Arm’s length principle in times of COVID-19 pandemic
Rather than developing specialised guidance beyond the existing 2017 OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations ('OECD TP Guidelines'), the newly published guidance focuses on how to apply the arm’s length principle and the OECD TP Guidelines to issues that may arise from COVID-19. The guidance identifies and addresses four priority areas through questions & answers where practical challenges of the COVID-19 pandemic are most significant:
- Comparability analysis
- Losses and the allocation of COVID-19 specific costs
- Government assistance programs
- Advance Pricing Agreements (‘APAs’).
Here’s an overview of the position taken by the OECD with respect to these topics in a COVID-19 context.
Chapter I. Transfer Pricing Guidance on Comparability Analysis
As a consequence of the unforeseen and significant changes in the economic reality while facing the COVID-19 pandemic, unique challenges arise when performing comparability analysis. As the pandemic can significantly impact the pricing of transactions between independent enterprises, the reliance that can be placed on historical data for comparability analysis may be negatively affected. Moreover, using data from other crisis periods is also not considered representative, as the consequences of the COVID-19 pandemic are so unique, given the fact that not all companies have suffered to an equal extent during the pandemic.
The guidance identifies some practical approaches which may be adopted to address information deficiencies amongst others by referencing to certain sources of contemporaneous information that may be used to support the performance of a comparability analysis applicable for FY 2020 or by suggesting to review the budgeted or forecast financial results to those actually achieved in order to approximate the specific effects of COVID-19 on revenues. In addition, the OECD indicates that it could be considered to use more than one transfer pricing method to corroborate the arm’s length price of a controlled transaction. Obviously, this should only be done by following the general guidance of the OECD TP Guidelines.
Chapter II. Transfer Pricing Guidance on Losses and Allocation of COVID-19 Specific Costs
The crisis resulting from the worldwide COVID-19 pandemic may have led to loss-making situations for many MNE Groups. Transfer pricing questions answered by the OECD in it’s guidance report include the following:
- Can entities operating under limited risk arrangements incur losses?
- Under what circumstances may arrangements be modified to address the consequences of COVID-19?
- How should operational or exceptional costs arising fromCOVID-19 be allocated between related parties?
- How should exceptional costs arising from COVID-19 be taken into account in a comparability analysis?
- How may force majeure affect the allocation of losses derived from the COVID-19 pandemic?
Again, reference is made to the OECD Guidelines, by indicating that “simple or low risk functions in particular are not expected to generate losses for a long period of time”. A loss making low risk-entity could therefore be considered under specific facts and circumstances, but only in the short-run. Indeed, in determining whether or not a ‘limited-risk’ entity may incur losses, the risks assumed by an entity will be paramount. This reflects the fact that at arm’s length, the allocation of risks between the parties to an arrangement affects how profits or losses resulting from the transaction are allocated. For example, in case of a significant decline in demand due to COVID-19, a ‘limited-risk’ distributor that assumes market risk may at arm’s length earn a loss associated with the playing out of such a risk.
Chapter III. Transfer Pricing Guidance on Government Assistance Programs
During the COVID-19 pandemic, governments worldwide have been concerned with public health and controlling the spread of the virus, while at the same time trying to help both (i) enterprises manage the impact of the decline of business activities and (ii) workers facing a decline in employments opportunities and income.
The availability, substance, duration and take-up of these programmes could also have transfer pricing implications as it might affect the behaviour of independent enterprises engaged in potentially comparable transactions. Hence, the ‘Guidance on the transfer implications of the COVID-19 pandemic’ aims at providing answers to the following questions raised in this respect:
- Is the receipt of government assistance an economically relevant characteristic?
- Is guidance on other local market features relevant when analysing the transfer pricing implications of government assistance?
- Does the receipt of government assistance affect the price of controlled transactions?
- Does the receipt of government assistance modify the allocation of risk in a controlled transaction?
- Does the receipt of government assistance affect the comparability analysis?
Chapter IV. Advance Pricing Agreements
As the pandemic has led to material changes in economic conditions, some taxpayers may face challenges in applying existing APAs under these new economic conditions. In those instances, the OECD recommends taxpayers to adopt a collaborative and transparent approach with the relevant tax administrations in a timely manner.
The newly published OECD guidance take into account that the economic impact of the COVID-19 pandemic varies widely across economies, industries and businesses, which is an important element when considering and interpreting its content. Even if this crisis has led to an unprecedented economic situation, the OECD strongly highlights that it is key not to lose sight of the existing guidance and their objective, which is to find a reasonable estimate of an arm’s length outcome. This will in many cases, however, require flexibility and an exercise of judgment on the part of taxpayers and tax administrations.
The OECD also strongly underlines the importance of contemporaneous documentation of how and to what extent businesses have been impacted by the COVID-19 pandemic in any transfer pricing analysis. MNE Groups should carefully consider how the group as a whole responds to the manifestation of hazard risks associated with the pandemic, as well as its effects on other significant risks, e.g. marketplace risks, operational risks and financial risks.