On December 18, 2020, the OECD published “Guidelines on the Effects of the COVID-19 Pandemic on Transfer Pricing” (guidelines).
A major motivation for the publication of the guidelines was the OECD's awareness that transfer pricing is typically set by taxpayers and verified by tax administrations using historical and out-of-date information on market prices. The pandemic could therefore lead taxpayers to set unrealistic transfer prices or tax administrations to impose additional taxes based on unrealistic assumptions about current market rates.
Another problem is that some tax administrations expect transfer prices or profit margins to be in line with the market each year, while others accept it for several years. The guidelines addressed several important issues including comparability analysis, government assistance programs and upfront pricing agreements (APAs). The issue that could create the most controversy about transfer pricing (TP) concerns losses and the sharing of COVID-19 specific costs.
Obviously, the pandemic has caused significant losses for many companies. For example, the United Nations Conference on Trade and Development reported a significant decline in the production of motor vehicles as well as machines and equipment in industrialized countries in the first half of 2020. Likewise, the UK National Statistics Bureau reported that services such as hospitality were almost recorded in April and May 2020, there was no production, but food retailing and industries such as information and communication (where employees could mostly work from home) were changing hardly.
Pharmacies saw sales spike during the pandemic, while furniture retailers largely regained their sales losses in the months they were allowed to reopen. Online sales increased from 20.1% to 28.5% between February and October 2020.
More generally, the pandemic could be expected to cause losses for companies involved in certain functions, such as: B. Manufacturing or distribution (in the case of lower sales to distribute the fixed costs) and to parties to certain transactions (such as loans, license agreements or leases) where one party may be required to maintain payments even if it does not have sufficient profits ). Sometimes these losses were exacerbated or caused by exceptional costs of complying with government regulations such as the use of protective clothing, social distancing, additional reporting, or the closure of premises.
These losses can lead to TP issues for a number of reasons, such as: For example, when the arm's length does not appear to involve losses and when a functional analysis or TP agreement appears inconsistent with a particular party exposed to significant risk.
To avoid a wave of national and international TP controversy, the OECD has quickly put in place guidelines for taxpayers and tax administrations to determine the correct TP response to the financial impact of the pandemic.
Methods of sharing losses
It is worth stepping back to examine how related parties could distribute additional costs and losses caused by the pandemic. For example, interest may be rolled up or waived on a loan, or debts may be waived, or financial covenants may be ignored (if this would otherwise have allowed the loan and a new loan to be drawn on at a higher interest rate).
Under the domestic laws of some jurisdictions, such action may result in the Supporting Party receiving an adequate tax deduction if it can demonstrate that failure to follow these steps would have put its subsidiary out of business and thereby damaged the parent company's investment, or if a The manufacturer had to protect his business interests by supporting his close business partner, for example a major customer, or his way to an important market. In a way, the guidelines encourage this commercial analysis in the context of TP decision making.
Recent international case law provides some indication of the challenges that can arise from reporting losses and the evidence that could be accepted as justification.
For example, in Adecco A / S, Supreme Court of Denmark (Case BS-42036/2019-HJR) and A Oy, Supreme Administrative Court of Finland (Case No. KHO: 2020: 34) it was assumed that the taxpayer had valid economic reasons for reporting a loss. Whereas at the ice machine manufacturer A / S at the Danish West Court of Justice (case no. SKM2020.224.VLR) the taxpayer's records were found to be insufficient to provide this justification. It is noteworthy that the tax administrations made a number of arguments, including:
- Instead of comparing individual transactions and regardless of the functional analysis, the taxpayer's net margin should be benchmarked and should be within the normal market range every year. and
- The taxpayer should be taxed on an imputed income from providing an unrecognized service for the benefit of the rest of his group (which is sometimes not even defined by the tax administration).
These cases involved paying royalties and buying goods at fixed profit margins, which shows that significant loss problems can arise in a number of situations. As in previous loss cases, taxpayers continued to win when their TP records provided a compelling economic explanation for their losses. Where no such documentation was available, a successful justification was that the taxpayer “caught up” by posting a higher profit in subsequent periods.
These cases were not financial transactions, but the tax administration's loss-sharing challenges related to this type of transaction are in light of the February 2020 OECD Guidelines for Financial TPs, Section B, in the context of “The precise delineation of a alleged loan transaction.
Relevant considerations should include a fixed repayment date, an obligation to pay interest, the right to enforce the payment of principal and interest, financial covenants, the ability to service the loan and what happens if the "debtor" fails to repay the due date, include date or request for postponement and whether a borrower wanted to borrow that much on arm's length or would have looked for other terms (e.g. security over collateral). The following tax administration challenges are therefore to be expected:
- Deferred interest payments – accumulated interest should be calculated; Interest should be charged with a penalty rate; Offsetting a fee for including this option in the loan agreement, either upfront or as an adjustment to the interest rate;
- Interest Waiver – the interest added to the lender's taxable income; possible requalification of the loan instrument in equity;
- Debt relief – no deduction for the lender; treated as borrower's income; and
- Take no action if a financial contract is broken – the borrower is only granted a deduction proportional to the debt that a lender would have preferred on market terms; The lender must be taxed on the basis of the higher interest rate that a lender would have charged on market terms.
The potential challenges listed above are new, based on the “soft law” of the OECD guidelines. Unfortunately, the tax jurisdictions of multinational taxpayers have interpreted the guidelines in different ways.
This could lead to a redistribution of losses to a foreign company in a country in which the tax administration does not make a corresponding income adjustment and the taxpayer has to resort to the amicable procedure of the respective tax treaty. The outcome will be uncertain and potentially unsatisfactory for the taxpayer, especially if a competent authority is unwilling to accept arbitration (e.g. as provided for in EU Directive 2017/1852). In such a situation, negotiating an APA with a “rollback” can be a solution.
TP justifications for sharing losses
The guidance notes that companies in some industries are more likely to pass on costs than companies in other industries (as mentioned above) due to different market pressures.
In general, the "price elasticity of demand" is lower (or even negative) for more important items such as food, oil, natural gas and medical services, and higher for "luxury" or "discretionary items" such as hotels and restaurant meals, airlines, international travel, new Automobiles and luxury goods. Therefore, it is important to first identify the net additional cost each company has incurred as a result of the pandemic, regardless of the immediate cost of complying with government security measures.
Similarly, different cost structures mean that, in the face of falling demand and falling sales, companies in some industries are less able to reduce costs and therefore suffer greater losses. This effect can even vary between companies of the same multinational group. The starting point for a TP justification of the loss pattern reported by the group companies is an analysis of how they were each affected by the pandemic.
Second, the guidelines explain that losses can be justified if it can be demonstrated that the benchmark companies would have reported losses during prepandemic periods if they had suffered the same reductions in demand or additional government-imposed costs. This requires an analysis of how their costs have moved when their sales have changed.
Third, the guidelines suggest that the starting point for loss sharing is the contractual sharing of risk between the parties, including whether certain costs are not covered by the agreement. The guidelines state that it is acceptable for “low risk” parties to suffer losses in the short term, for example when sales are significantly reduced.
Fourth, the OECD advises taxpayers to check whether it would be in the longer-term interests of the parties – if they were independent – to flexibly structure compliance with the TP agreement in the short term or even to switch to a new agreement which losses could be shared. If a company chooses to apply this flexibility to some of its related counterparties but not to others, this commercial analysis must be carried out on a company-by-company basis.
Action points
Taxpayers are advised to act in the following ways and as simultaneously as possible:
- Calculate and document the impact of the pandemic on each company in its group.
- Make the relevant tax administration aware of a possible violation of a critical APA acceptance. Depending on local tax regulations, the APA in question may no longer be valid and binding if the factual background has changed and a new, amended APA may need to be submitted.
- Check whether existing agreements with related parties would allow certain costs or losses to be shared.
- Assess whether it is in the longer term interest of the parties to share certain costs or losses and adjust transfer pricing accordingly.
- Change transfer prices if you think the pandemic will have longer-term effects on a business.
- Modification of TP agreements when it is believed that the immediate change of TP implies that the roles of the parties were in fact not as described in the existing agreement (e.g. when a party with limited risk is asked to assume risks and losses share, possibly suggesting that it is more accurately viewed as a full risk deal that should have a normal margin for carrying that risk);
- Adopt new TP agreements when the business had to be restructured to survive (e.g. by centralizing functions such as procurement); and
- Make sure that this analysis has the required mix of legal and business skills to produce compelling TP documentation.
Regardless of the outcome of a pandemic review in relation to the relevant TP policies, the main requirement is to have a solid economic rationale for all decisions, to adequately document that analysis, and then to amend or prepare the relevant legal documentation.
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Danny Beeton |
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From advice Danny Beeton is a consultant at Arendt & Medernach, where he works as a senior economist in the TP practice. Danny advises clients on setting market prices for all types of related party transactions, including goods, services and intellectual property, with a particular focus on financial transactions such as loans, guarantees, group treasury policies and asset management fees. His assistance is often sought in the context of TP compliance and reporting, controversy and planning, and has provided expert reports on litigation. Danny holds a master's degree in economics from the University of Essex and a doctorate in economics from the University of London. He has served on two HMRC advisory committees, as well as on committees of the Confederation of British Industry and the Chartered Institute of Taxation. |
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Alain Goebel |
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partner Alain Goebel is a partner at Arendt & Medernach. He advises international clients on tax and TP aspects of Luxembourg and cross-border transactions with a focus on corporate restructuring, acquisitions and financing structures. Alain has been a member of the Luxembourg Bar Association since 2002. From 2013 to 2016 he was President of the Young IFA network (International Fiscal Association) and from 2012 to 2015 Luxembourg's national representative of the International Association of Young Lawyers (AIJA). Alain holds a Masters Degree in Business Law and a Graduate Degree in Tax Law from Paris 2 Panthéon Assas University and an LLM in Banking and Finance Law from King & # 39; s College London. From 2009 to 2016 he lectured on corporate taxation at the University of Luxembourg and regularly gives lectures at tax seminars. He has published several articles on tax law, including national reports for IFA and AIJA. |
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