OECD guidance on the transfer pricing implications
of the COVID-19 pandemic has been published

On 18 December 2020, the OECD Guidance on the transfer pricing implications of the COVID-19 pandemic was published. The recommendations of the Guidance represent the consensus view not only of the OECD member countries, but also that of the wider Inclusive Framework on BEPS, which counts 137 members, and provide a basis for addressing transfer pricing issues affecting most groups of companies. The authorities of the countries concerned, including the Hungarian authorities, will be evaluating these recommendations when developing their own approaches. The document undoubtedly deserves to be studied in detail by experts, while our article describes the most useful consequences.

Due to the COVID-19 pandemic, companies have faced or continue to face unprecedented economic conditions. The period is characterised by significant cash-flow difficulties, wide swings in profitability, and supply chain disruptions. In some industries, the demand has completely collapsed, companies have been forced to close, while in others it has merely shifted distribution channels, or even increased (e.g. the market for online video conferencing services). Some enterprises have reviewed their contractual arrangements with third parties to renegotiate conditions that have become onerous due to the pandemic. Markets have also been significantly affected by comprehensive economic policy responses adopted by governments.

These unique, unprecedented economic conditions have led to practical challenges for the application of the arm’s length principle. Based on consultations with the business sector, the OECD has identified four priority issues that the Guidance addresses: comparability analysis, the allocation of losses and the allocation of the COVID-19 specific costs, government assistance programs, and Advance Pricing Arrangements (“APA’s”). It should be noted that the Guidance should in no way be regarded as an expansion or revision of the OECD Transfer Pricing Guidelines, but merely explains the application of the existing guidance under the OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations 2017 to fact patterns typically encountered in connection with the pandemic.

• Comparability analysis

In principle, any form of publicly available information regarding the effect of COVID-19 on the business, industry and the controlled transaction may be relevant in ascertaining the arm’s length nature of an enterprise’s transfer pricing policy for FY 2020. The following sources of information may be used to support the comparability analysis:

• an analysis of how sales volumes have changed during COVID19;
• an analysis of the change in capacity utilisation;
• specific information relative to incremental or exceptional costs borne by parties to the controlled transaction or by the MNE group as a whole;
• the extent to which government assistance has been received (as well as quantifying this effect, identifying the type of assistance and the accounting treatment) and its details that affected the controlled transaction and its pricing;
• etc.

Another potential approach is to compare budgeted or forecast financial results to those actually achieved, to approximate the specific effects of COVID-19 on revenues, costs and margins, which may be performed as a part of a more general set of approaches utilised to evaluate the context and the factors that may impact the arm’s length nature of prices.

Although in some instances (e.g. for financial transactions) current or recent information on uncontrolled transactions may be available, this is not the case for all types of transactions. However, it should not be overlooked that taxpayers are likely to have current information on potential internal comparables that can be used for analysis.

FY 2020 may be a challenge for the application of the net transaction profit method (“TNMM”), as FY 2020 financial information will typically not be available until mid FY 2021 at the earliest. In the absence of contemporaneous information, the OECD recommends that the comparability analysis be based on available prior year financial information, utilising whatever current year information is to support the transfer prices.

The OECD recognises that data from independent comparable transactions or companies from previous periods may not provide a sufficiently reliable benchmark if they are not adjusted for the specific impact of the pandemic. The Guidance outlines several practical approaches designed to remedy this. It is recommended that national tax administrations apply these to the taxpayers who make good faith efforts to determine arm’s length prices in the context of information deficiencies and not seek to use the pandemic circumstances to manipulate their pricing strategy. These approaches assume the followings:

• Allow for the use of reasonable commercial judgement supplemented by contemporaneous information to set a reasonable estimate of the arm’s length price. This will prevent a sudden rise in the number of mutual agreement procedures (“MAP”), although tax administrations need to be prepared for its increase and ensure access to the MAP or to some alternative applicable procedure to the taxpayers who need them;
• Where feasible, allow for an arm’s length outcome testing approach, incorporating information that becomes available after the close of the financial year. (In contrast, the “price-setting” approach preferred by many tax administrations, uses historical data updated to reflect any change in economic conditions). Where tax administrations temporarily allow the use of outcome-testing approach, they could also temporarily allow the use of price adjustment mechanisms (e.g. adjustment of prices relevant for FY 2020 through adjusted invoicing in a later period, likely FY 2021);
• Use of more than one transfer pricing method, although the arm’s length principle doesn’t require the applications of more than one transfer pricing method.

As it might have been expected, the OECD considers the template use of financial data from other crises (e.g. from the 2008-2009 global financial crise) to be highly debatable, given the specific nature of the economic crisis caused by the COVID-19 pandemic.

The use of multiple year data and averages remain applicable during the pandemic, too, but it may be appropriate to have separate testing periods for the duration of the pandemic (or for the periods when certain material effects of the pandemic were most evident). It is also important that any government interventions are taken into account equally for the controlled transaction and for the comparable uncontrolled transactions. If the comparable enterprises have not faced similar restrictions to those suffered by the taxpayer or have not benefit from the governance assistance similar to that received by the taxpayer, the economic data for the comparison period should be adjusted accordingly (e.g. excluded from the sample).

In those circumstances where the taxpayer rolls forward an existing set of comparables to cover FY 2020, it may be necessary to review the suitability of these existing comparables; if necessary, the set might be revised based on updated search criteria.

In general, there is no overriding rule on the inclusion or exclusion of loss making comparables in the OECD Transfer Pricing Guidelines. Consequently, if such data satisfy the comparability criteria, they should not be rejected and may be included for both previous periods and the pandemic period.

• The allocation of losses and the allocation of the COVID-19 specific costs

One of the typical issues in this area is whether the loss-making operation of a company classified as a limited risk service provider is compatible with the arm’s length principle. In this respect, the OECD Transfer Pricing Guidelines state that, „simple or low risk functions in particular are not expected to generate losses for a long period of time”. Therefore, it holds open the possibility that simple or low-risk functions may incur losses in the short-run. The risks assumed by such a low-risk service provider play a major role in deciding the issue. It is entirely viable that where there is a significant decline in demand due to COVID-19, a low-risk service provider (classified as such, for example, based on limited inventory ownership – such as through the use of "flash title" or drop-shipping – and therefore limited risk of obsolescence of inventories) that assumes some marketplace risk may at arm’s length earn a loss associated with the playing out of this risk.

Overall, in such cases, it is important to evaluate the consistency of the taxpayer position: if it claims that the low-risk provider did assume marketplace risk before the pandemic and hence was entitled to a low return, it is questionable why it is exposed to marketplace risk after the outbreak and hence should be allocated losses.

Whether it is compatible with the arm’s length principle that related parties may not strictly hold another party to their contractual obligations during the pandemic period or renegotiate the essential terms of their existing agreements must be examined in the light of whether it is consistent with the behaviour of unrelated parties in a similar situation. The Guidance explicitly states that, in the absence of clear (and duly substantiated) evidence that independent parties in comparable circumstances would have revised their existing agreements, the modification of existing intercompany agreements is generally not consistent with the arm’s length principle.

As a result of the pandemic, many enterprises have incurred exceptional, non-recurring operating costs in order to adapt to the changed operating environment. These include, for example, expenditure on Personal Protective Equipment (PPE), reconfiguration of workspaces to enable physical distancing, the IT infrastructure expenses related to test, track and trace obligations and to implement teleworking arrangements. For the purpose of allocating these costs between related parties, it will be important to consider primarily which party assumes the risks of the activity and in whose interests those costs are incurred.

It is no less important, whether the exceptional costs incurred may in fact be viewed as exceptional. Thus, for example, if working from home becomes more common as a result of a pandemic, the costs associated with teleworking arrangements may become permanent in line with normal business practice. Furthermore, it should not be overlooked that certain costs that were typically incurred (e.g. rent, running expenses of a physical office, travel expenses) have even been reduced or eliminated.

The competitiveness of a given industry also plays a major role in which party ultimately bears such costs. In highly competitive market, with undifferentiated products, companies may be unable to pass on the exceptional costs to their customers without causing a decline in demand.

• Government assistance programs

By government assistance, the Guidance refers to monetary or non-monetary programmes where a government or other public authority provides a direct or indirect economic benefit to eligible taxpayers, such as grants, subsidies, forgivable loans, tax deductions, investment allowances.

The receipt of government assistance may be an economically relevant characteristic of the controlled transaction if it has a direct impact on the controlled transaction or comparative independent transactions, including their prices (such as wage subsidies, government debt guarantees or short-term liquidity support). In this case, information on the received government assistance should be included as a part of documentation to support the transfer pricing analysis.

In the cases where government assistance has no direct impact on the controlled transaction and its pricing (for example, the provision of local infrastructure at a discount or free of charge), government assistance is a less economically relevant characteristic of the transaction. However, the situation may be different where the taxpayer has not received government assistance and the comparable independent parties have received it; in such case, this may be an economically relevant characteristic of the transaction.

The Guidance contains the main principles along which government assistance programmes implemented in different countries can be analysed. This information helps to understand whether the receipt of government assistance affects the price of the controlled transaction and can also be decisive in the comparative analysis. In addition, the particular nature of the government assistance should always be reviewed in the transfer pricing analysis.

The provision of government assistance to a related party will not change the allocation of risk in a controlled transaction. A distinction should be made between the quantitative negative impact of a risk (which may be reduced by the receipt of government assistance) and the allocation of risk between related parties (which remains unchanged in line with OECD Transfer Pricing Guidelines).

The government assistance programmes introduced in each country may differ significantly, which should be taken into account in the comparative analysis. The most reliable approach is to use transaction data from the same or comparable geographic market, where such data is available.

Care must be taken that the accounting treatment of government assistance is specifically identified in the analysis. Particularly, when applying a one-sided method (such as the resale price method, the cost plus method, or the TNMM), it is important to identify the accounting treatment applied by the taxpayer and the comparative independent parties. Different accounting treatment may impact different levels of profitability (e.g. gross profit, operating profit, net profit etc.), or might even be accounted for in the other comprehensive income statement, only being recycled into the “profit or loss statement” over time. Different accounting treatments may require a comparability adjustment. Furthermore, divergences in the accounting treatment of government assistance could point to a difference in the type of government assistance, which also could affect comparability and might be more difficult to adjust for than a simple accounting difference.

• Advance Pricing Arrangements (“APA’s”)

One of the primary benefits of advance pricing arrangements is that they provide tax certainty to taxpayers and tax administrations even when there have been significant changes in the economic environment. The COVID-19 pandemic caused just such unpredictable changes. The OECD states that, as a general rule, contingent tax assessments should be respected, maintained and upheld unless a condition (e.g. a breach of critical assumptions) has occurred that leads to the cancellation or revision of the APA. Taxpayers and tax administrations cannot automatically disregard or alter the terms of existing APA’s due to the change in the economic circumstances.

Generally, the APA itself will explicitly describe what constitutes a situation of non-compliance or failure to meet a critical assumption, as well as the consequences arising from it. In addition, the domestic law or procedural provisions may also impose consequences or obligations on the taxpayer and the affected tax administrations.

Breaches of critical assumptions should be analysed on a case-by-case basis. If a taxpayer believes that the terms of the APA are no longer appropriate because the critical assumptions have been breached, it is advisable to approach the relevant tax administration as soon as possible. However, the tax authority may want to consider waiting for a reasonable period until data and information on the magnitude and longevity of the economic impact of the pandemic are available. By deferring their response, tax administrations may find it easier to revise, rather than cancel, an APA.

In the absence of other rules and procedures prescribed by domestic laws, the guidance of the OECD Transfer Pricing Guidelines applies, which recognises three potential outcomes of a breach of critical assumptions: revision, cancellation, and revocation.

The Guidance provides a recommendation on how to document a failure to meet critical assumptions, such as a description of the narrowest relevant business segment involved in the APA, forecast and actual business segment profits, sufficiently detailed income statements, and so on.

For the APAs under negotiation, the Guidance suggests several possible solutions that Member State authorities are likely to consider. One solution assumes the conclusion of two APAs: a short-period APA covering the pandemic period and a separate APA covering the post-COVID period. The other proposed solution would be to conclude the APA for the whole period of the planned transaction (e.g. 2020-2024) with a condition that the relevant impacts of the COVID-19 pandemic will be analysed and reported annually once known to the tax authority, so that retrospective amendments to the APA could be made accordingly, when appropriate. Another solution would be to extend the period of APA to mitigate the short-term effects of the pandemic. Additionally, the use of cumulative test (where the usually individually examined transactions are examined cumulatively) or term test (where the arm’s length prices are tested over a period of more than one year) throughout the APA period could be given a consideration.

To sum up, the practical significance of the long-awaited document is that the preparation of transfer pricing documentation for 2020 implies complex analytical tasks, which may make it necessary to involve highly qualified external experts. Company managements may need to allocate greater budgets for the preparation of the transfer pricing documentation for the periods concerned.