Transfer pricing: The OECD publishes recommendations addressing the impact of COVID-19 on controlled transactions

The document neither modifies nor entails a revision of the OECD’s Transfer Pricing Guidelines, so it does not alter the arm’s length principle, which is deemed wholly applicable to the situations caused by the crisis.

However, it provides a practical perspective on situations affected by the pandemic and reiterates the need to accurately delineate controlled transactions (in terms of functions, assets and risks assumed by the parties).

The aim of this guidance, developed and approved by the 137 Member States of the OECD/G20 Inclusive Framework on Base Erosion and Profit Shifting (BEPS), is to provide tax administrations and MNE a series of guidelines that can be used to evaluate and comply with transfer pricing rules in the periods affected by the pandemic.

The issues that are analyzed in the document are grouped into four specific areas: (1) comparability analysis, (2) losses and the allocation of COVID-19 specific costs, (3) government assistance programmes, and (4) advance pricing agreements (APAs).

 

Chapter I. Comparability analysis

The pandemic has had a significant impact on transfer prices and on the reliability of the data used in comparability analyses, so the OECD recommends using alternative sources to address information deficiencies.

In this respect, analyses of changes in sales volumes during the crisis, of increases in exceptional costs, or of the effects of public policies, can be useful as can any macroeconomic information or industry indicator. In particular, one option for performing the comparability analysis in 2020 is to consider the comparison between actual and budgeted data relating to sales, costs and profitability.

Another matter to be considered is the time factor. Generally, the financial information relating to the controlled and to the uncontrolled comparable transactions should refer to the same period. While in some instances it may be possible to use contemporaneous information, in other instances it is more challenging to use contemporaneous comparable transactions, notably in the application of the transactional net margin method.

In these cases, taxpayers and tax administrations typically rely on historical information from commercial databases. Given that, regarding fiscal year 2020, the information will not be available until mid-2021 -at the earliest-, the OECD recommends taxpayers making a reasonable use of the available information that may reduce the financial data deficiencies; and, on the other hand, it suggests to tax administrations to be understanding when evaluating taxpayers’ efforts, in an attempt to minimize transfer pricing controversies.

The possible solutions noted by the OECD include the use of the so-called “outcome-testing” approach, which seeks to verify that a controlled transaction that has already taken place complies with the arm’s length principle. Although some administrations have traditionally rejected this approach, the OECD recommends allowing the use of information that taxpayers become aware of once the corporate income tax return for 2020 has been filed, inter alia, permitting the filing of amended returns.

The OECD also recommends taking other measures into account, such as the possibility of making transfer pricing adjustments in the corporate income tax returns for 2020, or ensuring access to mutual agreement or similar procedures between taxpayers and tax administrations to facilitate negotiated settlements.

Another proposal made in the document relates to pricing methods. Although it is not mandatory, the OECD notes that in this context, it might be advisable to combine more than one method to corroborate the arm’s length conditions of the controlled transactions.

Regarding the period on which the comparison is based, in ordinary circumstances, the use of multiple year data and multiple year averages for comparability analyses may be useful to ensure the uniformity of the compared data. However, for the analysis of the years affected by the pandemic, it might be recommendable to separate pre-COVID-19 and post-COVID-19 periods, so that the results of both periods are not distorted.

Also, government measures limiting or restricting the performance of certain activities should also be taken into account. For example, if a taxpayer has had to close its facilities for three months, the sample of comparables should focus on competitors that have been in the same situation, or otherwise the controlled transaction´s financial figures should be adjusted to exclude from the economic analysis the data corresponding to the closure period.

Possibly, one of the most important and awaited issues in this document is that relating to the updating of sets of comparables. In ordinary circumstances and during a certain period of time (normally, three years), tax administrations usually do not require taxpayers to perform a complete benchmark analysis, instead allowing them to simply update the financial data of the sample each year.

In this regard, in this extraordinary situation, the OECD suggests reconsidering if a mere roll forward of the financial data of the sample is adequate, given the actual relevance in the new context of certain comparability factors that might have been deemed insignificant when setting the initial sample.

Lastly, the OECD also recalls that there is no overriding rule on the exclusion of loss making comparables from the sample. If the selected companies satisfy the appropriate comparability criteria, there is no reason to exclude them from the sample of comparables in 2020 just because they suffer losses.   

 

Chapter II. Losses and allocation of COVID-19 specific costs

Certain situations that have taken place during the pandemic, such as the decrease in demand, the inability to obtain or supply products or services, or the incurring of exceptional operating costs, will cause losses in more than a few MNE groups that will have to be allocated amongst the different group entities, which can give rise to disputes with their respective tax authorities.

The arm’s length principle must be observed in that process of allocation of losses and costs, considering the risks assumed by the group companies in the controlled transactions, in accordance with the Guidelines.

The allocation of exceptional, non-recurring operating costs arising as a result of the health crisis should be allocated based on an assessment of how independent enterprises under comparable circumstances operate, taking into account their nature when carrying out the comparability analysis (notwithstanding the label given for accounting purposes), and potentially making any necessary adjustments in the comparables.

The document published by the OECD includes some examples and considerations on the allocation of costs caused by COVID-19 (expenditure on personal protective equipment, measures to reconfigure office space to implement physical distancing requirements, investments in IT and the implementation of teleworking arrangements).

These exceptional costs must be taken into consideration also when carrying out comparability analyses given that they can have a significant impact.

As a general rule, these costs should be excluded from the net profit indicator of the tested party, except where they are strictly related to the transaction under review.

Likewise, that exclusion should also be done in the comparables used to determine the margin, although the OECD recognizes the difficulties that may arise when making the exclusion in the comparables due to limitations on information.

The same thing occurs when performing an analysis based on costs: to determine the basis, it will be important to consider whether the basis should include or exclude exceptional costs and, if included, whether a profit margin should be applied to them.

In any case, adjustments for accounting consistency are designed to eliminate the effect of differing accounting practices between the controlled and uncontrolled transactions and should be considered if they are expected to increase the reliability of the results of a comparability analysis.

Another element that may affect the allocation of costs and losses is the possibility of applying force majeure clauses, or even of breaching the conditions established in intercompany contracts due to the exceptional circumstances caused by the pandemic.

Along these lines, the OECD notes that, just as between independent parties, group entities can consider the possibility of canceling or renegotiating contracts signed before the pandemic.

When analyzing this issue, tax administrations should review the agreements and conduct between related parties bearing in mind the guidance in section D of Chapter I of the Guidelines, and the characteristics of the transaction and the behavior of independent parties in comparable situations.

For their part, taxpayers should carefully substantiate and document the contractual modifications made in order to corroborate that they comply with the arm’s length principle. 

Moreover, one of the most relevant and contentious aspects relating to the impact of the pandemic on transfer pricing policies of multinational groups is that referring to the possibility for entities characterized functionally as “limited risk” to incur losses.

As the Guidelines do not contain a specific definition of the concept of limited risk entity, a general rule cannot be established. Therefore, in determining whether or not limited risk entities can assume the losses caused by the pandemic, it will be necessary to make a detailed case-by-case risk analysis, according to the provisions of the Guidelines.

When assessing the risks assumed by MNE groups, the OECD states that tax administrations should analyze the economic reasonableness of any changes there may have been as a result of the pandemic, for which purpose both Chapter IX of the Guidelines and the practical examples and considerations included in the guidance will be particularly illustrative.  

 

Chapter III. Government assistance

The OECD defines “government assistance” as a monetary or non-monetary program where a government or other public authority provides an economic benefit to taxpayers.

The characteristics of these programs can affect transfer pricing, either because they are directly provided to a member of a MNE group company or because they are made available to independent parties within the market where a MNE group operates, which can affect the behavior of enterprises engaged in potentially comparable transactions.

Given the practical difficulty of obtaining information on the nature of government assistance, its specific characteristics should be analyzed to determine when its reception is economically relevant, either directly (i.e., wage subsidies) or indirectly (provision of local infrastructure by the government).

If it is concluded that the assistance is economically relevant, it should be taken into account to accurately delineate the controlled transaction and perform the comparability analysis, and this information should be included in the taxpayer’s documentation.

The OECD suggests some aspects to be considered when analyzing the potential impact of government assistance on a controlled transaction, such as availability, purpose, duration and other conditions imposed by the government in granting the assistance (as they could limit or even prevent the capacity of the party receiving the assistance from modifying the pricing of its transactions).

Regard should also be had to the allocation of the economically significant risks and the level of competition and demand within the relevant markets, to determine whether the entity of the group that receives government assistance changes its pricing strategies towards unrelated customers, either to retain the assistance within the MNE group or to pass it on to third parties.

The effect of government policies on transfer pricing is discussed by the Guidelines (Section D.4 of Chapter I), stating that, as a general rule, government intervention should be treated as conditions of the market in the country where the transaction takes place.

With respect to the impact of government assistance on the risks of a transaction, the OECD states that, although the receipt thereof may reduce the quantitative negative impact of such risks, it will not change the allocation of risk between the parties in a controlled transaction for transfer pricing purposes.

Another issue analyzed refers to the most reliable approach for identifying comparables in contexts where government assistance is granted.

In this regard, the OECD recommends analyzing independent transactions in the same geographic market or in a comparable one, and reviewing search strategies or performing corroborative analyses, when government assistance is identified in any of the transactions analyzed.

Furthermore, when applying one-sided methods, taxpayers should avoid using mechanical approaches (such as recognizing the assistance as extraordinary income or offsetting costs savings achieved through government assistance against the relevant cost base for the transaction), as these approaches could determine prices that do not comply with the arm’s length principle.

Moreover, the accounting treatment given to the government assistance received should be identified, especially when the tested party and the comparables apply different accounting standards, as this different treatment may impact to different levels of profitability, requiring comparability adjustments.

Lastly, it should be noted that divergences in the accounting treatment of government assistance could point to a difference in the type of government support provided, which could affect comparability and might be more difficult to adjust for than a simple accounting difference.

 

Chapter IV. Advance pricing arrangements

The health crisis has led to material changes in the economic conditions that were taken into account in signed APAs that are still in force. Thus, it is important to determine to what extent, if any, those changes affect APAs. COVID-19 can also affect APAs that were being negotiated when the pandemic started.

Regarding APAs in force in 2020, as a general rule, the OECD says that their terms should continue to be respected, unless the actual circumstances represent a breach of critical assumptions considered when the agreement was signed. To this end, tax administrations and taxpayers should consider the terms of the APA itself or the domestic legislation of the relevant jurisdiction, which should be analyzed case by case and considering the impact of the pandemic on the industry and the region.

Where there is deemed to be a breach of critical assumptions, the consequences should also be analyzed in light of the terms of the APA itself, bearing in mind all the administrations involved and the applicable legislation and, in any case, if that were not sufficient, Chapter IV of the Guidelines suggests three possibilities:

• Revision of the APA: That would make it possible, through an agreement between the taxpayer and tax administration, to maintain the APA in force but reviewing specific parts of its content without modifying the rest of its terms.
• Cancellation of the APA, which would mean that the APA would cease to be in force as of a certain date.
• Revocation of the APA, the main effect of which is to consider that the APA had never been entered into.

In any case, the OECD advises against unilateral actions by taxpayers, to whom it recommends providing notification of the potential existence of a breach of critical assumptions as soon as they become aware of the change and contacting the tax administration in a timely manner to express their position transparently.  

Along with the notification, taxpayers should provide documentation supporting the breach, with business segment data, forecast and actual business segment profits, modifications to agreements during the pandemic or detailed profit and loss statements that make it possible to determine the effects of the crisis. 

Also, the OECD recognizes that, given the current uncertainty, taxpayers may be reluctant about continuing or initiating new APA applications.

For this reason, in view of the benefits associated with APAs, the OECD encourages taxpayers and tax administrations to adopt a flexible and collaborative approach, exploring innovative formulas that enable them to reach agreements.

Examples of this include agreeing a short period APA, covering the period affected by the COVID-19 pandemic, and a subsequent APA covering the post-COVID period; or APAs for longer periods with commitments to retrospectively amend their conditions to appropriately reflect the effects of the pandemic once they are known.

Another possibility is to evaluate executing the APA considering its effects throughout the period covered by the agreement, rather than doing so year by year, which would make it possible to mitigate the short-term effects of COVID-19 in the years affected by the pandemic.

 

Conclusion

The help provided by this guidance, long-awaited by all interested parties and especially by taxpayers who need to make decisions now for the closing of 2020, is expected to be applied on a widespread basis (also by tax administrations) and to contribute to international coordination and to reducing disputes in the transfer pricing area.

In particular, it is recommendable for taxpayers who:

• appropriately analyze, quantify and document the effects of the pandemic in their transfer pricing policies, in particular as regards the allocation of losses and costs among group entities;
• adjust their economic comparability analyses in light of the current circumstances;
• review their intercompany agreements and adapt their procedures according to their contents; and
• verify whether there are any substantial changes in the critical assumptions of their APAs and contact their tax authorities.