Tax Alert – December 21, 2020

                         OECD Guidance on the transfer pricing implications of the COVID-19 pandemic

 Introduction and summary.

On December 18, 2020 the OECD published the awaited “Guidance on the transfer pricing implications of the Covid-19 pandemic” (hereinafter, the “Guidance”) detailing the main tools for taxpayers and tax administrations in order to deal with the transfer pricing rules for periods impacted by the COVID-19 pandemic.

In particular, four priority issues have been identified and are covered in the Guidance:

1. comparability analysis;
2. losses and the allocation of COVID-19 specific costs;
3. government assistance programmes; and
4. advance pricing agreements (“APAs”).

The importance of the Guidance is also due to the fact that this represents the consensus view of the 137 members of the Inclusive Framework on BPES, including Italy.

* * *

Our Firm is at your disposal for any assistance you may need to evaluate the impacts of the Guidance on your 2020 transfer pricing policy and/or either your existing APA, or APA for which an agreement has not yet been reached.

* * *

1. Comparability analysis.

With reference to the information that may be used to support the performance of a comparability analysis applicable for FY 2020, the Guidance emphasizes that – due to the absence of official data on “contemporaneous uncontrolled transactions” – “any form of publicly available information regarding the effect of COVID-19 on the business, industry and controlled transaction may be relevant in ascertaining the arm’s length nature of an enterprise’s transfer pricing policy implemented for FY 2020”.

To this end, the following main sources of information have been identified:

• an analysis of how sales volumes have changed during COVID-19, including whether the change is due to the use of other sales channels, and specifically compared to sales generated in pre-COVID years;
• specific information relative to the incremental or exceptional costs borne by parties to the controlled transaction (either with associated or unrelated parties) or by the MNE group as a whole;
• macroeconomic information like country specific GDP data or industry indicators from central banks, government agencies, industry or trade associations to the extent they are useful in understanding the context of the controlled transaction;
• an analysis of the effects on profitability or on third party behavior observed in previous recessionary periods or using any data available in the current year, even if partial.

Furthermore, the Guidance states that also the comparison between budget and forecast data can be utilized as an approach in order to “approximate the specific effects of COVID-19 on revenues, costs and margins”.

In this context, data from independent comparable transactions or companies from other time periods, such as average returns in preceding years, may not provide a sufficiently reliable benchmark for the current period without considering the specific impact of the pandemic on the controlled transactions under review.

For this reason, the Guidance provides for some practical approaches that may be used to address the information deficiency issue (which however may face concrete difficulties in the Italian jurisdiction given the general scarce degree of flexibility provided by the domestic legislation):

• allow for the use of cautious judgement encouraging “tax administration to keep these complexities in mind when preforming risk assessments [and] evaluating the transfer pricing position on audits”;
• allow for an arm’s length outcome testing approach. In brief, in the view of the OECD (i) the taxpayers should wait for the publication of the 2020 official data in order to carry out the transfer pricing analysis and consequent compensating adjustments; and (ii) the tax authorities should grant more flexibility to the taxpayers in order to report those data. Although unfortunately – at least in Italy – this approach in the absence of specific provisions, may give rise to the possible application of late-payment penalties and/or forms of double taxation, since taxpayers are not allowed e.g. to make the so-called ‘downward adjustments’;
• use of more than one transfer pricing method. Which appears – in our view – to be the most viable option, albeit clearly increasing compliance costs for taxpayers.

The Guidance, instead, rejects the possibility to utilize 2008/2009 global financial crisis data to approximate the effects of the 2020 COVID-19 Pandemic mainly due to the differences between the two crises.

Another important topic that is covered by the Guidance concerns the so-called year-end adjustments.

In particular, the OECD states that “the adjustments of prices relevant of FY2020 through adjusted invoicing or intercompany payments effectuated in a later period (Likely FY2021), when more accurate information to establish the arm’s length transfer pricing becomes available” should be considered as the best approach to follow since this “would give flexibility to taxpayers and tax administrations while also ensuring ultimate compliance with the arm’s length principle”.

In our view, this approach should be carefully pondered given – again – the possible occurrence of forms of double taxation which could be problematic to address under the Italian domestic rules.

Finally, the Guidance confirms that when performing a comparability analysis for FY 2020 “it may be appropriate” to include loss-making companies provided that those are “reliable”. Just a minor note on this matter: we would have expected a stronger position which could have finally addressed the long-lasting disputes about the utilization of loss-making comparable.

2. Losses and the allocation of COVID-19 specific costs.

As mentioned in the Guidance, during the COVID-19 pandemic, many MNE groups have incurred losses due to a decrease in demand, inability to obtain or supply products or services or as a result of exceptional, non-recurring operating costs.

For the Guidance purposes, the emergence of the aforementioned losses is relevant, since their allocation between associated entities can give rise to several disputes and litigations.

As regards losses, the Guidance clearly outlines that the allocation of risks between the parties to an arrangement affects how profits and losses resulting from the transaction are allocated at arm’s length through the pricing of the transaction.

The OECD takes the view that limited risk distributors – “LRD” could in principle register losses provided that they suffer some risks, such as marketplace risk and credit risk. However, where this is not the case, no losses would in principle be attributable to the LRD.

From a different perspective, the Guidance also provides for the possibility that, in response to the COVID-19 pandemic, independent parties could seek to renegotiate certain terms in their existing agreements and, associated parties may consider revising their intercompany agreements and/or their conduct in their commercial relationships.

However, despite those possibilities that should be taken into account by the parties, the Guidance underlines that in the absence of clear evidence that independent parties in comparable circumstances would have revised their existing agreements or commercial relations, the modification of existing intercompany arrangements and/or the commercial relationships of associated parties would not be consistent with the arm’s length principle.

Secondly, the Guidance considers it necessary to provide a method by which non-recurring operating costs arising as a result of COVID-19 should be allocated between associated parties. It is also considered that those costs should be excluded from the net profit indicator.

Finally, the Guidance emphasizes that the COVID-19 pandemic has created conditions in which associated parties may consider, if they have the option, to apply force majeure clauses, to revoke or otherwise revise their intercompany agreements impacting the allocation of losses and COVID-19 specific costs between associated parties. Clearly, to the extent that third parties would have done so under the same circumstances.

3. Government assistance programmes.

Government assistance is a programme aimed at providing a direct or indirect economic benefit to eligible taxpayers. Such benefits could consist in measures like grants, subsidies, forgivable loans, tax deductions or investment allowances.

Government assistance programmes may present  transfer pricing implications if the assistance is rendered to a member of an MNE group directly or made available to independent parties within the market where an MNE group operates (thus affecting the behavior of enterprises engaged in potentially comparable transactions).

Within this context the Guidance, first of all, qualifies which economic assistance can be considered as more economically relevant (e.g. wage subsidy, a government debt guarantee or a short-term liquidity support) for the analysis at stake, so that the non-relevant assistance is to be excluded, and, secondly, details the economic factors that need to be considered in order to verify whether the programmes qualify as local market features (e.g. they provide a market advantage to the recipient; increase in revenues and decrease in costs are attributable to them).

Also here, according to the Guidance, a case by case analysis must be conducted in order to ascertain the implications of “the receipt of government assistance on the pricing of controlled transaction, if any”. To this end, the main aspects that need to be considered are “the availability purpose, duration and other conditions imposed by the government in granting the assistance; the allocation of the economically significant risks; and the level of competition and demand within the relevant markets”.

Finally, while confirming that the receipt of government assistance does not change the allocation of risk in a controlled transaction (i.e. the distributor does not lose the credit risk when subsidised by its government), the Guidance clarifies that it does affect the comparability analysis. In this latter case, the solutions proposed in order to fix the issue are (i) making comparability adjustments; (ii) the utilization of comparables belonging to the same geographical area of the tested party; or (ii) the utilization of a corroborating transfer pricing methodology.

4. Advance pricing agreements (“APAs”):

The Guidance, obviously, contains a focus on one of the most discussed topics related to COVID-19 and its effects on transfer pricing: the advance pricing agreement (“APA”).

In fact, it is unquestionable that COVID-19 has led to material changes in economic conditions that were not anticipated when many APAs, covering FY 2020 and potentially future financial years affected by COVID-19, were agreed.

In this context, assuming that an existing APA should still be applicable provided that the event of the breach of critical assumptions has not occurred yet, the Guidance clarifies that the occurrence of the breach should be determined also considering “the extent of the divergence between the agreed parameters in the APA and the new parameters under the COVID-19 economic circumstances”

In this regard, the Guidance highlights that some taxpayers may face challenges by applying existing APAs under the economic conditions resulting from the COVID-19 pandemic and encourages them to adopt a collaborative and transparent approach by raising these issues with the relevant tax administrations in a timely manner and through the submission of relevant supporting documentation.

The above-mentioned discussion can result in:

(i) a revision of the agreement, when there has been a material change in conditions noted in a critical assumption in the APA,

(ii) a cancellation of the agreement, when it is established that: in FY2020 (ii.a) there is a material breach in an APA’s critical assumptions as a result of a change in economic circumstances; or, (ii.b) the taxpayer failed to materially comply with any term or condition of the APA; or

(iii) revocation of the existing APA, when (iii.a) there is a misrepresentation, mistake or omission; or (iii.b) the taxpayer fails to materially comply with a fundamental term or condition of the APA.

Moreover, the Guidance also deals with situations where the agreement has not been reached yet.  In this context, the Guidance makes several proposals on how to handle the matter and, among them, it is worth mentioning the one that envisions the possibility that two APAs are agreed: (i) a shorter one dedicated to the period affected by the pandemic and (ii) a longer one dedicated to the post-pandemic period.