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Pandemic-Related Losses May Trigger Scrutiny for Past Years

Posted on Mar. 24, 2021

Multinationals that allocate losses or pandemic-related costs to what have historically been considered limited-risk entities may prompt tax administrations to reassess the appropriateness of the group’s pre-pandemic risk allocation, according to an OECD official.

Addressing the OECD guidance note released in December 2020 on the effects of the COVID-19 pandemic on transfer pricing, Mayra Lucas, a senior OECD transfer pricing adviser, cautioned multinationals against taking positions for years affected by the pandemic that might cast doubt on positions taken before it began. Speaking during the March 23 American Bar Association U.S. and Europe Tax Practice Trends virtual conference, Lucas stressed the general need for taxpayers to be consistent in their treatment of years before and after the pandemic.

“I think it's very important to raise a flag here to taxpayers — especially when you're trying to argue that a simple, limited-risk entity should be bearing part of the losses arising as a result of COVID for the affected years — that you should be wary that [you] might actually open the door to reassess the profits of that entity for the pre-COVID years,” Lucas said. “That means that maybe the risk allocation that was done for previous years is not an accurate one, and therefore that the entity was assuming greater risks than it was reported, and might need to see their profits increased for years before 2020. So it's a matter of being consistent between your analysis for COVID years and the pre-COVID years.”

The guidance note, which OECD officials have consistently characterized as a guide for applying established principles rather than substantively novel guidance, draws heavily on the risk allocation approach described in Chapter I, section D of the 2017 OECD transfer pricing guidelines. That section provides that the assumption of risk — which requires control over that risk and the financial capacity to bear it — determines which party to the controlled transaction should benefit from the upside or suffer from the downside associated with the corresponding outcome. According to Lucas, that means the proper allocation of losses among group entities must be carefully determined, case by case, based on the parties’ assumption of risk.

“This is very fact-based, and you need to look at each case separately on its own merits. And so we cannot jump to conclusions when we're dealing with these issues,” Lucas said. “Especially important will be the risk framework in Chapter I [of the OECD guidelines] because, as you know, risk assumption will in the end dictate how profits and losses will be allocated among the parties to the controlled transaction if that risk materializes.”

While acknowledging that the OECD’s guidance note recognizes that some limited-risk entities may appropriately bear losses during the pandemic, Lucas cautioned that the tolerance of losses by entities that are generally expected to earn a steady fixed return is not open-ended. The OECD guidance note “is opening the door to low-risk arrangements to give rise to a certain degree of losses for limited-risk distributors or limited-risk manufacturers. But that should only be in the short term, and only as long as it is substantiated by the analysis in Chapter I, and also a comparability analysis looking at what third parties would actually be facing,” Lucas said.

Lucas also echoed the guidance note in observing that responsibility for unanticipated pandemic-related costs should be allocated among group members in line with the parties’ assumption of risk. According to Lucas, the allocation of those costs among unrelated parties, the duration over which they will be incurred, and the potential to pass them on to consumers will all be relevant when determining how to treat pandemic-related costs.

Lucas added that any costs properly regarded as extraordinary should be excluded from the profit-level indicator used in a transactional net margin method analysis to ensure comparability between the tested party’s financial results and financial data for the selected comparables. “You need to also pay attention when doing your comparability analysis [to] how these costs are actually being treated under the applicable accounting system of the tested party and comparables” and adjust the financial data accordingly, she said.

Regarding taxpayers’ freedom to invoke force majeure clauses or simply terminate their existing contracts, Lucas said the arm’s-length principle may require evidence that unrelated parties operating in comparable circumstances would have renegotiated their contracts as well.

Although some national tax officials have questioned whether unrelated parties’ practices are of direct relevance, Lucas said observations drawn from arm’s-length transactions can help taxpayers establish that renegotiation of the contract was the parties’ best realistic alternative.

“It's very important to also look at what are the options realistically available to the parties to the controlled transactions and what is in their best interests. Third parties might be willing to be let go from the contract and renegotiate, if that is in the interest of both parties,” Lucas said. “So if the taxpayer can actually identify that sort of evidence in external comparables, or with internal comparables, that will certainly be helpful in documenting and evidencing that sort of change in the controlled transaction.”

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