On 18th December 2020, OECD issued a guidance on transfer pricing implications during COVID 19. The guidance is the consensus view of 137 members of the Inclusive Framework of BEPS regarding application of OECD Transfer pricing Guidelines (TPG). The guidance is meant for the taxpayers as well as tax administrations, that would help both of them in their process of price fixation and transfer pricing assessments respective for the period of pandemic.
For theoretical and administrative ease, the guidance is divided in to four parts i.e. (1) comparability analysis (2) Losses and the allocation of COVID 19 specific costs (3) Government assistance programmes and (4) Advance Pricing Agreements. From a reader’s perspective, for ease, one may need to look at this guidance from an overall consideration (rather than 4 isolated parts), as there could be multiple business dynamics involved while deciding upon a solution.
The below summary provides you with practical insights on how to adopt the OECD transfer pricing guidance in your day to day cross border business transactions in COVID 19 times.
- Build documentation by using various sources: Business to maintain any form of publicly available data showcasing business, industry performance which could aid in determination of ALP and hence could be used to justify the transfer pricing policy for year 2020. Important to document effect of pandemic by using data on changes in sales volume during COVID 19, changes in capacity utilisation, government assistance and intervention, interim financial statements, macroeconomic information, forecasts incremental or exceptional costs by the MNE Group etc. Documentation is going to be the key around proving the comparable scenarios.
- Use of budgets: Comparison of budgeted financials to actuals could be a very efficient way of showcasing the specific effects of COVID 19 on the revenues, costs and margins.
- Timing of comparability : Use of comparable information during the same period of the controlled transaction is reliable in bringing out the economic factors. Internal comparables in such a case could act as a good potential comparables. Availability of real time information by using databases, especially TNMM, seems a challenge as the information on comparability would be available only in mid 2021. One may like to look at undertaking economic adjustments on the comparables in such a case.
- How to practically access information in difficult times: There is a need to use pragmatic approaches to information availability and set a transfer price. This approach could be used by the taxpayer and should be kept in mind by the tax administration while auditing the year of trouble. If the tax administration showcases aggressiveness in their approach it would lead to increased litigation thereby clogging the hours of court time. A taxpayer should use his commercial judgement and document the reasons via best available market evidences and comparables.
- Price fixation vs price testing approach: There are two main approaches to transfer prices. One is the setting approach, where the prices are fixed at the start of the year, while the other approach (outcome approach) tests the outcome after the year end. By allowing the use of outcome approach, the restriction on availability of comparable information could be done away with, as the approach uses past data in future.
- Flexibility in return revision: Where ever possible the guidance urges the tax authorities to use a tax return revision approach or compensating adjustment approach to provide a fair treatment to the taxpayers.
- Use of more than one TP method: The taxpayers could use more than one method to justify the arm’s length nature of transaction. Such an approach could strengthen documentation and also the reasoning.
- Use past experience: As a taxpayer, you may like to use data from similar economic down turn to justify your prices. For example, one may like to see if the economic circumstances are comparable to 2007 downturn and accordingly take decisions and documentation.
- Period of data to be used: The tax law of a particular jurisdiction may provide for use of only a single year data in such exceptional cases, as past year data may not represent the correct economic trends in business.
- Price adjustment approach: If the tax law and authorities permit, the taxpayer may like to adjust the prices in future for the past losses or mis-prcing that the taxpayer had to suffer due to ill effects of COVID 19. However, aspects on GST/ VAT needs a check with such an approach.
- Review of comparables: A mere roll-forward of comparables in the year of COVID could mean invitation to a tax adjustment trouble. It would be prudent to review or revise the set of comparables that represents the actual functional and economic profile of the tested party.
- Use of loss making comparables: Considering the economic circumstances, one should take care not to reject loss making companies ab-initio. Reason out, check if the company is a consistent loss making or losses are due to the pandemic.
- How to allocate COVID related costs in value chain: Due to circumstances of lockdown, corporates and multinationals have incurred heavy costs of discontinuance, business adaption or costs that are exceptional in nature. The onus of the cost should be borne by the entity that undertook the risk of such an action. Accurate delineation of transaction is important and a careful study around allocation of risks to be undertaken to allocate the costs to the risk bearing entity in an MNE group.
- Can limited risk entities incur losses: A short answer to the question is yes, as the entities are limited risk and not no risk. A long answer would depend on what type of risks are undertaken by such limited risk entities and whether such risks have materialised for the entity to incur loss against the risk. For example if a limited risk distributor (LRD) undertake market risk , then in case of absence of market demand, the risk boils down to the LRD. However, if such risk was on the other AE, then making a loss due to market risk by the LRD may need to be looked through the eyes of business re-structuring. This is a very important take away.
- Whether modification of arrangements and agreements is the right approach: The approach could be a right approach, if independent parties in comparable circumstances revises or modifies the arrangement. If an independent purchaser to a distributor changes the terms of payment from 30 to 90, then the related party transaction/ controlled transaction of purchase of goods by the distributor could also have a change in terms from 30 to 90 days. Appropriate documentation to be maintained around the same.
- Treatment of exceptional cost: Exceptional costs could be allocated in the value chain based on the risk profiling of the members in the value chain. Some value chains would be able to pass on such costs to the customers. Appropriate details to be maintained by the taxpayer. In the comparability analysis appropriate adjustments could be undertaken for the tested party.
- Government assistance: A receipt of assistance from government is an economically relevant characteristic and the same should be evaluated based on the factual background of the transaction. If such an assistance has been an economically significant in the case of taxpayer, then in the comparability analysis, such an assistance should also be considered as a relevant factor. The type of government assistance i.e. whether it creates market advantage or increases revenue or decreases cost etc shall be evaluated in the light of comparability analysis including how the assistance is allocated/ shared amidst the value chain.
- APAs are still functional in crises: Yes, APA conditions as signed by the agreement still hold true in the period of pandemic unless revised. Any changes to the factual position that are not envisaged in the critical assumptions of an APA may lead to an APA being void. A taxpayer should avoid taking a unilateral call and should approach tax authorities or APA authorities for further guidance. The most appropriate approach could be revision if there is a material change to the critical assumptions in the APA. The taxpayer should use best possible publicly available documentary proof to justify his case before the APA for revision. Such documents could involve the following:
- Details of financial segments and actual performance
- Budget vs. actual performance
- Any revised or modification in business agreements
- Detailing out anticipated effects of the current economic conditions
- Information on third party behaviour
While the OECD has provided a broad level guidance, one important takeaway from the detailed version of the guidance is the additional requirement of maintenance of documentary proofs and evidences in relation to economic effects of COVID on the industry and the taxpayer. The practical application of the guidance goes a long way where the transfer pricing in COVID needs to be looked with separate lenses, which are pragmatic, less riskier, true to the business world and most importantly easy to defend. Also, a shift in the thought from a tax administration point of view is essential in tough times. Together with the same vision, the taxpayer and the tax authorities have potential to build a strong foundation to the economy and recover. As it is said, ‘when going get tough, the tough gets going’. Let the collaborative approach between the taxpayer and the tax authority begin a new chapter in the history of taxes.