With COVID-19-induced lockdowns and countries restricting the movement of people and goods, the world fell into recession with a 3.5% contraction in 2020 alone (World Bank Group flagship report – Global Economic Prospects, June 2021).
To counteract such a contraction, governments across the world extended a much-needed impetus, amounting to US$16 trillion until March 2021 (Fiscal Monitor – International Monetary Fund, April 2021). However, this coupled with rising health care expenses, led to a fiscal deficit of 11.7% of GDP (2020) for advanced economies (Fiscal Monitor – International Monetary Fund, April 2021).
To fill such a deficit, tax administrations around the world could be expected to perform large-scale transfer pricing (TP) audits. Accordingly, tax policy and management of pandemic-related tax controversies are becoming increasingly important and are likely to take centre stage in MNCs’ boardroom discussions.
Considering the unprecedented and extraordinary nature of COVID-19’s impact, this article identifies key business disruptions and areas that may lead to tax controversies. Select areas of the 2020 ‘OECD Guidance on the transfer pricing implications of the pandemic’ (OECD COVID-19 Guidance) and the application of the arm’s-length standard (ALS) during the COVID-19 years is analysed. Best practices for risk mitigation are also considered.
COVID-19-induced business disruptions
COVID-19 has impacted the way companies undertake their operations, altering business value chains temporarily or even permanently, given that certain changes are likely to stay.
- For instance, movement restrictions led to the shift to digital marketplaces/e-commerce platforms from brick-and-mortar retail chains. In such cases, while historically, the relative contribution of physical stores, sales staff, and in-store-advertising took predominance in the overall value chain, the value contribution by digital marketplace/e-commerce platforms has increased substantially during the pandemic;
- For businesses traditionally using centralised sourcing for their manufacturing/trading activities, COVID-19 posed an enhanced risk of supply-chain disruption. In some industries, this resulted in decentralised sourcing mechanisms using alternate sourcing locations/suppliers;
- For businesses engaged in the provision of services, there was a tectonic shift in operations with a substantial part of the workforce moving to remote work (work from home) arrangements. Many taxpayers envisage remote and hybrid working solutions to be the new normal of the future model of work; and
- Businesses that were faced with a cash-flow crisis, had to review their internal and external financing resources to fund operations during the pandemic, including modifying the terms and conditions of both third-party, as well as inter-company debt financing and guarantees.
The above and similar changes in supply chains and the corresponding shift in value contribution are expected to impact the TP policies of multinational corporations (MNCs), both in the short and the long term. Such changes should be appropriately reflected in the inter-company pricing models of MNCs following BEPS Actions 8–10 that require taxpayers to “align the return with value creation”.
COVID-19-related TP issues that may lead to controversies and mitigation strategies
While COVID-19 has been an unprecedented and extraordinary event, the OECD COVID-19 Guidance (paragraphs 7 and 8) defines it as a ‘hazard risk’ (which led to unusual outcomes and economically significant risks) and not as a ‘force majeure’ event.
As a result, in principle, inter-company pre-pandemic TP models and agreements continue to be valid and should not be renegotiated merely on account of COVID-19. If MNCs wish to change their inter-company policies and agreements, evidence towards whether independent parties would do the same is needed.
Accordingly, it would be important for MNCs to analyse specific fact patterns and evaluate whether they could lead to tax controversy risks and if yes, how to account for them. The following could be helpful.
Review pre and post COVID-19 relationships from a contract perspective
It would be important to identify any changes in actual conduct/relationship between group entities pre- and post-pandemic, and the extent to which, there arises a need to amend/modify existing agreements/contracts and remuneration to depict evolved commercial realities. In case of tax controversy, commercially aligned agreements/contracts and TP policies would help in forming an essential base for any arm’s-length evaluation. In such cases, changes to business arrangements may attract possible business restructuring-related exposures, which would need to be addressed by taxpayers.
Allocation of non-recurring and extraordinary costs
Businesses would need to track and monitor non-recurring and extraordinary costs arising during COVID-19. Early and accurate identification/delineation of such costs would be key towards understanding their appropriate allocation as well as operating/non-operating treatment, while undertaking any economic adjustments (OECD COVID-19 Guidance, paragraph 49).
Once accurately delineated, in principle, as indicated by the OECD COVID-19 Guidance, extraordinary costs caused by the pandemic should be allocated to the group entity that bears the underlying materialised risks.
When reviewing 2020 pricing and preparing 2020 TP documentation, MNCs should review their functional profile pre- and post-pandemic, review which risks have materialised due to the pandemic and allocate the COVID-19 extraordinary costs based on proper delineation of the transaction and assumption of corresponding risks.
Allocation of losses to limited risk entities
TP controversy may also arise on account of losses incurred by limited risk entities. While the OECD COVID-19 Guidance acknowledges that limited risk entities could record short-term losses (paragraphs 38–41 of the OECD COVID-19 Guidance read with paragraph 3.64 of the OECD TP Guidance), many countries in the pre-COVID-19 era did not allow such entities to bear even short-term losses, except for losses incurred during start-up periods.
With the above explicit guidance from the OECD, the appropriateness of COVID-19 short-term losses in routine entities should be allowed, provided the basis of the allocation is properly documented and supported by robust comparability analysis. Nevertheless, a lot will depend on the extent to which individual countries follow the OECD COVID-19 Guidance. In case of different local treatment, allocation of losses, similar to allocation on COVID-19 extraordinary costs, may become a new major trigger of cross-border transfer pricing disputes.
Migration of risks following remote work practices
With enhanced remote working levels, it would also be important for enterprises to closely monitor whether as a result of people traveling/working from remote locations, the risks arising from decision-making functions, undertaken by remote working directors and employees, are also migrating. Possible reallocation of risk might impact the underlying TP policies.
With increased cost of capital, loss or reduction in the value of investments and pressure on cash flows during COVID-19, businesses have had to prioritise and re-evaluate capital funding and allocation. It would be important for MNCs to distinguish between pure financing vis-à-vis active decisions managing capital risk and determining which party has undertaken it.
Product obsolescence risk
With MNCs focussing available resources on sustenance of business operations, discretionary spending such as research and development or product enhancement might have taken low priority. While this may have helped in rechannelling much-needed resources to other important functions of the group during the pandemic, its long-term impact on the business and the allocation of such impact amongst the group entities would need to be closely evaluated.
The pandemic has resulted in an unprecedented level of assistance provided by the governments in various forms to enterprises to secure employment and continuance of operations. In principle, the benefits from such assistance should be allocated to this group entity, which undertakes the risk that could have materialised during COVID-19 or has materialised to a lesser extent due to the receipt of COVID-19 assistance funds.
Nevertheless, due to the varied nature of such assistance in individual countries, the OECD COVID-19 Guidance does not provide conclusive answers to the TP treatment of such assistance. This could result in different country-by-country treatment and give rise to another wave of TP disputes.
While the above developments are essential from a COVID-19 perspective, there are also certain other events including digitisation of businesses and changes in the regulatory landscape, which have had their own impact on businesses. It would, therefore, be important for MNCs to holistically review their overall tax governance structure and the underlying TP policy, considering upcoming changes in the international tax landscape due to pillar one and pillar two.
Continued viability of the arm’s-length standard
While the arm’s length standard in the international tax arena has existed for several years, it has evolved over time. While COVID-19 is likely to raise various TP challenges, the arm’s length standard, armed with ‘substance over form’, ‘proper delineation of transaction’, ‘comparability analysis’ and other tools, has enough reach to address COVID-19-related challenges and continue providing economically viable results.
Still, given the unprecedented nature of the pandemic, certain principles established by the OECD guidelines play a critical role in evaluation of the arm’s-length nature of transactions affected by COVID-19.
In particular, as COVID-19 is defined as a hazard risk, this could result in the materialisation of other risks (marketplace, credit, inventory, etc.) and the (pre-COVID-19) allocation of risks between entities in deciding which one bears the negative (and positive in some industries) results of the pandemic. What matters is not the mere labelling of the activities or type of entity (e.g. limited risk) but the actual conduct of the transacting parties.
In addition to the above, the OECD COVID-19 Guidance recommends additional contemporaneous information that may support determination of arm’s-length.
Such analysis would help in estimating the COVID-19 impact in arm’s length determination by using ‘but-for-COVID-19’ analysis, economic adjustments, third-party behaviour evidence, and other contemporaneous data.
To account for the COVID-19 impact on profitability, companies can consider various economic/statistical/econometric tools to help estimate the impact on inter-company transactions.
The techniques applied may vary depending on the case and availability of data and may include, for example, isolation of COVID-19’s impact on tested party data, analysis of correlation between changes in revenues and profitability of comparables, analysis of fixed cost levels, and other approaches.
Alternative analysis using econometric tools such as regression and variance analysis may also be undertaken to establish and quantify the impact of declining or varying macro-economic factors on comparable companies. Relying on such predictive models could help bridge the issues arising from the ‘time lag’ on the availability of relevant comparable data during the COVID-19 period.
During the pandemic, tax audit activity generally diminished. For example, in Japan, the number of field audits in 2020 dropped by approximately 23%, year-on-year, as an effect of COVID-19 (National Tax Agency publication on tax audits in FY2020), although in many countries remote audits continued. This has pushed governments to go for digital submissions and virtual hearings, with countries like India already implementing the entire audit cycle under a digital format, from initial notice to finalisation.
As a dispute mitigation effort, it is imperative that taxpayers resort to real-time data collation, as well as perform a diagnostic review considering pre-and-post-COVID-19 changes in a functional profile and economically significant risks, as well as identify and document a specific COVID-19 industry impact and changes in the value chain alignment.
Taxpayers can also resort to deployment of process-intelligent technology for monitoring the management of their pricing models. Based on such reviews, in line with their internal tax policy, taxpayers may decide on mitigation avenues such audit-ready documentation, advance pricing agreements (APAs), for example advance rulings.
Notably, the role of APAs in providing advanced certainty during COVID-19 years is specifically covered by the OECD COVID-19 Guidance. Given that the pandemic has led to material changes in economic conditions that may have resulted in breach of critical assumptions of existing and pending APAs, the guidance encourages taxpayers and tax administrations to take constructive and collaborative approaches in finding solutions. Such solutions may include:
- Evaluating aggregated financial results for the whole APA term rather than testing annual results;
- Accepting different financial result levels for COVID-19 impacted years and normal years;
- Agreeing on separate APA terms for COVID-19 and non-COVID-19 years;
- Accepting different critical conditions for COVID-19 and non-COVID-19 years; or
- Aggregating and testing the results of a series of covered transactions.
Accordingly, subject to the adoption of flexible working approaches by tax administrations and collaboration of taxpayers, APAs could play an increased role in COVID-19-related effective dispute prevention.
As evident from the aforesaid discussion, while an intensive scrutiny by tax administrations in the future cannot be denied, high-quality, audit-ready TP documentation, and bilateral and multilateral APAs can help taxpayers manage tax controversy by preventing TP adjustments rather than dispute escalation.
Manisha Gupta is a partner at Deloitte India. She has over 20 years’ experience in TP and international tax and has been a part of Deloitte TP team since June 2009. She is the APAC TP technology leader and India TP technology media and telecom leader. She also leads the global in-house/capability Centres (GIC/GCC) initiative for tax.
Over the years, Manisha has provided TP services to leading Indian and foreign multinationals in technology, media and telecommunication sectors. She has assisted multinationals by planning business models in India and settling audit controversies. She is actively involved in TP planning and documentation projects to determine arm’s-length compensation for tangible property, intangible property and services.
Manisha has been recognised, on numerous occasions, as one of India’s leading tax controversy advisors by ITR, as well as a ‘Women in Tax’ leader and TP advisor.
Iva Georgijew is a partner at Deloitte Poland and she leads Deloitte’s TP team in Poland and Central Europe. In a career lasting more than 25 years, she has been leading controversy cases and APA negotiations, as well as advising clients operating in various industries, including e-commerce, consumer, energy and telecommunications.
Iva has been a non-governmental member of the European Union Joint Transfer Pricing Forum, a body of the European Commission focused on the development of common TP guidelines for the EU member states between 2011 and 2019. She is also regularly recognised in industry rankings as being among the leading TP advisors.
As part of her contribution to the development of TP standards and education Iva is a regular lecturer on TP matters at the Warsaw School of Economics. She co-leads the COVID-19 working group of the Polish TP forum on developing guidance on the impact on COVID-19 on TP.
Bhupendra Kothari is a senior director in the TP practice and is based in Mumbai office. He has more than 16 years of international TP consulting experience. Before joining DHS India, he was a part of Deloitte Tax LLP, US as a TP consultant in the Chicago office.
Bhupendra has assisted clients with complex business model optimisation – tax supply chain projects and large cross-border due diligences and post- merger integration projects. He advises on TP audit defense and tax controversy management for both inbound and outbound companies and has assisted in negotiating APAs and MAP settlements involving complex TP issues including one of the largest MAP resolutions in the country. He has a particular interest in helping large MNCs put together global TP policies and documentation covering inbound and outbound transactions focusing on the overall group’s value chain analysis.
Bhupendra is a law graduate and holds an MBA in finance. He is a regular speaker at seminars and client workshops and is actively involved with various knowledge management initiatives.
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