The first section of the guidance covers types of contemporaneous information that may be used to support the performance of comparability analyses, including 2020 results.
Specifically, the OECD proposes sources of information that may be used to evaluate the effects of COVID-19 on the business, industry and controlled transactions that may be relevant to a taxpayer's transfer pricing for fiscal year 2020, including:
- Changes in sales volume;
- Changes in utilization;
- Incremental or exceptional costs;
- Government assistance received, or government interventions that have affected the pricing of controlled transactions;
- Publicly available financial statements, e.g., U.S. Securities and Exchange Commission filings or earnings releases;
- Macroeconomic trends;
- Statistical analyses;
- Comparisons of budgeted versus forecasted taxpayer data; and
- Analyses on the effects of profitability or third-party behavior observed during fiscal year 2020 or in previous recessionary periods.
The OECD recognizes that timing issues may exist when performing comparable analyses such as the transactional net margin method or the U.S. transfer pricing regulation's comparable profits method — TNMM and CPM, respectively — given that fiscal year 2020 information will typically not be available until mid-2021 when public companies have filed their financial statements.
Taxpayers should use current-year data, when available, and if not, realize that applying historical data without considering the impact of the pandemic may not provide for a reliable benchmarking analysis.
Typically, benchmarking analyses for use in a TNMM or CPM suffer from imperfect information and comparability between the tested party and the benchmark companies.
Differences in areas such as market or jurisdictional differences — when local comparable companies are not available, product or industry that may be understandable during more usual economic conditions, will likely face more scrutiny in light of the COVID-19 pandemic given its differential impact in specific geographies and industries.
Certain practical approaches may be available to address such data or information deficiencies.
Given the varied impact of the pandemic and availability of data, taxpayers may consider adjustments, e.g., based on statistical analyses or regressions, use of multiple-year data or use multiple methods for benchmarking in order to improve the reliability of transfer pricing analyses and support their intercompany pricing positions for fiscal year 2020.
How can the comparability section of the OECD guidance be used effectively by companies that are still finalizing their 2020 financials and determining how they will document their 2020 results?
We have heard considerable discussion by tax authorities, transfer pricing practitioners and taxpayers about the potential to use data from prior financial crises — such as the 2008 global financial crisis — to adjust prior-year results to reflect the economic impact of the COVID-19 pandemic.
Such adjustments are helpful to determine where, within a predetermined interquartile range, one might target; but likely have limited reliability given, as the OECD comments, the unprecedented and unique nature of the COVID-19 crisis. As a practical point, many taxpayers and tax authorities are now taking a wait-and-see approach to analyzing 2020 results.
This approach may come up again in developing 2020 transfer pricing documentation, wherein it may be necessary to revisit the impact of timing differences between the comparable company data and that for the tested party.
As we look toward transfer pricing documentation season, the OECD also suggests the use of multiple years of data for the comparable analysis. Such an approach is common practice in many jurisdictions when analyzing comparable company results under the TNMM or CPM.
However, some tax authorities, e.g., Canada, still rely on a single-year analysis when analyzing whether transfer prices are consistent with the arm's-length principle. We may see more tax authorities, like the Inland Revenue Authority of Singapore, consider this option more broadly.
Another option for taxpayers to consider is the inclusion of loss-making comparables in TNMM/CPM analyses. While the rejection of potential comparables due to persistent operating losses is common practice during usual economic times, under the OECD guidelines there is no specific guidance related to the inclusion or exclusion of loss-making comparables.
When considering the inclusion of loss-making companies, one should perform careful review to support and document whether or not the loss-making comparables assume similar levels of risk and have been similarly impacted by the COVID-19 pandemic. The acceptance of loss-making comparables in transfer pricing documentation may vary by jurisdiction.
No potential comparability adjustment is one-size-fits-all and taxpayers should take into consideration their company's specific facts and circumstances when performing and adjusting arm's-length benchmarking analyses.
What can companies with losses throughout the supply chain do to support lower than typical returns to their limited risk entities?
One-sided transfer pricing methods, such as the TNMM and CPM, provide a target level of profitability for limited risk entities in certain jurisdictions. By construction, one-sided methods do not consider the profit or loss earned by related entities in other jurisdictions.
Given the impact of the COVID-19 pandemic, there may be excess losses throughout the system that are not taken into consideration by one-sided methods.
While the arm's-length principle does not require the use of more than one method, taxpayers should consider examining both sides of transactions when determining the appropriate level of profitability and sharing of unusual losses as it may be useful to corroborate the arm's-length price of a controlled transaction.
Taxpayers can determine whether it is advantageous to include multiple methods in their fiscal year 2020 document or if such analyses should serve as additional support should challenges arise under audit review.
Losses and the Allocation of COVID-19 Specific Costs
During the COVID-19 pandemic, many companies have incurred losses due to decreased demand, an inability to obtain or supply products or services, or as a result of exceptional, nonrecurring operating costs.
When considering the allocation of COVID-19 specific costs or losses between associated entities, the OECD emphasized the following:
- The allocation of risks between related parties to an arrangement affects how profits or losses resulting from the transaction are allocated at arm's length through the pricing to the transaction.
- It is necessary to consider the allocation of exceptional, nonrecurring operating costs arising as a result of COVID-19 between related parties, and such allocations should be based on an assessment of how independent enterprises allocate costs under comparable circumstances.
- Parties to intercompany agreements may consider whether they have the option to apply force majeure clauses, revoke or revise their intercompany agreements.
Can entities under limited risk arrangements incur losses?
The term "limited risk" is not explicitly stated in most transfer pricing regulations. The OECD commented that while limited risk is a commonly used term, the functions performed, assets used and risks assumed by limited risk entities varies, and therefore it is not possible to establish a general rule that entities described as limited risk should or should not incur losses.
Early indication from the IRS' Advance Pricing and Mutual Agreement group is that with detailed and relevant data, such losses may be appropriate in the pandemic year(s). However, it remains to be seen how this could play out in a regular audit cycle as opposed to a mutual agreement context such as an advance pricing agreement, or APA.
While it is still unclear what position most tax authorities will take on limited risk entities with losses during pandemic years, companies can look to certain considerations in determining whether an operating loss on a controlled transaction under a limited risk arrangement can be supported:
- Identifying the actual factors that resulted in losses, e.g., limited risk entity nonoperational for a period of time due to local authorities attempting to control the pandemic;
- Consistency of actual dealings with terms and conditions outlined in the intercompany agreement; and
- Operating results of the counterparty to the transaction, e.g., did the entrepreneurial entity also incur losses.
Taxpayers should consider intragroup risk-allocation decisions made in past positions and consider the longer-term impact of changes such risk allocations.
How should operational or exceptional costs arising from COVID-19 be allocated between related parties?
A review and segregation of COVID-19 related costs which can be considered unusual or nonrecurring, e.g., severance costs, can provide perspective on which costs to include in the calculation of the tested party's operating profitability for the application of the TNMM or CPM. In this process, it will be important for taxpayers to identify and document the facts and circumstances that resulted in the losses.
For example, taxpayers can document items such as how long a limited risk entity may have been left idle or with excess capacity due to local government restrictions, or where there were operational business decisions made by the parent company which may have been out of the control of the limited risk entities.
To ensure a reliable outcome of the TNMM or CPM analysis, taxpayers should, where possible, consider that the exclusion of exceptional or unusual costs are done consistently for both the tested party of the intercompany transaction and the selected comparable companies.
Under what circumstances can intercompany agreements be modified to address issues due to COVID-19?
Prior to making modifications to existing agreements, taxpayers and their advisers should view terms outlined in the existing agreements to determine if there is already some flexibility to make certain changes to address issues resulting from the COVID-19 pandemic.
If such clauses do not exist or need revision, the unprecedented impact of the COVID-19 pandemic could provide the opportunity for intercompany agreements to be modified or renegotiated to further clarify how certain issues should be handled.
Tax authorities have often struggled to accept that this behavior is consistent with the arm's-length principle, so the burden of proof on the taxpayer appears to be high.
Amended intercompany agreements are more likely to be supported if the taxpayer can demonstrate that unrelated parties would likely agree to similar modified terms under similar circumstances. Independent parties dealing at arm's length will, in times of economic hardship, renegotiate to protect and preserve a long-term mutually beneficial arrangement.
A likely outcome of the COVID-19 pandemic is taxpayers looking to add more flexibility into their intercompany contracts, so we expect to see, and recommend, companies reconsidering how their current contracts account for the impact of unforeseen exogenous shocks to the economy.
Government Assistance Programs
Government assistance programs can be monetary or nonmonetary programs where a government or other public authority provides a direct or indirect economic benefit to eligible taxpayers.
These programs potentially have transfer pricing implications. In their discussion, the OECD covers certain aspects to consider when analyzing the potential impact of government assistance on the pricing of a controlled transaction.
Further, the OECD notes that it may be necessary to similarly take into account the impact of government assistance on potential comparable companies, but this may be difficult in practice given the lack of public availability of such information for comparable companies.
Does the receipt of government assistance affect the price of controlled transactions and allocation of risk within those transactions?
Most tax authorities are yet to provide specific guidance on the treatment of COVID-19 related government assistance but, at a minimum, taxpayers must be aware of the impact any government assistance has had on the financial performance of parties to controlled transactions.
It is recommended that taxpayers review their intercompany agreement terms to determine what, if anything, is said regarding government incentives. Additionally, it would be helpful to gather evidence that identifies instances where unrelated parties address how government assistance credits are treated.
It is expected that tax authorities will challenge taxpayers if they suspect local government assistance was passed on through transfer pricing. Our experience thus far is that most taxpayers are ignoring government assistance that may have been received locally when reviewing 2020 results and considering any necessary transfer pricing adjustments.
Advance Pricing Agreements
The COVID-19 pandemic has led to material changes in economic conditions that were likely not anticipated when APAs covering fiscal year 2020, and potentially future years, were agreed to. As such, there may be challenges when applying existing APAs under these economic conditions.
In those instances, the OECD encourages taxpayers to adopt a collaborative and transparent approach by raising these issues with the relevant tax administrations in a timely manner and to not seek resolution unilaterally without consulting with all relevant tax administrations.
How should taxpayers address difficulties meeting terms of existing APAs?
For existing APAs, the terms and conditions should be respected, maintained and upheld, unless a condition leading to cancelation or revision to the APA has occurred such as a breach of a critical assumption.
It is possible that the market or economic conditions due to COVID-19 classify as a breach of critical assumptions, but this should be analyzed on a case by case basis, taking into account the individual circumstances of the taxpayer and commercial environment.
How should taxpayers proceed with APAs currently under negotiation?
For APAs currently under negotiation, including those intended to cover fiscal year 2020, the OECD suggests that taxpayers and tax administrations adopt a flexible and corroborative approach to take into account the current economic conditions.
APAs are intended to provide certainty for all parties involved and can be just as beneficial, if not more so, in times of uncertainty such as the COVID-19 pandemic.
The OECD's guidance on the impact of the COVID-19 pandemic on transfer pricing is a helpful starting point for taxpayers but there remains potential for disagreement between tax authorities in each of the areas discussed. We expect to see specific guidance by local tax authorities be provided in the coming months as many, e.g., the U.S., were waiting for initial commentary by the OECD.
Taxpayers should understand and weigh accurately the implications of transfer pricing decisions that will be taken during the COVID-19 crisis and be prepared to explain and defend their decisions for fiscal year 2020 for contemporaneous documentation and upon future tax audits.
Being able to support these positions with legal agreements, specific business facts and circumstances, comparability adjustments supported in actual financial results, and contemporaneous documentation will be important for managing double taxation and competent authority issues where the guidance may not correspond to local tax authority views.
Susan Fickling is a managing director and TJ Michaelson is a director at Duff & Phelps LLC.
The opinions expressed are those of the author(s) and do not necessarily reflect the views of the firm, its clients or Portfolio Media Inc., or any of its or their respective affiliates. This article is for general information purposes and is not intended to be and should not be taken as legal advice.
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