In April 2021, around 200 leaders from businesses and tax authorities around the world joined experts from the OECD and Grant Thornton to explore the transfer pricing issues thrown up by COVID-19. The level of interest from countries as far apart as Argentina and New Zealand attests to the deep uncertainties over transfer pricing and resulting concerns over the potential for double taxation and dispute.
We are indebted to Sabine Wahl, Senior advisor transfer pricing, OECD, and Norman Wingen, Advisor transfer pricing, OECD, for their insights during their presentations and question responses.
Making sense of the exceptional transfer pricing landscape.
So, what’s the background to all these issues and why do they matter? Many businesses have suffered severe losses over the past year, though others have seen a surge in profits. Even within sectors, there are marked variations. The closure of borders and suspension of some operations have further disrupted intra-group service and supply.
And these exceptional times are far from over. The uncertainties ahead don’t just stem from further waves of infection, but also the increased demands on intellectual property and intra-group service as businesses resupply, step up marketing or shift more of their business online.
Credible policies and clear justification are always important within transfer pricing. The bar will now be even higher. Approaches may diverge quite considerably from the past. In turn, tax authorities are themselves under pressure to maximise their tax take, which could heighten the risk of challenge, audit and dispute.
“The fiscal deficits within many countries mean that tax authorities will be keen to maximise tax take and reluctant to share this with other jurisdictions. Transfer pricing scrutiny and the potential for double taxation and disputes have increased as a result. This makes it even more important to ensure that transfer pricing approaches are watertight.” Christophe Ludwig, Partner, Grant Thornton Germany
OECD guidance only goes so far
Published in December 2020, the OECD’s Guidance on the transfer pricing implications of the COVID-19 pandemic sets out practical recommendations on how to tackle some of these challenges. Areas covered include comparability analysis; losses and the allocation of pandemic-specific costs; government assistance programmes; and advance pricing agreements (APAs).
The clarification of how the arm’s length principle would apply in current circumstances represents a hard-won consensus between more than a hundred ‘inclusive framework’ jurisdictions. However, this is guidance rather than guidelines, which leaves a lot of grey areas for both businesses and tax authorities. In turn, the need to reach agreement within reasonable deadlines means that some of the more contentious areas such as intangibles have been omitted from the guidance.
“While the OECD recommendations are a good starting point for determining transfer pricing under current circumstances, they offer guidance rather than firm guidelines. Businesses will still need to present clear justification and supporting documentation to secure tax authority approval during these exceptional times.” Pascal Luquet, Partner, Head of Transfer Pricing, Grant Thornton France
So, what are the key considerations for your business? The main transfer pricing issues that need to be addressed fall into five broad categories, though there is considerable overlap and knock-on impacts between them.
Issue one: Sharing exceptional losses or super-profits
As revenues have plummeted or surged, key questions from a transfer pricing perspective include which entity bears these exceptional losses or gains?
There have also been significant shifts, as revenues within many businesses recovered in mid-2020, only to fall back again as lockdowns were reimposed. The question here is whether to treat these periods of exceptional loss in isolation or smooth the financial evaluations to create a full-year view.
Implications and complications
You can’t simply say that ‘exceptional times demand exceptional measures’. The arm’s length principle and the transfer pricing rules that spring from it should apply in bad times as well as good. Risk bearing is at the heart of how income is owned and allocated. So, if an operation such as a distribution centre is designated as low risk and associated transfer pricing income in normal times reflects this, then it is hard to justify why it should incur major losses as a result of a pandemic. Either the majority of the losses should be incurred elsewhere, or perhaps the operation needs to be re-designated.
Similarly, industry-wide comparisons are not enough in themselves to justify any shift in risks borne or losses allocated. Given how varied and localised the impacts have been, your business would need to set out how the risks manifested themselves and how you responded for each entity and the group as a whole.
Build a clear and demonstrable picture of how the economics and risks for each entity have been affected. Justifications should be built around analysis of resulting outcomes or relevant comparisons with third-parties.
Ensure gains and losses are aligned with your risk control framework. If not, it’s important to justify this and gauge the impact on past and future transfer pricing if risk designations change.
Given the current levels of uncertainty and volatility, you may need to work with shorter planning cycles. This includes considering the impact of a shock such as temporary collapse in revenue during lockdown, and a later rebound, separately.
In certain circumstances, it may be possible to apply force majeure clauses (freeing parties of obligations) and potential modification of existing arrangements. But as the effects of the pandemic vary by industry, business model or market, this question can only be answered through a careful analysis of the specific costs under consideration.
Issue two: Comparability analysis
Precedents from the past can usually provide a useful basis for applying the arm’s length principle. But 2020 and 2021 couldn’t be more different from 2018 and 2019.
Are there precedents in the more distant past that we can fall back on? Unfortunately, this is not easy. As the OECD representatives underlined during the webinar, the current situation is so exceptional that no previous crises, including the global financial crisis, offer any general guide to dealing with the dislocation and its impact on transfer pricing.
Implications and complications
Given the levels of upheaval and unreliability of past assumptions, you may need to deploy new approaches to make up for any gaps or deficiencies. The OECD recognises this in its guidance.
It’s important to identify the most appropriate approach or approaches for your particular circumstances.
Approaches cited by the OECD representatives during the webinar include outcome testing and/or the use of budgeted financial information. In our experience, this tends to work best when budgeted forecasts in areas such as sales and costs are compared to actual outcomes.
Certain publicly available information could also help to estimate and validate the impact of the pandemic. Potential sources include interim financial statements, changes in capacity utilisation or government interventions that affect pricing.
Issue three: Government assistance
Many businesses have been reliant on subsidies, loans, tax breaks and other state support. Governments naturally want this aid to benefit citizens and businesses within their country, rather than going abroad. This creates legal and reputational as well as technical transfer pricing dilemmas.
The OECD has offered some limited guidance on government assistance programmes. But it doesn’t discuss the effects of other government interventions, including measures such as border controls that impede the fulfilment of existing intra-group agreements.
Implications and complications
Government assistance is generally deemed to be an economically relevant factor and should therefore be considered when making and justifying changes to transfer pricing. Government assistance should also be considered when performing comparability analyses.
The allocation of benefits between related parties could be open to challenge and dispute. For example, many operations deemed low risk from a transfer pricing perspective such as warehousing are also relatively labour intensive and therefore likely to have benefited from wage subsidies.
In the face of government scrutiny, it’s important to ensure that transfer pricing and other tax decisions, calculations and payments are aligned.
Consider the extent to which the receipt of government assistance is economically relevant. As part of this analysis, it’s important to gauge whether any other local market features are relevant.
Consider how government assistance could modify the allocation of risk in a controlled transaction.
Issue four: Treatment of intangibles
Intangibles have always been an area where tax authorities’ views differ. The long deliberations over the treatment of hard to value intangibles (HTVI) under BEPS attest to this. This helps to explain why the OECD wasn’t able to secure a consensus within its transfer pricing guidance within the time permitted.
While there is no new OECD guidance on this topic, there have been important local developments in a number of jurisdictions including increased reporting requirements and a broadening of the definition of HTVI.
The challenges are heightened by changes unrelated to COVID-19. These include changes in tax legislation (eg onshoring demands) and need for closer alignment between legal ownership and economic substance.
Implications and complications
The absence of updated OECD guidance on intangibles means that interpretation is more open to individual tax authorities, potential differences between them, and the resulting risk of double taxation and disputes.
Identify what has happened in the business or its markets to drive any changes in transfer pricing.
Regularly test assumptions against outcomes.
“The risks of challenge surrounding intellectual property transfer and other intangibles are greater than ever. This has always been an area where interpretations vary. Now, we’re seeing the disruptive impact of both COVID-19 and tighter rules on offshoring and economic substance. In the absence of guidance from the OECD, it’s important to ensure that economic substance rules are robustly applied and that the drivers for any changes are clearly explained.” Charles Marais, Partner, Grant Thornton Netherlands
Issue five: Advance pricing agreements
The pandemic has changed economic conditions in ways that may not have been anticipated when many APAs were negotiated. It’s therefore important to determine how these developments might affect the application of existing APAs or require their amendment.
Implications and complications
Changes in economic circumstances may not necessarily provide grounds to alter or disregard the agreement unless they constitute a material change in the critical assumptions underpinning the APA. So, its’ important to consult with the tax authority.
Openness to revising the APA varies according to the tax authority.
Respect the terms of the APA unless a legitimate reason for cancellation such as a clear breach in critical assumptions occurs. These assumptions should be spelt out in the APA.
If economic conditions have changed, it’s important to engage proactively with tax authorities and work with them collaboratively and transparently to raise relevant issues and agree modifications. It would be unwise to act unilaterally without consulting with the relevant tax authorities.
Document and deal with any breaches in critical assumptions or reasons why the APA terms may need to be changed.
“Changes in economic conditions or critical assumptions may negate the terms of some APAs. It’s important for both businesses and tax authorities to be proactive, flexible and openminded about how to resolve these issues. This collaborative approach can help to ease tax risk and avoid needlessly adversarial audits and disputes.” Paolo Besio, Partner, Grant Thornton Italy
Get on the front foot
Navigating the transfer pricing rules has never been easy. The economic impact of COVID-19 has added a fresh layer of complexity and heightened the risk of challenge. That’s why it’s so important to make sure policies are justified and there is documentation to support this. Further priorities include engaging with tax authorities, understanding how they’re applying the rules under current conditions, and gauging what they expect. Five key areas of potential challenge that need to be addressed stand out:
- Sharing exceptional losses (or super-profits) and government support payments
- Comparability analyses and outcome-testing
- Dealing with intangibles
- Consider APA critical assumptions
- Be ready for disputes (contemporaneous documentation).
“COVID-19 hasn’t changed the rules on transfer pricing. It’s just made them harder to apply and more open to challenge. The best way to avoid disputes or deal with them effectively is to be ready. That means ensuring you have the analysis and documentation to back up what you are doing and why. The big danger is going to tax authorities empty handed.”
Wendy Nicholls, Partner, Grant Thornton UK
Here to help
If you would like to discuss any of the issues raised in this paper or want to find out more about the impact of the pandemic on your transfer pricing and wider tax arrangements, please feel free to get in touch with one of the people listed in the article or speak to your local transfer pricing contact.