The OECD published ‘Guidance on the transfer pricing implications of the COVID-19 pandemic’ (guidance) on December 18 2020.
A key motivation for the publication of the guidance was the OECD’s awareness that transfer prices tend to be set by taxpayers – and reviewed by tax administrations – by reference to historic rather than current information on market prices. The pandemic could therefore cause taxpayers to set unrealistic transfer prices or cause tax administrations to assess additional tax based on unrealistic assumptions about current market rates.
Another problem is that some tax administrations expect transfer prices or profit margins to be in the arm’s-length range every year, whereas others accept this across a run of years. The guidance addressed several important issues, including comparability analysis, government assistance programmes and advance pricing agreements (APAs), but the issue which could create the most transfer pricing (TP) controversies is that of losses and the allocation of COVID-19-specific costs.
Clearly, the pandemic has created significant losses for many businesses. For example, the United Nations Conference on Trade and Development reported significant declines in the output of automobiles and of machinery and equipment across industrialised economies in the first half of 2020. Likewise, the UK Office of National Statistics reported that services such as hospitality recorded almost no output in April and May 2020, but food retailing and industries such as information and communication (in which staff could work largely from home) experienced little change.
Dispensing chemists have enjoyed increased sales throughout the pandemic, while furniture retailers largely recovered their lost sales in the months when they were allowed to reopen. Online sales rose from 20.1% to 28.5% of the total between February and October 2020.
More generally, the pandemic could be expected to create losses for businesses involved in certain functions, such as manufacturing or distribution (given smaller sales over which to spread fixed costs) and for parties to certain transactions (such as loans, licence agreements or rental agreements, in which one party may be obliged to maintain payments even when it has insufficient profits). Sometimes these losses have been exacerbated or created by exceptional costs of complying with government regulations, such as the use of protective clothing, social distancing, additional reporting or closure of premises.
These losses can create TP problems for various reasons, including if the arm’s-length range does not appear to include loss-making and if a functional analysis or a TP agreement does not appear to be consistent with a particular party being exposed to significant risk.
In order to help avoid a wave of domestic and international TP controversy, the OECD has stepped in quickly with guidelines for taxpayers and tax administrations for determining the correct TP response to the financial impact of the pandemic.
Methods of allocating losses
It is worth stepping back to consider how related parties might allocate additional costs and losses that are caused by the pandemic. For example, in the context of a loan, interest may be rolled up, or waived, or debt may be forgiven, or financial covenants may be ignored (where these may otherwise have allowed the loan to be called in and a new one at a higher interest rate to be put in place).
In the domestic law of some jurisdictions, such actions may result in the supportive party enjoying a commensurate tax deduction, if it can show that not taking these steps would have pushed its subsidiary out of business and thereby damaged the parent company’s investment, or if a manufacturer needed to preserve its business interest by supporting its close business partner, for example a large customer or its route to an important market. In some ways, the guidance promotes this commercial analysis more broadly in the context of TP decision-making.
Recent international case law provides some clues as to the challenges that may arise as a result of reporting losses and the evidence which might be accepted as justification.
For example, in Adecco A/S, Supreme Court of Denmark (Case No. BS-42036/2019-HJR) and A Oy, Supreme Administrative Court of Finland (Case No. KHO: 2020: 34), it was accepted that the taxpayer had valid commercial reasons for reporting a loss. Whereas in Ice Machine Manufacturer A/S, Danish Western High Court (Case No. SKM2020.224.VLR), the taxpayer’s documentation was found to be insufficient to provide this justification. It is notable that the tax administrations advanced a range of arguments, including that:
- Rather than benchmarking individual transactions and notwithstanding the functional analysis, the taxpayer’s net margin should be benchmarked and should be in the arm’s-length range every year; and
- The taxpayer should be taxed on an imputed income from providing an unrecognised service for the benefit of the rest of its group (which sometimes is not even defined by the tax administration).
These cases involved the payment of royalties, and the purchase sale of goods for fixed profit margins, showing that significant loss challenges can arise in a range of situations. As in earlier cases involving losses, the taxpayers continued to win where their TP documentation provided a convincing commercial explanation for their losses. Where no such documentation existed, a successful justification has been that the taxpayer ‘caught up’ by reporting a higher profit in subsequent periods.
These cases did not involve financial transactions, but it is easy to anticipate the tax administration challenges to loss-sharing in the context of this kind of transaction in light of the February 2020 OECD guidance on financial TP, Section B, in the context of ‘the accurate delineation’ of a purported loan transaction.
Relevant considerations are said to include a fixed repayment date, an obligation to pay interest, the right to enforce payment of principal and interest, financial covenants, the ability to service the loan, what happens when the ‘debtor’ fails to repay on the due date or seeks a postponement and whether an arm’s-length borrower would have wanted to borrow so much or would have sought different terms and conditions (such as offering security over collateral). The following tax administration challenges could therefore be anticipated:
- Deferral of interest payments – cumulative interest should be charged; interest should be charged at a penalty rate; imputation of a fee for including this option in the loan agreement, either up-front or as an adjustment to the interest rate;
- Interest waiver – the interest added back to the taxable income of the lender; possible requalification of the loan instrument into equity;
- Debt forgiveness – no deduction for the lender; treated as income of the borrower; and
- Not taking action when a financial covenant is broken – the borrower only to be allowed a deduction proportionate to the debt that an arm’s-length lender would have continued to advance to it; the lender to be taxed on the basis of the higher interest rate which an arm’s-length lender would have charged.
The potential challenges listed above are new ones based on the ‘soft law’ provided by OECD guidelines, and unfortunately for multinational taxpayers tax jurisdictions have interpreted the guidance in different ways.
This could lead to reallocation of losses to a foreign entity in a jurisdiction in which the tax administration will not give a corresponding income adjustment and the taxpayer has to resort to the mutual agreement procedure of the relevant tax treaty. The outcome will be uncertain and possibly unsatisfactory for the taxpayer, especially where a competent authority is unwilling to accept arbitration (for example, as envisaged in the EU Directive 2017/1852). In such a situation, negotiating an APA with a ‘rollback’ may be a solution.
TP justifications for allocating losses
The guidance notes that because of differing market pressures, businesses in some industries are more able to pass on costs than businesses in other industries (as mentioned above).
In general, the ‘price elasticity of demand’ is lower (or even negative) for more essential items such as food, petroleum, natural gas and medical services, and higher for ‘luxury’ or ‘discretionary’ items such as hotels, restaurant meals, airlines, foreign travel, new automobiles and luxury goods. Therefore, it is important first of all to identify the net additional costs which each company has suffered as a result of the pandemic, whatever the immediate cost of complying with government safety measures.
Similarly, different cost structures mean that companies in some industries are less able to reduce their costs in the face of reductions in demand and sales, and will therefore suffer larger losses, and this effect may even vary between companies in the same multinational group. The starting point for any TP justification of the pattern of losses reported by group companies is an analysis of how they were each affected by the pandemic.
Second, the guidance explains that losses can be justified if it can be shown that the benchmark companies in pre-pandemic periods would also have reported losses if they had suffered the same reductions in demand or additional government-imposed costs. This will require an analysis of how their costs have moved as their sales have changed.
Third, the guidance suggests that the starting point for allocating losses is the contractual allocation of risks between the parties, including whether certain costs are not covered by the agreement. The guidance states that it is acceptable for ‘low-risk’ parties to bear losses in the short run, for example if sales fall significantly.
Fourth, the OECD advises taxpayers to consider whether it would be in the longer-term interests of the parties – if they were independent – to be flexible about adherence to the TP agreement in the short term, or even to switch to a new agreement in which losses might be shared. Where a company decides to adopt this flexibility with some of its related counter-parties but not others, this commercial analysis will have to be carried out company-by-company.
Taxpayers are advised to act in the following ways, and as contemporaneously as possible:
- Calculate and document the impact of the pandemic on each company in their group;
- Alert the relevant tax administration to any likely breach in a critical APA assumption. Depending on local tax regulations, the relevant APA may no longer be valid and binding to the extent that the factual background has changed and a new adjusted APA may need to be filed;
- Review whether existing related party agreements would permit certain costs or losses to be shared;
- Assess whether it is in the longer-term interests of the parties to share certain costs or losses, and change transfer prices accordingly;
- Change transfer prices if it is felt that the pandemic will have a longer-term effect on a company;
- Amend TP agreements if the immediate change in TP is thought to imply that the roles of parties had not in fact been as described in the existing agreement (for example, if a ‘limited risk’ party is asked to share risks and losses, perhaps suggesting that it is more accurately viewed as a full-risk business which should earn a normal margin for bearing this risk);
- Adopt new TP agreements if the business has had to be restructured to survive (for example, involving the centralisation of functions such as procurement); and
- Ensure that the necessary mix of legal and economic skills is brought to bear in this analysis in order to produce convincing TP documentation.
Whatever the outcome of a review of the pandemic on the appropriate TP policies, the key requirement is to have a strong economic rationale for any decisions, to document this analysis in an appropriate manner and then to amend or prepare the relevant legal documentation.
Danny Beeton is an of counsel with Arendt & Medernach, where he is the senior economist in the TP practice.
Danny advises clients on the determination of arm’s-length prices for all types of related party transactions, including goods, services and intellectual property, but with a special focus on financial transactions such as loans, guarantees, group treasury policies and asset management fees. His assistance is often sought in the context of TP compliance and reporting, controversy and planning, and he has provided expert reports in the context of litigation.
Danny holds a master’s degree in economics from the University of Essex as well as a PhD in economics from the University of London. He has been a member of two HMRC advisory committees, and committees of the Confederation of British Industry and the Chartered Institute of Taxation.
Alain Goebel is a partner with Arendt & Medernach. He advises international clients on the tax and TP aspects of Luxembourg and cross-border transactions, focusing on corporate reorganisations, acquisitions and financing structures.
Alain has been a member of the Luxembourg Bar since 2002. He acted as president for the Young IFA (International Fiscal Association) Network between 2013–2016 and as Luxembourg’s national representative for the International Association of Young Lawyers (AIJA) between 2012–2015.
Alain holds a master’s degree in business law and a postgraduate degree in tax law from Paris 2 Panthéon-Assas University, as well as a LLM in banking and finance law from King’s College London. He has worked as a lecturer in business taxation at the University of Luxembourg from 2009-2016 and is a regular speaker at tax seminars. He has published several papers on tax law, including national reports for IFA and AIJA.
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