2020 may go down in history as one of the most challenging years in modern times. Transfer pricing professionals, in particular, have had a front row seat witnessing the impact that COVID-19 and other disruptions had on the flow of trade within global supply chains.
But now that we’re well into 2021 and still seeing major global disruptions, many tax and transfer pricing professionals may be wondering how long they may ultimately last. To this point, the Organisation for Economic Co-operation and Development (OECD) is warning that the current unprecedented economic environment is likely to continue through 2021, and potentially even beyond that.
Given this timeframe, the OECD has recently published a report with the aim of assisting transfer pricing teams on best practices to follow given the current climate. The publication, titled, Guidance on the Transfer Pricing Implications of the COVID-19 Pandemic, represents the consensus view of the 137 members of the OECD/G20 Inclusive Framework on Base Erosion and Profit Shifting (BEPS), providing clarification and support for taxpayers and tax administrations alike as they evaluate the application of transfer pricing rules for the period impacted by COVID-19.
Writing on the OECD’s Forum Network, Grace Perez-Navarro, Deputy-Director at the OECD Centre for Tax Policy and Administration, said: “The uniqueness of current economic conditions has led to practical challenges for taxpayers and tax administrations in applying and administering transfer pricing rules, which are used to calculate how much profit should be allocated among the different jurisdictions in which an enterprise operates.”
She added that, for taxpayers, these challenges create increased uncertainty. For tax administrations, transfer pricing reviews and audits are resource intensive. For both, the risks and costs associated with disputes are high.
The difficulty for businesses is that the impact of COVID-19 has been so wide-ranging and profound, says EY in an analysis of the guidance. “Many enterprises have faced or continue to face significant cash flow constraints, swings in profitability, restrictions affecting their business, and disruptions to their supply chains. In the presence of significant financial hardship, some enterprises have reviewed their contractual arrangements with third parties to ascertain whether they remain bound by them or have attempted to renegotiate key terms.”
The arm’s length principle
While the arm’s length principle (ALP) has been found to work effectively in the vast majority of cases, according to the OECD’s report, the unique economic conditions arising from, and government responses to, COVID-19 have led to some practical ALP challenges.
For example, the pandemic may raise new issues or otherwise exacerbate the complexity and magnitudeof pre-existing challenges. These can include, for example, the effect of government assistance on pricing or the availability of reliable comparable data of competitors.
The report therefore addresses four priority issues: comparability analysis; allocation of losses and COVID-19 specific costs; government-assistance programs; and advance pricing arrangements (APAs). Although explained as separate issues, all four should be considered together and within the analytical framework of the OECD transfer pricing guidelines.
The OECD further acknowledges that the economic impact of the COVID-19 pandemic varies widely across economies, industries, and businesses. This is a key factor when considering and interpreting the content of the report. It also recommends that in any transfer pricing analysis of the implications of the COVID-19 pandemic, businesses should seek to document how, and to what extent, they have been impacted by the pandemic.
Looking at the four sections of the report in more detail, the report provides pragmatic examples of how to deal with each issue. It warns, however, that these approaches “would not be appropriate in cases in which 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.”
The report says that 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.
One alternative is to allow for the use of reasonable commercial judgment, supplemented by contemporaneous information to set a reasonable estimate of the arm’s length price. MNEs should document the best market evidence currently available, which may be in the form of internal comparables, external comparables, and other relevant evidence of the economic impact of the COVID-19 pandemic. When feasible, MNEs should continue to follow rigorous arm’s length testing approaches, and even consider using more than one approach to confirm the robustness of their updated strategies and prices.
However, the report advises against using a comparability analysis that draws on information from what happened during the global financial crisis of 2008/2009. This would raise “significant concerns given the unique and unprecedented nature of the COVID-19 pandemic and its effect on economic conditions.”
Allocation of losses and the allocation of COVID-19 specific costs
The allocation of losses between associated entities can give rise to dispute and is an issue that requires consideration, given the probable increase in the frequency and magnitude of losses in the current economic environment.
Three issues are of particular pertinence here. First, the allocation of risks between parties affects how profits or losses are allocated at arm’s length through the pricing of a transaction. Existing guidance on the analysis of risks in commercial or financial relations will be particularly relevant for determining how losses are allocated between associated parties.
Second, it will be necessary to consider how exceptional, non-recurring operating costs arising as a result of COVID-19 should be allocated between associated parties. These costs should be divided based on an assessment of how independent enterprises under comparable circumstances operate.
Third, the COVID-19 pandemic has created conditions in which associated parties may consider whether they have the option to apply force majeure clauses, revoke, or otherwise revise their intracompany agreements.
The availability, substance, duration, and take-up of government-assistance programs potentially have transfer pricing implications. These apply whether they are provided to a member of an MNE directly or are otherwise made available to independent parties within the market in which an MNE group operates (thus affecting the behavior of enterprises engaged in potentially comparable transactions).
The terms and conditions of government-assistance programs related to COVID-19 need to be considered when determining their potential impact on controlled transactions and when comparing their effects with those of other pre-existing assistance programs.
Advance pricing arrangements (APAs)
The report states that COVID-19 has led to material changes in economic conditions that were not anticipated when many APAs covering FY2020, and potentially future financial years affected by COVID-19, were agreed.
Given this situation, it is important to determine to what extent the change in economic conditions affects the application of existing APAs. Taxpayers negotiating APAs that apply to FY2020 may also face questions about how the economic conditions arising from COVID-19 should be taken into account. However, the report encourages taxpayers and tax administrations to adopt a flexible and collaborative approach given the current economic conditions.
Technology’s role in mitigating disruptions
Finally, the report encourages organizations to lean in to the technology solutions they have found to be useful, exploring additional ways to enhance their capabilities in light of the current disruptions we’re seeing. If manual or inflexible tasks are holding back the department from adequately managing its shifting prices and supply chains, it’s time to identify technology that can help. Easy examples include virtual tax administration conferences in the place of physical meetings, as well as electronic documentation sharing. More robust examples include automated tax reporting, consolidation, and transfer pricing software that move beyond spreadsheets and into the world of connected finance.
Longview Tax and Longview Transfer Pricing are two such tools. To find out how Longview Transfer Pricing from insightsoftware can help you monitor how your subsidiaries are tracking toward their targeted profitability, and how you can respond to deviations quickly and efficiently, book a demo or give us a call.