Background
Companies conducting cross-border supplies and service relationships with foreign affiliated companies have to keep their pricing in line with the so-called arm's length principle. As a result of the Covid-19 pandemic, the question on possible consequences in the determination and auditing of intercompany transfer prices arises due to the impact of the crisis on the national and global economic environment. In order to ensure that these consequences are properly taken into account for the determination of arm's-length transfer prices, the OECD published guidelines on the implications of the Covid-19 pandemic on transfer prices on December 18, 2020. These guidelines apply to both taxpayers and the relevant tax administrations.
OECD Guidelines
The OECD confirms that the economic impact of the Covid-19 pandemic has extensive implications on transfer pricing arrangements. Basically, the OECD Transfer Pricing Guidelines of 2017 are still applicable. The published guidelines supplement this general guideline only with respect to the handling of the special circumstances caused by the Covid-19 pandemic.
The OECD has identified the following issues affected by the impact of the Covid-19 pandemic:
- Comparability analysis
- Treatment of losses and allocation of Covid-19 specific costs
- Treatment of government support programs
- Impacts on an Advance Pricing Agreement (APA)
Comparability analysis
The comparability analysis is used to derive an arm's length transfer price by comparing transactions between affiliated parties with comparable transactions between unrelated third parties. It is important that the underlying data used for the comparability analysis subject to the same basic economic and factual conditions so that they allow an arm's length comparison. Therefore, 2020 data cannot be compared to historical data prior to the Covid-19 pandemic outbreak unconditionally because they were determined under different economic conditions, which could affect pricing.
A case-by-case assessment shall show if the consequences of the Covid-19 pandemic could have an impact on the comparability analysis or the underlying transactions. If this is the case, appropriate adjustments must be made to the data so that the relevant economic changes are considered for the determination of the transfer prices. This also applies to already existing long-term contractual agreements that have been affected by the Covid-19 pandemic. For this purpose, it has to be considered whether or not third parties would have attempted to make corresponding adjustments on the agreements as a result of the changed economic situation due to Covid-19.
The short-term acquisition of data on comparable transactions and companies has also been increasingly complicated or delayed by the impact of the Covid-19 pandemic. The guidelines provide a list of potential sources which could be used for a plausibility check or adjustment of the comparability analysis. For example, an analysis of the impact of the Covid-19 pandemic on sales performance or a comparison of internal target sales figures with actual numbers could be used. The comparison with data derived from "unprofitable" companies as comparative values or foreign data shall (as an exception) be possible if all other required comparison criteria are met.
As a practical solution, according to the OECD guidelines, tax administrations could switch their procedure to determine transfer prices using an outcome testing approach. Subsequent transfer pricing adjustments or the use of multiple transfer pricing methods for the arm's length analysis could also be useful. Considering the difficult conditions for 2020, the guidelines encourage tax authorities to exercise some flexibility when assessing the arm's length principle to avoid subsequent disputes. Taxpayers are encouraged to adequately analyse and document the impact of the Covid-19 pandemic with regard to transactions between related parties.
Treatment of losses and allocation of costs caused by the Covid-19 pandemic
In many cases, the Covid-19 pandemic has had a negative impact on profits and has led to losses for corporate groups in 2020. On the one hand, these losses caused by the pandemic can occur as "indirect costs", for example, due to reduced demand or forced closures. On the other hand, such losses may also be "directly" (Covid-19 specific costs) associated with the consequences of the Covid-19 pandemic, for example, for costs of hygiene measures or costs of meeting necessary regulatory requirements.
The OECD guidelines highlight the following three key points for handling the costs caused by the pandemic:
- The allocation of risks incurred by related parties with respect to a transaction may have a material impact whether the allocation of the profit or loss associated with a transaction can be considered at arm's length. Accordingly, the existing guidelines on the analysis and allocation of risks are also applicable and highly relevant to the consideration of losses caused by the Covid-19 pandemic.
- Assessments on extraordinary, non-recurring operational costs caused by the Covid-19 pandemic must be made and it has to be determined if and how these costs shall be allocated when transactions between affiliated companies are performed. The allocation of these costs shall be based on an analysis that takes into account how third parties would consider the pricing of such costs under comparable circumstances.
- The Covid-19 pandemic has opened up the possibility of applying existing contractual force majeure clauses in order to cancel existing intercompany agreements or adapt them to the changed economic conditions.
Furthermore, the OECD has commented on the circumstances under which so-called "routine companies" with a limited risk profile may generate losses considering the arm's length principle. Such companies must regularly generate stable (small) profits from a transfer pricing perspective. In accordance with the OECD guidelines, it cannot be ruled out that even routine companies may suffer losses in the short term. The circumstances of each individual case have to be considered. In particular, the risk profile of the company is also decisive if it may suffer a loss measured according to the arm's length principle.
Treatment of government support programs
In order to circumvent the negative economic and social impacts of the Covid-19 pandemic, many states have established support programs or business assistance programs. The availability, duration and utilization of such support programs may have an impact on the determination of arm's length transfer prices. It does not play a role whether the government support is provided directly to a company in a multinational group of companies or whether the government support is provided to independent parties in the market in which the group of companies operate. The financial aspects of government support are also taken into account in pricing agreements between third parties.
Accordingly, the OECD explains that the terms and conditions of government assistance programs related to Covid-19 pandemic also have to be considered to determine the potential impact of such government programs on transactions between affiliated companies. According to the guideline, this generally requires an analysis of the specific characteristics of the government support as well as the economic impact of the government support on the intercompany transaction. The results should be considered accordingly when determining arm’s length transfer prices.
Because of the different assistance programs varying from state to state as well as the different impacts on the assistance of local economies, it may be difficult to obtaining reliable and detailed information on the effects of assistance programs in order to conduct an appropriate analysis.
According to the guidelines, such cases, where the received government support probably has no significant effect on the controlled transaction do not require a corresponding analysis in respect of the impacts on the government support.
Furthermore, government support programs may have an impact on the comparability analysis. For example, transactions between third parties that generally meet the usual comparability criteria cannot be used as comparative data for the analysis of transactions between affiliated companies if one of the transactions is affected by government support programs and the other is not.
Impacts on Advance Pricing Agreements (APAs)
The guidelines explain how advance pricing agreements are affected by the Covid-19 pandemic. Advance Pricing Agreements are agreements between taxpayers and the relevant tax administrations in the field of transfer pricing. In these agreements, a method for determining arm's length transfer prices is stipulated prior to incurring certain business relationships or transactions between affiliated companies. As many Advance Pricing Agreements for 2020 were conducted prior to the Covid-19 pandemic, they could not consider or anticipate the consequences caused by the Covid-19 pandemic. However, the existing agreements continue to apply and must be complied with. However, in individual cases it is also possible that certain economic conditions ("critical assumptions") have been contractually agreed upon which, in the event of a significant change or deterioration, would lead to a cancellation or adjustment of the Advance Pricing Agreement.
For current negotiations on non-concluded Advance Pricing Agreements, the supplement of a corresponding flexible agreement on the framework conditions should be borne in mind.
Conclusion
The publication of these guidelines by the OECD is appreciated as it provides both taxpayers and tax administrations with options when dealing with the consequences of the Covid-19 pandemic in relation to complex transfer pricing issues. The OECD guidelines are written in a general manner and will have to be "filled with life" by companies and tax administrations. It becomes clear that taxpayers will have additional tasks in terms of documentation and analysis of the consequences of the Covid-19 pandemic in order to demonstrate the appropriateness of transfer pricing - especially in 2020 and 2021.