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Transfer Pricing and Loss Allocation for the COVID-19 Era

Posted on Dec. 14, 2020
Oriol Soler
Oriol Soler
Bernardo Misle
Bernardo Misle

Bernardo Misle is a transfer pricing controversy senior manager and Oriol Soler is a transfer pricing associate with Deloitte Spain in Barcelona.

In this article, the authors consider COVID-19’s effect on transfer pricing and how the OECD’s guidelines apply to loss allocation in an unforeseen crisis.

The views and opinions expressed herein are those of the authors and do not necessarily reflect the official position of Deloitte Spain. All information provided is of a general nature and is not intended to address the circumstances of any particular individual or entity.

The COVID-19 pandemic is a global crisis without precedent in living memory. It has triggered the most severe economic recession in nearly a century and has caused — and continues to cause — enormous damage to people’s health, jobs, and overall well-being. The lockdowns that most governments instituted likely helped slow the spread of the virus and reduce the death toll, but they also froze business activity in many sectors, widened inequality, disrupted education, and undermined public confidence. Even in places where containment measures have been relatively light, early data show that the pandemic’s economic and social costs will be huge. Growth prospects depend on many factors, including the magnitude and duration of the latest COVID-19 outbreaks, the degree to which containment measures are maintained or reinforced, and the time until an effective treatment or vaccine is deployed.1 One thing seems clear: Uncertainty is going to prevail for an extended period of time.

The unprecedented scale of these human, economic, and social crises will necessarily have repercussions in the transfer pricing domain: A unique crisis — particularly one with effects on the supply chain and business relationships that has led to significant business disruption and widespread losses — requires unique transfer pricing analyses and actions during a period characterized by uncertainty and lack of adequate data.

The COVID-19 crisis may also force multinational enterprises to revisit their international dealings (including their intragroup agreements) to help their businesses withstand the pandemic and its aftermath — as independent companies have already begun to do. MNEs must analyze, document, and retain evidence of the business and transfer pricing policy decisions and changes stemming from the crisis and address these issues in their transfer pricing documentation. Ultimately, the potential distribution of losses that an MNE incurs because of the COVID-19 crisis should be in line with what independent parties would have agreed to in comparable situations.

Furthermore, depending on the economic impact of COVID-19 on a specific MNE, the option of not reassessing whether the transfer pricing policy still fulfills the arm’s-length principle under existing market circumstances may represent a decision in itself. Cross-border transactions are characterized by the competing incentives of the tax administrations in those jurisdictions involved. Thus, a key consideration on a future tax audit could be whether the transfer pricing policy agreed to under completely different conditions continues to uphold and respect market value.

With that said, when and if taxpayers revisit their international related-party dealings, they should remember that even if they do not directly address all the transfer pricing issues arising from COVID-19, the OECD transfer pricing guidelines2 continue to represent internationally agreed-upon principles and — regardless of the underlying economic circumstances — provide guidance for the application of the arm’s-length principle (and article 9 remains the authoritative statement thereof).3

For that reason, taxpayers must review the OECD transfer pricing guidelines and consider how the guidelines should be used and interpreted during the ongoing crisis. They should do so without waiting for specific guidelines that might be issued by the inclusive framework. Notably, the inclusive framework has not released any additional guidance on transfer pricing issues related to COVID-19. Further, any new OECD material should not override the principles that the existing OECD transfer pricing guidelines already establish.

Therefore, this article analyzes what the OECD transfer pricing guidelines foresee in terms of delineating controlled transactions in exceptional times and the proper allocation of losses (or returns) resulting from unexpected circumstances.

Accurate Delineation Amid a Crisis

A detailed functional analysis is critical to the proper delineation of a controlled transaction. It seeks to identify the economically significant activities performed, responsibilities undertaken, assets used or contributed, and risks assumed by the parties to the transaction.

The COVID-19 crisis caused a sudden decrease in demand for the vast majority of products and services across industries. It also affected the supply side of the system, including variations in supply chain workflow because of government regulations, social distancing, and running operations under capacity. The resulting drop in income during the COVID-19 crisis has created a dreadful shock to MNEs’ profit and loss accounts, and thus — at least potentially — a shock to their transfer pricing system. In this context, it is crucial to conduct an analysis in order to determine the entity (or group of entities) compelled to bear the consequences of the pandemic downturn on a transaction-by-transaction basis.

This analysis should not only be transactional rather than based on the overall functionalities of any given legal entity, but it should also be restricted to the unique period under analysis. In other words, the historically accurate delineation of any transaction is of little importance if the activities and responsibilities undertaken by the parties were modified during 2020 to manage the risk of the pandemic: The characterization of a transaction may vary not only depending on the undertaking analyzed, but when it was performed.

The OECD transfer pricing guidelines prescribe a powerful six-step process for analyzing risk — a process that potentially disregards the parties’ contractually agreed-upon risk-return allocation. Thus, to determine the allocation of risks and returns within an MNE during the COVID-19 crisis, taxpayers must revisit the above mentioned six-step process bearing in mind the new economic circumstances.

Step 1

Paragraphs 1.71 through 1.76 of the OECD guidelines set out step 1: identifying economically significant risks with specificity.

The relevance of a risk depends on its probability and the significance of the profit or loss that may arise from it. Considering the overall impact of COVID-19 on both supply (for example, the inability to service customers because of operational closures) and demand (for example, reduced demand stemming from voluntary or government-enforced shutdowns), it is clear that the pandemic poses a risk of great importance for all entities in the value chain, regardless of their role or risk profile as identified for transfer pricing testing purposes in the past.

Paragraph 1.72 includes a list of external risks categories. Hazard risks, described as “likely to include adverse external events that may cause damages or losses, including accidents and natural disasters,” seem to be particularly relevant. However, the COVID-19 crisis affects all the types of risks described in the paragraph.

Step 2

Paragraphs 1.77 through 1.81 of the guidelines call for determining how the associated enterprises have allocated specific, economically significant risks under the terms of the transaction.

The actual transaction between related parties should not be defined solely by the terms of the intercompany agreement; it should also be determined based on the conduct of the parties. Nevertheless, in practice, the feasibility of sharing the financial consequences of the crisis among related parties will largely depend on the contractual terms that the parties agreed to at the beginning of their relationship. Therefore, identifying and analyzing those contractual clauses is key for transfer pricing policy setting and defense purposes.

For example, in the ACER case (Appeal No. 125/2017 (Mar. 29, 2019)) before Spain’s National High Court (Audiencia Nacional), the Spanish Tax Authority argued that a local distributor’s bearing of the financial costs arising from delayed deliveries and extended collection periods contradicted its self-characterization as a limited risk distributor in a contract signed with another group entity. The court ultimately agreed with the authority and focused on the contractual terms when determining the permissibility of an expense deduction.4

Ideally, the contractual terms of an intercompany agreement should provide clear evidence of a commitment to assume a risk well before the actual materialization of the risk’s outcomes. Still, the pandemic and resulting crises were unexpected and unforeseeable. Odds are that the contractual terms delineating most related-party transactions do not address the assumption of risks stemming from the
COVID-19 pandemic.

Paragraph 1.77 of the OECD transfer pricing guidelines states that “the identity of the party or parties assuming risks may be set out in written contracts between the parties to a transaction involving these risks” and notes that some of the risk may be implicitly assumed when non-contingent remuneration for one of the parties is agreed upon. This could (wrongly) lead one to believe that if an entity has agreed to a non-contingent remuneration in a transaction, then the COVID-19 risks would be implicitly assigned to its counterpart.

Nevertheless, one should not conclude that pricing arrangements adopted in the contractual arrangements are the sole determinant of which party assumes risk. As paragraph 1.81 explains:

The form of remuneration cannot dictate inappropriate risk allocations. It is the determination of how the parties actually manage and control risks . . . which will determine the assumption of risks by the parties.

Furthermore, as paragraph 1.76 of the OECD guidelines indicates, even in a pre-pandemic world, a wide transfer pricing policy could not anticipate all possible risks for risk allocation purposes. Rather, the losses stemming from the COVID-19 pandemic should be allocated depending on the particular circumstances of each transaction.

Perhaps the main question is whether the unpredictable occurrence of the COVID-19 pandemic has led to a change in the value of a given transaction that is so fundamental that it should trigger force majeure or rebus sic stantibus clauses, price adjustment mechanisms, or revisions to key terms and conditions in existing intercompany agreements. This will require a transaction-by-transaction study since it seems safe to assume that many independent enterprises — irrespective of their profile (that is, as a purchaser, buyer, or both) — have had to renegotiate their agreements because of the difficulty of complying with them as written.

Moreover, the terms of a transaction can change over time. Thus, in accordance with paragraph 1.47 of the OECD guidelines, “where there has been a change in the terms of a transaction, the circumstances surrounding the change should be examined to determine whether the change indicates that the original transaction has been replaced.” In other words, has there been a significant renegotiation of the initial terms, or does the change reflect the intentions of the parties from the outset? For example, if taxpayers have a transfer pricing policy and they are changing their target arm’s-length ranges for 2020, the question would be whether the taxpayers are changing their transfer pricing policy or trying to comply with it. Perhaps the taxpayers are trying to comply with an arm’s-length return policy.

Step 3

Step 3 is, as paragraph 1.82 in the OECD guidelines explains, to determine through a functional analysis how the associated enterprises that are parties to the transaction “operate in relation to the assumption and management of the specific, economically significant risks.” This process should focus in particular on which enterprises perform control and risk mitigation functions, encounter positive or negative consequences of risk outcomes, and have the financial capacity to assume the risk.

Paragraph 1.38 states that:

Independent enterprises, when evaluating the terms of a potential transaction, will compare the transaction to the other options realistically available to them, and they will only enter into the transaction if they see no alternative that offers a clearly more attractive opportunity to meet their commercial objectives. . . . Therefore, identifying the economically relevant characteristics of the transaction is essential in accurately delineating the controlled transaction and in revealing the range of characteristics taken into account by the parties to the transaction in reaching the conclusion that there is no clearly more attractive opportunity realistically available to meet their commercial objectives than the transaction adopted.

In this sense, the analysis must, in accordance with paragraph 1.123, show whether the actual undertaking possesses the commercial rationality of arrangements that unrelated parties would agree to under comparable economic circumstances considering the options realistically available to all entities involved in the related-party transaction.

The comparability analysis should include a review of the alternatives available for an entity. This is especially important this year because it is likely that in many cases there will be no commercially viable option other than to continue trading at reduced profitability.

Step 4

Steps 2 and 3 identify information relevant to the assumption and management of risks in the controlled transaction.

The goal of step 4 is to interpret that information and determine whether the contractual assumption of risk is consistent with the conduct of the associated enterprises and other facts of the case by analyzing (i) whether the related parties act in accordance with the contractual terms and (ii) whether the party that assumes the risk (as determined in (i)) also exercises control over the risk and has the financial capacity to bear the risk. Paragraphs 1.86 to 1.97 of the guidelines are dedicated to this exercise.

The contractual allocation of risk will be respected if and only if the accurate delineation analysis shows that each party to which a risk is allocated actually controls that risk and has the financial capacity to bear it. Importantly, as paragraph 1.78 specifies:

The purported assumption of risk by associated enterprises when risk outcomes are certain is by definition not an assumption of risk, since there is no longer any risk.

Therefore, if during the relevant period there is a disparity between the conduct of the entities and the contractual terms of the transaction — as is likely for the fiscal year affected by the COVID-19 crisis — then how the parties actually manage and control risks will determine the effective assumption of risks by the parties — and, ultimately, their associated expected return.

Step 5

Building on the first four steps, step 5 calls for applying the guidance on allocating risk when the party assuming risk does not control the risk or does not have the financial capacity to assume the risk.

As set forth in paragraph 1.99, in exceptional circumstances — such as the pandemic we are facing:

it may be the case that no associated enterprise can be identified that both exercises control over the risk and has the financial capacity to assume the risk. As such a situation is not likely to occur in transactions between third parties, a rigorous analysis of the facts and circumstances of the case will need to be performed.

Again, the OECD guidelines stress the importance of analyzing the facts and circumstances of the case, as well as the commercial reasonableness of the transaction, when analyzing and documenting this type of situation. Furthermore, this could be an opportunity to discuss with the tax authorities or competent authorities how the risks of the pandemic should be allocated. This could, for example, take the form of a discussion regarding an advance pricing agreement.

Step 6

Finally, in step 6 (paragraphs 1.100 through 1.106), the actual transaction — as accurately delineated considering all relevant evidence — should be priced considering the financial and other consequences of the properly allocated risk and ensuring appropriate compensation for risk management functions.

In paragraph 1.105, the OECD transfer pricing guidelines discuss the possibility that some entities may contribute to risk control without assuming the risks, and the guidelines note that these entities should bear the potential negative consequences of that risk in proportion to their contribution to control. Thus, to the extent that an entity participates in controlling the risk of the COVID-19 pandemic — for instance, by reacting to localized information, which differs greatly from place to place because the pandemic’s impact has differed across various countries, and responding to the wide range of government edicts stemming from the pandemic — that entity could be liable to bear some of the negative consequences of the pandemic.

For instance, the fact that an entity is characterized as “low risk” compared with other parties in the supply chain should not be automatically interpreted to mean that the entity operates risk free — that is, enjoying a stable return irrespective of the market situation. If an entity exercises some decision-making power that not only enables it to manage specific risks, but also allows it to control them effectively, and if it has the financial capacity to assume those risks, then it should be allowed to assume part of the downward consequences of the risks and incur losses during this crisis period.

The OECD recognizes that extreme results might still satisfy the arm’s-length principle. In particular, in the exceptional economic situation caused by the pandemic, the OECD transfer pricing guidelines could be read to suggest that a limited-risk entity might incur losses. Paragraph 3.64 admits that:

Simple or low risk functions in particular are not expected to generate losses for a long period of time. This does not mean however that loss-making transactions can never be comparable. In general, all relevant information should be used and there should not be any overriding rule on the inclusion or exclusion of loss-making comparables. Indeed, it is the facts and circumstances surrounding the company in question that should determine its status as a comparable, not its financial result.

In other words, limited-risk entities may incur losses because of the adverse economic effects of the pandemic. The OECD supports this conclusion when it recognizes that extreme results may satisfy the arm’s-length principle if they comply with established comparability standards.

Final Remarks

Now is the time for companies to develop a resilient controversy strategy and prepare for inevitable inquiries about transfer pricing. The burden of proof regarding the reality of transactions, structures, and MNEs’ operational and functional models is very significant; it requires more than simply submitting intragroup agreements or the transfer pricing documentation itself (master and local files).

Collecting the right evidence on a contemporaneous basis and preparing a COVID-19 controversy memorandum — a document that MNEs would be well advised to prepare before the close of the fiscal year — should help to diminish the risk of the tax authorities’ challenges. These could be demanding tasks, especially considering that COVID-19 will most likely affect transfer pricing examinations for many years after the pandemic has faded (given, for example, the statute of limitations on tax assessments). For that reason, the use of technology could be crucial to help reduce costs and risks, improve efficiencies, and enhance the quality and quantity of evidence.

Companies will need to be able to support, in a contemporaneous manner, the extraordinary reasons for any departures from an initially agreed-upon transfer pricing policy — or the decision to keep the same policy unchanged despite extraordinary circumstances. This justification should include a detailed study of the contractual terms agreed between the parties to the transaction, an explanation of the reasonableness of the assumptions used to set the original transfer pricing policy conditions (that is, based on information known or reasonably foreseeable by the parties at the time the transactions were entered into), and the proper delineation of the actual transaction.

FOOTNOTES

1 OECD, “Coronavirus (COVID-19): Living With Uncertainty,” OECD Economic Outlook Interim Report (Sept. 2020).

2 OECD, “Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations” (2017).

3 See OECD Working Party No. 6 on the Taxation of Multinational Enterprises, “Transfer Pricing Implications of COVID-19 Pandemic: Questionnaire for Business,” CTPA/CFA/WP6/NOE2(2020)6 (June 3, 2020).

4 See Josep Serrano and Bernardo Misle, “The COVID-19 Downturn and Limited-Risk Structures: A Spanish View,” Tax Notes Int’l, May 4, 2020, p. 565.

END FOOTNOTES

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