supporting that this would qualify as being at arm's length.

Treatment of losses and COVID-19 specific costs

Costs or losses resulting from COVID-19 should be allocated based on how independent enterprises would operate under comparable circumstances. While the characterization of an entity as being a so-called "limited-risk" entity is not necessarily considered decisive, but the extent to which risk, such as for example market risk or credit risk, is assumed by an entity is, tax authorities may question the commercial rationale for any purported change in risk assumed by a party before and after the COVID-19 pandemic outbreak. That said, in principle, a "limited-risk" entity can bear part of the economic impact of the COVID-19 pandemic in case it assumes the relevant risk (e.g., the market risk resulting from COVID-19 which would qualify as a hazard risk) and such a risk also materializes.

Force majeure

Essentially, invoking force majeure to alter an intercompany agreement is no different from doing so in an unrelated party agreement. To invoke a force majeure clause in a related party setting during the COVID-19 pandemic the underlying intercompany agreement should be considered and it must be reviewed if that clause can actually be invoked considering the circumstances. Force majeure may also be invoked in situations where intercompany agreements do not contain such clause, provided domestic law would allow such remedy.

Government Stimulus measures

A main transfer pricing question is whether the benefit of a government stimulus measure should be passed on through the supply chain or not. Government stimulus measures qualify as economically relevant characteristics that need to be evaluated when accurately delineating a controlled transaction. Therefore, the availability, purpose, duration and other conditions of a government grant of assistance will need to be reviewed. However, as the variation of government assistance programs is quite broad, aspects such as eligibility criteria and the impact on the price of goods or services of such assistance programs should be reviewed (but which impact on comparables may be challenging to ascertain).

Advance Pricing Agreements

Advance Pricing Agreements (APAs) serve to provide tax certainty and generally provide for a three to five year agreement between the taxpayer and tax authorities on a unilateral, bilateral, or on occasion multilateral basis, of the arm’s length nature and price/profit margin of intercompany transactions. Only when the APA itself provides for a reason for cancellation or revision of the APA, can it be considered how to handle a breach of the critical assumptions. The APA can alternatively be revised, cancelled or revoked. Therefore, to opt out of pre-agreed profit margins, critical assumptions will need to be carefully reviewed. Taxpayers are recommended to approach the relevant tax authorities on critical assumptions if they are concerned about the negative economic effects of the COVID-19 pandemic and to not act unilaterally.

Final remarks

There is little doubt that to get the COVID-19 impact, such as extraordinary costs and losses, properly reflected in the pricing of transactions between associated enterprises MNEs will need to present ample evidence and corroboration with their transfer pricing analysis. The Simmons & Simmons Tax and Transfer Pricing team members are able to assist you in this respect.