Recommendations on the impact of COVID-19 on related party transactions

The Organisation for Economic Co-operation and Development (OECD) published on 18 December 2020 a guide to clarify and illustrate in a practical way how the arm’s length principle should be applied in related party transactions affected by the COVID-19 crisis. Based on the content of the guide, taxpayers should analyse the effects of the pandemic on their transfer pricing policies, adjust their economic analysis, review their intra-group contracts and check whether there are any material changes to their previous valuation arrangements.

The document does not modify or entail a revision of the OECD’s own transfer pricing guidelines and therefore leaves unchanged the arm’s length valuation principle, which is understood to be fully applicable to the situations caused by the crisis.

However, it provides practical insight into situations affected by the pandemic and reiterates the need to properly delineate intra-group transactions (in terms of roles, assets and risks assumed by the parties).

This guide, developed and endorsed by the 137 Member States of the OECD/G20 Inclusive Framework on Base Erosion and Profit Shifting (BEPS), aims to provide tax administrations and multinational groups with a set of guidelines that can be used in the assessment and enforcement of transfer pricing rules in the periods affected by the pandemic.

The issues addressed in the paper are grouped around four specific areas: (1) comparability analysis, (2) losses and imputation of specific Covid-19 related costs, (3) effects of government assistance programmes, and (4) impact on prior valuation agreements (VPAs).

Chapter I. Comparability analysis

The pandemic has significantly affected transaction prices and the reliability of data used in comparability analyses, and the OECD recommends using alternative sources of information to address this shortfall in data quality.

In this respect, analyses on changes in sales volumes during the crisis, on one-off cost increases, or on the effects of public policies may be useful, as well as any macroeconomic or sectoral information.

In particular, one option to address the comparability analysis in 2020 is to consider the comparison between actual versus budgeted financial figures.

Another issue to consider is the timing factor. Generally, the financial data for the linked transaction and the selected comparables should relate to the same period, and it is sometimes possible to have such information on a contemporaneous basis.

In other cases, however, it is more difficult to use comparable contemporaneous transactions, especially when the transactional net margin method is used. In these cases, taxpayers and administrations often rely on historical information contained in databases.

Given that, for the 2020 financial year, the information will not be available until – at least – mid-2021, the OECD recommends that taxpayers make reasonable use of data that can contribute to filling the gaps in the available financial information; and suggests that administrations be understanding in assessing taxpayers’ efforts, in order to avoid an excessive proliferation of transfer pricing disputes.

Among the possible solutions suggested by the OECD is the acceptance of the so-called ex post approach, which seeks to corroborate that a controlled transaction that has already taken place complies with the arm’s length principle.

Although some administrations have traditionally rejected this approach, the OECD recommends allowing the use of information known to taxpayers after the 2020 corporate income tax return has been filed, including through the filing of supplementary or corrective returns.

It also recommends considering other measures, such as the possibility of transfer pricing adjustments in 2020 corporate tax returns, or entering into amicable or similar procedures between taxpayers and administrations to facilitate negotiated solutions.

Another proposal in the paper concerns valuation methods. Although not mandatory, the OECD notes that in this context it may be appropriate to combine more than one method to corroborate that related party transactions have been valued on an arm’s length basis.

Regarding the period on which the comparison is based, it is usually useful to take into consideration data and averages from several years in order to homogenise the data compared. However, for the analysis of pandemic-affected years, it may be advisable to separate pre-COVID-19 and post-COVID-19 periods, so as not to distort the results of both periods.

Public measures limiting or restricting the exercise of certain activities should also be taken into account. For example, if a taxpayer has had to shut down its facilities for three months, the sample of comparables should focus on competitors that have been in the same situation, or adjust its own data to exclude from the comparison the magnitudes corresponding to the shutdown period.

Possibly one of the most relevant and expected issues in this paper concerns the updates of the sample of comparables. Under normal conditions and over a period of time (typically three years), administrations usually agree not to perform a full economic analysis, but simply to update the financial data in the sample on an annual basis.

In this regard, the OECD suggests that at this extraordinary juncture it should reconsider whether a mere updating of the financial data in the sample is appropriate, due to the supervening relevance of certain comparability factors that may have been considered insignificant in the initial sample.

Finally, it is also relevant to recall that there is no hard and fast rule to exclude loss-making companies from the sample of potential comparables. If the selected companies meet the comparability criteria deemed appropriate, all the more reason to avoid excluding loss-making companies from the sample in 2020 just because they are loss-making.

Chapter II. Losses and cost sharing caused by COVID-19

Certain situations that have occurred during the pandemic, such as a decrease in demand, the impossibility of obtaining or supplying products or services, or the appearance of exceptional operating expenses, are going to cause losses in many multinational groups that will have to be allocated among the different entities that make them up, and which may be a source of conflict with their respective tax administrations.

In this cost and loss sharing process, the arm’s length principle should be respected, taking into account the risks assumed by the group companies in the linked transactions, in accordance with the Guidelines.

The allocation of exceptional and non-recurring operating expenses caused by the health crisis should be made in the same way as would have been agreed by independent parties, taking into account their nature when carrying out the comparability analysis (without prejudice to the accounting qualification given); and possibly making any adjustments that may be necessary in the comparables.

The document published by the OECD includes some examples and reflections on the cost sharing caused by COVID-19 (expenditure on personal protective equipment, reconfiguration of workspaces to allow for physical distancing, investments in information technology and the implementation of teleworking).

These extraordinary expenses must also be taken into account when carrying out comparability analyses, as they can have a significant influence.

As a general rule, these expenses should be excluded from the net profit indicator of the related party under review, except where they are strictly related to the transaction under review.

Similarly, such an exclusion should also be made in the comparables used to determine the margin, although the OECD recognises the difficulties that may be encountered in making such an exclusion in comparables due to reporting limitations.

The same applies to a cost-based analysis: in order to determine the base, it should be analysed whether extra costs should be taken into account and, if so, whether a profit margin should be applied to them.

And, in any case, comparability adjustments may be necessary to eliminate the impact of different accounting policies adopted by the related party and the independent comparables.

Another element that may affect the allocation of costs and losses is the possibility of applying force majeure clauses, or even of breaching the terms of intra-group contracts as a result of the exceptional circumstances caused by the pandemic.

Along these lines, the OECD notes that, as is the case between independent parties, group entities may consider terminating or renegotiating contracts entered into before the crisis.

In analysing this issue, administrations should review related party arrangements and conduct, taking into account the recommendations in Chapter I(D) of the Guidelines, as well as the characteristics of the transaction and the behaviour exhibited by independent parties in comparable situations.

For their part, taxpayers should substantiate and solidly document contractual modifications to ensure that they comply with the arm’s length principle.

On the other hand, one of the most relevant and controversial aspects in relation to the impact of the pandemic on the transfer pricing policies of multinational groups is the possibility that entities functionally characterised as “limited risk” may incur losses.

In the absence of a specific definition of a limited risk entity in the Guidelines, it is not possible to establish a general rule. Therefore, in order to determine whether or not limited risk entities can bear the losses caused by the pandemic, it will be necessary to carry out a detailed risk analysis on a case-by-case basis, as foreseen in the Guidelines themselves.

In examining the risks taken by group companies, the OECD notes that administrations should analyse the economic rationale for changes that may have occurred as a result of the pandemic, for which both Chapter IX of the Guidelines and the examples and practical reflections included in the guide will be particularly instructive.

Chapter III. Government aid

The OECD defines “government assistance” as a programme of a monetary or non-monetary nature whereby a government, or any other public authority, provides a financial benefit to taxpayers.

The characteristics of these programmes may affect transfer prices, either because they are applied to a member of a group of companies or because they are made available to independent parties in the market where a group operates, which may affect the behaviour of companies involved in potentially comparable transactions.

Given the practical difficulty in obtaining information on the nature of government assistance, it is necessary to analyse its specific characteristics in order to determine in which cases its receipt may, by one means or another, have an economically relevant impact, directly (i.e. wage subsidies) or indirectly (provision of infrastructure by local government).

In case the aid is found to be economically relevant, it should be taken into account in defining and delineating the linked transaction and conducting the comparability analysis and this information should be included in the taxpayer’s documentation.

The OECD suggests some issues to consider when analysing the potential impact of government assistance on a linked transaction, such as the availability, purpose, duration and other conditions imposed by the government in granting the assistance (as these could limit or even prevent the recipient of the assistance from changing the remuneration of its operations).

Consideration should also be given to the allocation of economically significant risks and the level of competition and demand within the relevant markets, to see whether the aided entity or group changes the way it prices to unrelated customers, either to keep public assistance within the group or to pass it on to third parties.

The effect of government policies on transfer pricing is addressed by the Transfer Pricing Guidelines (Chapter I, Section D.4), noting that, as a general rule, government interventions should be treated as market conditions in the country of operation.

As regards the impact of government assistance on the risks of a transaction, the OECD indicates that, while the receipt of government assistance may reduce the negative impact of such assistance, the risk allocation as such in a tied transaction should not generally be altered by the receipt of government assistance.

Another issue addressed concerns what should be the most reliable approach to identifying comparables in government aid contexts.

In this respect, the OECD recommends analysing unrelated transactions in the same or a comparable geographic market, as well as reviewing search strategies or conducting corroborative analysis when state aid is identified in any of the transactions analysed.

Furthermore, when applying unilateral methods of analysis, mechanical approaches (such as recognising aid as windfall revenue or offsetting savings generated to reduce the cost base of the operation in question) should be avoided, as these approaches could lead to prices that are not in line with the arm’s length principle.

Moreover, it is necessary to identify the accounting treatment given to government aid received, especially when the entity under analysis applies different accounting methods than the identified comparables, as this differing treatment may lead to different levels of profitability and comparability adjustments may be necessary.

Finally, it should be borne in mind that the existence of different accounting treatments may indicate that different types of public aid are indeed involved, in which case it will be more difficult to make a comparability adjustment.

Chapter IV. Preliminary Valuation Agreements

The health crisis has led to substantial changes in the economic conditions that were taken into account in the VPAs that are still in force. It is therefore necessary to analyse whether and to what extent these unforeseen changes affect VPAs. In addition, COVID-19 has also had an impact on VPAs that were being negotiated when the pandemic broke out.

With regard to VPAs in force in 2020, the OECD states as a general principle that they should continue to have effect, except where it is understood that the current circumstances represent a breach of the critical assumptions considered at the time of their subscription. This will depend on the terms of the VPA itself or the legislation of the competent jurisdiction, which should be analysed on a case-by-case basis and considering the impact of the pandemic on the sector and the region.

Where a breach of the critical assumptions is deemed to have occurred, the consequences should also be analysed in the light of the terms of the VPA itself, taking into account all the administrations involved and the applicable law and, in any case, if the above is not sufficient, Chapter IV of the Guidelines suggests three possibilities:

• The revision of the VPA: This would allow, through an agreement between the administration and the taxpayer, to maintain the validity of the VPA, but revising specific parts of its content without modifying the rest of its terms.
• Its cancellation, which would imply that the VPA would cease to be in force after a certain point in time.
• Its revocation, the main effect of which would be that the VPA would be deemed never to have been entered into.

The OECD advises against unilateral action by taxpayers and recommends that taxpayers notify taxpayers of any non-compliance with critical assumptions as soon as they become aware of them and contact the administration as soon as possible to raise their concerns in a transparent manner.

Along with the notification, taxpayers must provide documentation to support the non-compliance, including sectoral data, budgeted and actual financial data, changes in contracts during the pandemic, or analytical profit and loss accounts to show the effects of the crisis.

On the other hand, the OECD recognises that, given the current uncertainty, taxpayers may be less inclined to apply for or continue to negotiate a VPA.

For this reason, given the benefits associated with VPAs, the OECD recommends that taxpayers and administrations adopt a flexible and collaborative approach, exploring innovative ways to reach agreements.

Examples of this may include the conclusion of short-term VPAs for pandemic-affected periods followed by a second VPA for the post-COVID-19 period; or longer-term VPAs with commitments to retroactively modify their terms to adequately reflect the effects of the pandemic as they become known.

There is also the possibility of assessing the implementation of the VPA in terms of its effects over the period covered by the agreement, rather than on a year-by-year basis, which would allow mitigating the effects of COVID-19 in the years affected by the pandemic.

Conclusion

It is to be hoped that the assistance provided by this guide, long awaited by all stakeholders, and in particular by taxpayers who already have to make decisions for the 2020 deadline, will be widely applicable (also by tax administrations) and will contribute to international coordination and reduce litigation in the transfer pricing field.

In particular, it is advisable for taxpayers who:

• Analyse, quantify and adequately document the effects of the pandemic on their transfer pricing policies, in particular as regards the allocation of losses and costs between group entities.
• Adjust their comparative economic analyses in the light of current circumstances.
• Review your intra-group contracts and adjust your actions accordingly.
• Check if there are any material changes to the critical assumptions of your VCTs and contact your tax administration.