COVID-19 - OECD Transfer Pricing guidance

Following our participation in this year’s virtual TPMinds International Transfer Pricing conference where the impact of COVID-19 on transfer pricing for business was discussed, Monique van Herksen and Clive Jie-A-Joen combined their thoughts together with observations and comments received into an “open” letter to the OECD, recommending areas in which OECD Transfer Pricing guidance as regards the COVID-19 impact would be valuable for business. The message for the OECD’s Centre for Tax Policy and Administration is as follows/included here:

[Dear Michael]

During our panel on COVID-19 and its impact on transfer pricing at the virtual TP Minds conference on September 1, 2020, we discussed a series of aspects relevant for corporates and their tax and transfer pricing directors. We also committed to try to assist you and the OECD with the project on transfer pricing guidance in light of the impact of COVID-19.

Following is an overview of items that came up during our panel discussion but also our thinking since then based on further discussions with corporate transfer pricing and tax practitioners, as to how the OECD may be able to assist corporates, tax directors (and tax auditors) in this highly uncertain and challenging time.

Shared corporate COVID-19 experiences

Almost every company, with few exceptions, had the same experiences more or less in the same sequence:

(1) Lockdowns and employees all having to work virtually from home;

(2) As consumption crashed to a halt, cash flow management needs led everyone to look for extended credit lines, trying to manage and reduce cost and reconsidering payment terms where possible;

(3) Since performance obligations were still outstanding there was nearly immediate pressure on corporate supply chains and logistics due to lack of people or lack of resources and inputs needed to make the supply chain continue and logistics function. This for many corporates resulted in temporary relocation of functions to other entities that (still) could perform, as such upsetting the original transfer pricing structure and incurring extra costs;

(4) As governments rose to the occasion and started to make available stimulus measures to avoid massive redundancies, companies had to assess what stimulus measures were available, whether they qualified for those measures and how to apply for the stimulus measures;

As the COVID 19 disruption was initially expected to be one with a relatively short-term effect, there appeared to be no immediate concern for restructured supply chains to become de facto business restructurings, but as the pandemic is proving to be more stubborn and there is speak of “second waves,” the next set of concerns include amongst others, the following aspects;

(5) Permanent Establishment exposure due to decision-makers or sales staff being locked down or situated in other countries longer than expected as a result of COVID-19;

(6) Perceived or actual change in the company’s transfer pricing structure due to extended “outsourcing” / re-location of functions and carrying of unexpected risks/costs and losses by entities, which could at some point be considered business restructurings;

(7) Cash tax concerns with calendar year-end coming upon us fast, as there are likely to be losses due to significantly reduced income and unexpected cost increases. This in particular arises within principal structures and limited risk entities where the latter, per their transfer pricing structure, are expected to report a stable profit margin whereas all risks and losses are to be allocated at the level of the principal. To support allocation of the actual losses incurred in 2020 to other entities, benchmark challenges exist in case of a transfer pricing structure with limited risk entities. Traditional comparable data usually lag behind quite a few years and current comparables will relate to years that did not include the COVID-19 market disruption, as a result of which they are likely to reflect higher margins than those that can be made in the current market.

Where guidance is needed most and why it matters

I. Benchmarking challenges

While it is difficult to decide what transfer pricing issue is in more need of guidance than any other, the issue of benchmarking has come up so persistently that it probably should be listed first. The question is: can you adjust benchmarked margins and anticipate 2020 data that are expected to show much lower margins or even losses? OECD guidance here could be as modest as recognizing that within a range of arm’s length comparables, a taxpayer can actually switch to the lower end of the range - as compared to the previously used median- ; or make the case for a switch to using one-year data where previously three or four-year comparable data were used. It could also be as bold as looking at the (average) observed drop in revenue that a sector experienced and applying that to your company’s financials and benchmarked margins for 2020. The impact of adjusting previous year comparables should be considered against what to do with subsequent year comparables and future margins, as benchmark data reflecting the years impacted by COVID-19 will only become available in about 2-3 years time. Alternatively, it may also be considered to recommend a multiple-year analysis so that an incidental COVID-19 annual result that is outside the (normal) range may not require adjustments. And since adjusting for 2020 at this point in time (mid-September) is hardly realistic, can transfer pricing for 2020 and 2021 be looked at on a consolidated basis perhaps?

Without guidance (but probably also with guidance) benchmarking is likely to become a major transfer pricing audit issue in the near future, as companies are generally expected to apply some consistency in their transfer pricing methodology.

While companies may be able to take some action currently to position themselves better as regards the allocation of COVID-19 related costs and losses by adjusting intercompany contracts based on Force Majeure or “changed circumstances” clauses, this should probably be done sooner than later and there may be (too) little time to do so for calendar year 2020.

If and to the extent companies do consider adjusting or updating intercompany contracts, it would behoove them to at least look for the following aspects: (a) the presence of a Force Majeure or changed circumstances clause and (b) the choice of law clause and -where applicable- whether they have chosen to reference or include soft law such as the Unidroit Principles of International Contracts. If and to the extent the Force Majeure clause definition includes a pandemic, chances are that changes to pre-agreed performance and pricing is contractually possible.

A polling question during the panel discussion asked whether the audience expected that a judicial body reviewing a dispute between a company and the revenue authorities on income allocation based on the pandemic would be sympathetic to the company’s position. More than 80% of attendees were of the opinion that the judiciary would probably be considerate of the extraordinary circumstances. Reality may be less flexible, however. While we would like to be able to renegotiate contracts in those situations, that may not be possible unless they are drafted carefully. In few countries will there be a general remedy to renegotiate a contract based on hardship, so associated enterprises are likely be held to the same standard of contracting rules. Difficulty to perform is not the same as impossibility to perform. Foreseeability is another issue. Two years from now, witness previous experiences with SARS, Ebola and the Avian Flu, some may say the COVID-19 impact was (somewhat) forseeable.

If and to the extent intercompany agreements are adjusted it is recommended that they reference that both parties to the agreement will perform in good faith and will do everything they can to avoid frustration of performance. Similarly, they could outright acknowledge the global pandemic and that the future development of the pandemic and future consequences of government-imposed COVID-19 restrictions are not known and cannot be taken into account by the parties to the contract. As such these consequences cannot be reasonably foreseen or are not reasonably foreseeable. The parties can thus agree up-front that the risk of future COVID-19 restrictions are not attributable to the parties and beyond their respective control and that they will inform each other on the COVID-19 developments and agree that COVID-19 consequences will be considered as hardship by both parties. This change would not neccesarily be strange, if you consider that commercial contract lawyers are advising just that to their clients and we are already seeing travel and health insurance policies being adjusted for COVID-19 exposure.

Unrelated parties are certainly granting breaks and exceptions to contract partners during the current pandemic, such as banks temporarily waiving interest rates, companies extending payment terms from 30 to 120 days or companies granting deferrals for performance. However, using those as comparables for transfer pricing purposes may prove to be difficult, as tax authorities tend to request hard evidence and exact comparables. OECD guidance would be helpful to recognize that in case independent enterprises revise their contractual terms because of COVID-19, even if that may not be in the very same industry or contractual situation, this can still be considered in evaluating the impact of COVID-19 on transfer pricing models of MNEs under comparable circumstances and to clarify what specific evidence is needed.

What including an updated Force Majeure or specific COVID-19 clause could possibly do, is that -without neccesarily changing risk profiles in the transfer pricing structure materially-, it would carve out the consequences resulting directly from the COVID-19 pandemic and allow those to be applied after the -regular- comparables are consulted and support an adjustment to the comparable margins. As indicated above, it is no secret that unrelated parties are negotiating the same changes with respect to Force Majeure and COVID-19 in their contractual arrangements currently.

OECD Guidance would be welcome here to clarify what “self-help” companies can apply to address the very real impact of COVID-19 yet at the same time remain true to transfer pricing principles and not have those practical remedies backfire. Without that, simply put, reacting to COVID-19 can lead to conflicting actions. One of those being the prudent provisioning for plausible audit adjustments after having applied such “self-help”. The provision, together with stimulus measures may lead an otherwise loss-making entity to be flush with cash, which it, for practical purposes may lend on to its group treasury company, leading theoretically to a possible interest remuneration obligation by the group treasurer.

Will tinkering with limited risk distributor margins without any changed contractual arrangements be possible? And if so, what evidence do you use for that adjustment and what do you do in future years when pandemic-affected comparables are included in benchmark data. The last thing tax directors would want is that an ad hoc change triggers the perception that the limited risk entity was actually an entrepreneur all along and that tax authorities take the position that as a result, in pre-COVID-19 years there has been an underreporting of taxable income.

II. Impact of Government stimulus measures on Transfer Pricing

Stimulus measures are widely available currently and range from (indirect) tax deferral or full suspension to VAT/GST rate reductions, job retention bonuses, lending support, but also retail, hospitality, leisure or health sector promotion plans or support for the transportation sector. The OECD has listed an overview of the different stimulus measures on its website. While the stimulus measures available are all national and bespoke for individual country economies and industries, the difference in measures between the respective countries and challenges to determine if companies qualify for them significantly impacts their effectiveness. To the extent that some uniformity can be obtained in this area and clear guidance on qualification can be made available, that would in and of itself constitute a major improvement and help the stimulus measures reach the right parties in a timely fashion. Here, the OECD may be able to render helpful guidance and detailed formats to countries as to how to present such measures best.

Next, for transfer pricing purposes, the impact of stimulus measures is uncertain. In some situations stimulus measures come with strings attached that were not anticipated or clear from the get-go. Also, do job-retention bonuses reduce employment costs such that this reduction in cost gets considered when a cost-plus remuneration is in place for the entity where the relevant employees work? In other words, can the benefit of the subsidy or stimulus measure be passed on in the supply chain or not? While some countries may have some guidance on this (like the Netherlands does) most do not. And even in cases where there is guidance, it is still not clear if COVID-19 support would be included or not.

The Dutch transfer pricing decree provides that subsidies that consist of a cost reduction or discount that directly relates to the service being rendered or the product being made available can be passed on and applied to reduce the cost base. An example would be a (government) subsidy for the use of acquiring environment-friendly raw materials, or subsidies for the acquisition of energy-efficient machinery and equipment. Subsidies and tax benefits that are provided to an entity as such without any causal relationship with the entity’s activities would not qualify for being passed on in the supply chain. Considering this description, it would appear that COVID-19 measures would generally not qualify to be passed on in the supply chain, but this would most likely need to be considered for each and every individual stimulus measure. One could say that, if the measure is industry-specific, there would seem to be a possible argument that there might be causal effect and it might be available for inclusion in the transfer pricing system under the above guidance.

OECD guidance on this issue would be most welcome, because if the subsidy is passed on through the system and local auditors believe that is incorrect, there will be adjustments and double taxation, the cost of which would undermine the purpose of granting the stimulus measure to begin with.

III. Permanent establishment and place of effective management exposure

Lockdowns and government travel restrictions to and from locations that are considered high risk for COVID-19 infections have led to people working from home (WFH) or wherever they are located, and not able to work from their formal designated offices.

Article 5 of the OECD Model Convention defines a permanent establishment as a fixed place of business through which the business of an enterprise is wholly or partly carried on. It includes inter alia a place of management and an office. To the extent premises of an employee are not at the disposal of an enterprise, those premises should not be considered an office or a permanent establishment. That said, as WFH is becoming a new normal, it may be worthwhile to reiterate that WFH does not neccesarily make a home a place that is at the disposal of an enterprise, and in what circumstances that would be the case.

If and to the extent the permanent establishment definition applied by a State includes the clause that individuals being present in another State for a period or periods exceeding in the aggregate 183 days (i.e. 6 months) in any twelve-month period the exposure to having a permanent establishment gets more serious. Now an employee WFH who is acting on behalf of its employer in another jurisdiction may very well be considered as rendering services from a permanent establishment, as the COVID-19 lockdowns and travel restrictions (or simply time spent in a country due to concerns over safe travel) in many countries have already reached this critical time-period.

Some countries have issued statements to assure that COVID-19 lockdowns do not neccesarily lead to permanent establishments and that “a degree of permanence” is required, or habitual conclusion of contracts is required to lead to a dependent agent permanent establishment. The United Kingdom (HMRC) being one of them. HMRC went as far as saying that the income allocation, if a permanent establishment were to arise, would be dependent on the level of activity, perhaps trying to indicate that it would be relatively low. However, in the market we are observing concern that employees that are stranded in a State other than that of their employer, may be considered as rendering DEMPE functions where they are, and as such, their presence would attract significant transfer pricing challenges. As the COVID-19 virus appears to be more persistent than anyone expected, considering the 183 day test that some countries apply, revisiting and expanding the earlier issued OECD guidance that activities should only be regarded as habitual where there is a degree of permanence (as regards the habitual conclusion of contracts/doing business leading to a permanent establishment) would seem appropriate.

The same of course applies with respect to place of effective management determinations that affect corporate residency. While the OECD has issued guidance that the ordinary place of effective management should be considered for corporate residence purposes rather than exceptional circumstances, the persistence with which the COVID-19 virus remains a major influence on everyday life and hinders crossborder mobility may require more thoroughly considered guidance.

IV. Business restructuring

As the COVID-19 pandemic moved from the East to the West of the world, companies doing business globally noticed fall-out in their Asian manufacturing and supply chains before they did in the West. On the other hand, lockdowns lifted earlier in the East than in the West. Some multinational enterprises had the agility and the benefit to be able to shift production capacity and stock between their global sites to try to manage the impact. While the balancing of production resources, performance requirements and customer demand will likely remain an issue that requires significant managing in the near future, the experience of shifting to other production facilities for the short-term brought change, but may trigger long-term changes as well. Short-term adaptations intercompany can probably be seen as a service, and should not constitute a business restructuring. But longer-term changes may very well be just that. If a short-term solution becomes more permanent, when did the change effectuate? In 2020? Or only in later years when formal decisions have been made to continue operating that way? And what buy-out considerations are to be made in this respect? Guidance on this would be welcome too.

In conclusion

With the above, we hope to contribute to the important work of the OECD with respect to assisting companies and governments to address COVID-19 impacts for transfer pricing. The more and the clearer the guidance, the more likely that issues can be resolved amicably with tax authorities, the less additional cost companies will incur as a result of competing interpretations and the more likely it is that double taxation as a result of COVID-19 related actions will be avoided. We, of course, remain available to further discuss the above or assist.