The OECD’s new guidance on the transfer pricing challenges caused by the COVID-19 pandemic draws heavily on existing principles for analyzing the assumption of risk, including in the allocation of losses and coronavirus-related costs.
In a guidance note published December 18, the OECD released the guidance it developed after a consultation with taxpayers and business groups identified specific areas that are not addressed in sufficient detail by the OECD transfer pricing guidelines. As OECD officials have emphasized before its release, the guidance does not endorse any departure from the arm’s-length principle as set out in the existing transfer pricing guidelines. It focuses on how the established arm’s-length principle can be best applied for purposes of comparability analyses performed for the 2020 year, the allocation of losses and coronavirus-specific costs, the effect of government assistance programs, and advance pricing agreements.
The guidance generally stresses the need for detailed contemporaneous documentation that supports any differences in taxpayers’ transfer pricing approach to the 2020 year. “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. [Multinational enterprise] 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,” it says.
The guidance notes that comparables information remains the most reliable guide to how related-party transactions should be priced, but acknowledges that taxpayers may have to decide on an approach before such data are available for 2020. In particular, taxpayers applying the transactional net margin method — or its U.S. counterpart, the comparable profits method — using commercial databases may not have reliable financial data on comparable companies until mid-2021 at the earliest.
The OECD’s suggested solution is to use “reasonable commercial judgment” on the basis of the most reliable contemporaneous data available. The guidance recommends alternative sources of information for taxpayers while they wait for comparables data for 2020, including a comparison of the taxpayer’s own sales volume, asset utilization, or costs to its budgeted figures or prior years. Other sources identified by guidance include publicly available securities filings, macroeconomic data, statistical analyses, and historical information on previous recessions.
The guidance says that otherwise comparable companies that report losses — which are routinely screened out of transactional net margin method and CPM analyses — should not be excluded, noting that the OECD guidelines contain no rule requiring the automatic exclusion of loss-making companies. Regarding whether entities characterized as “limited risk” can justify a loss, the guidance emphasizes the principles for delineating the taxpayer’s transaction and evaluating a group’s intercompany risk allocation under section D.1, chapter 1 of the OECD guidelines. According to section D.1, the taxpayer’s contractual risk allocation should be respected as long as the entity that contractually bears the risk exercises control over that risk and has the financial capacity to bear it.
Focusing on what it refers to as marketplace risk, operational risk, and financial risks as the key sources of risk associated with the pandemic, the guidance recommends a careful assessment of the risks that the taxpayer purports to bear. “The widespread effects of the COVID-19 pandemic in an industry or within an MNE group do not suffice to claim that a member of an MNE group has to bear the consequences of risks materializing as a result of the COVID-19 pandemic without an analysis of how the outcome of the economically significant risks controlled by the member of the group has been affected by the pandemic,” the guidance says.
Similarly, the guidance says the allocation of exceptional pandemic-related costs should reflect the parties’ risk allocation. “If a cost directly relates to a particular risk, then the party assuming that risk would typically bear the costs associated with that risk,” it says.
Noting that unrelated parties may not hold each other to the strict terms of their contracts during exceptional economic circumstances, the guidance cites the realistic alternatives principle as the basis for determining whether existing contractual arrangements may be modified. Although parties dealing at arm’s length may modify their contractual arrangements when it is in their interests, any deviations allegedly necessitated by the pandemic should be reviewed with scrutiny, according to the note. The guidance recommends similar scrutiny for taxpayers that attempt to invoke contractual force majeure clauses as the basis for modifying their arrangement.
“It is important to emphasize that in the absence of clear evidence that independent parties in comparable circumstances would have revised their existing agreements or commercial relations, the modification of existing intercompany arrangements and/or the commercial relationships of associated parties is not consistent with the arm’s-length principle,” the guidance says.
The guidance also addresses the effects of government assistance, which it says may constitute an economically relevant feature of the tested transaction and may, in some circumstances, affect the allocation of risk, the selection of comparables, and the pricing of arm’s-length transactions.
Echoing statements made by multiple tax administrations, including Australia and the United States, the guidance also warns taxpayers against trying to unilaterally terminate the APA. Both taxpayers and tax administrations should remain bound to existing APAs, and the terms of the agreement applicable when there is a breach of material assumption should be followed, the guidance says. However, it suggests that taxpayers consider revision of the APA as a response to any breach in material assumptions.