COVID-19 and transfer pricing 

President Stefano Simontacchi, Milan-based Partner Marco Adda and Milan-based Senior Counsel Francesco Saverio Scandone are in the Tax Team at BonelliErede Introduction The COVID-19 pandemic has clearly put tremendous pressure on almost all the world’s health systems and economies, with the OECD warning that the pandemic poses the greatest threat to the global economy since the 2007–2008 financial crisis1, and the IMF’s projections for GDP growth paint a similarly grim picture2. Except for South Asia (with GDP growth expected to fall to +1.5), all regions around the world are expected to record negative growth rates (with western Europe plummeting to -7.3 and north America to -6), and even when one looks at the figures for individual countries, the figures are far from encouraging3. The impossibility to predict how long the crisis will last has inevitably brought much uncertainty about what the future holds; however how well businesses, industries and countries manage to overcome the challenges ahead greatly depends on what actions governments take – and many are taking quite different approaches. Given the varying effects on different sector, different approaches will be needed for each. Indeed: some sectors will be hit harder than others, with traditional fashion retail and automotive being some of the hardest hit sectors. In fact, colossus groups Kering Group4 and Volkswagen5 have already issued profit warnings due to the COVID-19 crisis; and consumer behaviour has taken a U-turn (although FMCG are, and will continue to in the short-term at least, seeing a spike in performance). The countless knock-on effects of the global turmoil need to be carefully assessed to understand the potential implications for MNE transfer pricing policies for both 2020 and 2021. Indeed, the OECD is planning to issue guidelines covering the effects of the COVID-19 crisis on transfer pricing specifically6. The widespread consensus7 is that, be we in the midst of a recession or a booming economy, the cornerstone for allocating income throughout MNE value chains should remain the same throughout the business cycle, ie. the arm’s length principle enshrined in the OECD Transfer Pricing Guidelines for Multinationals Enterprises and Tax Administrations (‘OECD TPG’)8. Businesses thus need to consider what aspects of the transfer pricing analysis need to be more carefully taken into account in the current economic cycle. The economic circumstances The economic circumstances are one of the key comparability factors mentioned in the OECD TPG9, but no explicit reference is made to economic conditions in the face of a pandemic and the potential effects on comparability. The only reference that can be considered close to a pandemic is the mention of ‘natural disasters’ in Chapter VI with reference too hard to value intangible, to identify a category of events that may be considered unforeseeable at the time of a given transaction10. In the absence of specific provisions that deal with pandemics, the general principles in the OECD TPG should be applied to formulate a possible approach that reconciles the extraordinary nature of the pandemic and compliance with the arm’s length principle. The OECD TPG states that the prices for products and services may significantly vary depending on: the markets, especially the nature and extent of government regulation of them11; and the existence of a cycle12. These elements should thus be considered in order to appropriately apply the arm’s length principle even during the COVID-19 crisis and making amendments to the transfer pricing policy (if needed) by performing the following steps: 1. Industry: the first step is to understand whether the existing transfer pricing policy does in fact need to be amended, based on the industry the given MNE operates in. MNEs in industries not affected by the COVID-19 crisis will clearly not need to make changes. Changes to the transfer pricing policies may well be needed not only to MNEs in industries negatively affected by the COVID-19 crisis (eg. automotive and fashion) but also to those in industries positively affected, at least in the short term (eg. home care and media and entertainment) to understand where to allocate in the first case the extra losses and in the second the extra profits13. 2. Market: the second step is to look at how the markets the MNE operates in have been affected. For example, associated entities operating in China, where the GDP growth prediction is still positive and where the lockdown measures were starting to be lifted as other countries were introducing them, should be treated differently to associated entities operating in Italy (despite the similarities in the lockdown measures). The latter should also be treated differently to associated entities operating in Sweden (because, despite both countries having negative GDP growth predictions, the governments have adopted different measures). 3. Third-party behaviour: given the obvious difficulties in performing obligations under contracts entered into before the crisis, it is worth trying to renegotiate the payment terms of contracts with independent parties. One must also bear in mind that, for the large majority of contracts, performance will be suspended on the grounds of force majeure. This should be reflected also into intragroup dealings in order to comply with the arm’s length principle. Should transfer pricing policies be affected by COVID-19? A significant number of transfer pricing policies apply a principal model whereby the group entities classified as limited risk takers (eg. contract manufacturers and limited risk distributors) are granted a routine return. The potential impact of the crisis on this model are evident: should the principal grant the same return despite a drastic fall in sales? The answer depends on how the pandemic risk is characterized, ie. whether this category of risk may be considered one of the risks from which the low risk entities should be relieved. The OECD TPG provides a wide definition of risk as “the effect of uncertainty on the objectives of the business.”14 One could thus conclude that the concept of risks should be linked to something predictable, which is confirmed by the OECD TPG with the following statement: “companies choose which risks they wish to assume in order to have an opportunity to generate profits.”15 It could be argued that the pandemic risk does not fit the definition of a predictable uncertainty, since companies had no choice but to assume the risk. This interpretation is supported by the concept of force majeure as applied in international commercial law: one of the essential features of this concept16 is foreseeability ultimately linked to a risk that a reasonable person would take based on the information and knowledge that existed when the contract was entered into17. The COVID-19 risk could thus be considered a risk that goes beyond the foreseeable and controllable risks assumed by stakeholders18. And as they are individually powerless to take decisions on or mitigate the risk, it could be argued that, in principle, the entire group should sustain the risk, including limited risk entities. This conclusion is consistent also with the assumption that, as pointed out by scholars19, low risk does not mean no risk. A further analysis to consider is the options realistically available (‘ORA’) analysis: The outcome could well confirm that the best option is to renegotiate contracts to introduce clauses whereby the repercussions of the COVID-19 crisis are shared between the parties20. Reliability of data for comparability analysis A further implication of the economic downturn relates to the use and reliability of data for comparability analysis, with the main issues being linked to the fact that benchmarking analyses are generally performed on: historical data, whereas the 2020 financial data of the comparable will not be available before autumn next year, and multiple year data. One might think that a possible shortcut to resolve this issue is to use financial data of periods of previous crises, such as the 2007–08 financial crisis. But this solution does not appear to be feasible due to the structural differences of crises, including the 2007–2008 one and to the fact that no guidance from the OECD was forthcoming after the 2007–2008 crisis on how to treat the negative economic cycle. Whereas it has announced, as mentioned, that it will be issuing guidance on the impact of the COVID-19 crisis on transfer pricing21. We thus believe that the above issues should be addressed by: performing comparability adjustments that take account of the effects of the crisis. The adjustments could take multiple forms (eg. reflect the reduction in the revenues of the tested parties in the turnover of the comparables or allocate extra costs deriving from the crisis and sustained by the principal to the other entities in the group). And this could be performed both on the independent entities or on the tested party; and performing a qualitative analysis, rather than a merely mechanical benchmarking one, that considers all the variables of the crisis (eg. geography, regulation and industry). Conclusion After just a couple of months into COVID-19 health crisis, it is clear that all world economies are being hit and will continue to be hit hard. But the extent of the damage will differ based on industry and geography. Multinationals will have a harder time determining arm’s length prices and have to carefully assess existing transfer pricing policies, documentation and advanced pricing agreements. MNEs will need to act fast to avoid significant year-end adjustments, for example, and to prepare robust documentation ready for future tax audits (and to avoid double taxation). We believe the solution is to carry out qualitative analyses that take account of all the variables of the crisis. Significant importance should be given to economic circumstances and market characteristics in order to determine the correct remuneration of MNE group entities. Furthermore, the inevitable uncertainty suggests that, at least for major transactions, it would be wise to open an official channel with the tax authorities involved through BAPA requests. Endnotes 1. 2. 3. Europe will face the peaks of Greece (-10) and Italy (-9.1) – but also the negative results of strong economies such as Germany and UK (-7 and -6.5, respectively). The US is predicted to record -5.9, Canada -6.2, and Russia -5.5. On the positive side, India and China are expected to record +1.9 and +1.2, respectively. 4. 5. 6. OECD Tax Talks, 4 May. 7. R Schatan, Transfer Pricing Practice in Times of Recession, International Transfer Pricing Journal, January–February 2010, pp. 63–64. 8. OECD (2017), OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations 2017, OECD Publishing, Paris. 9. See para. 1.110. 10. See para. 6.194. 11. See para. 1.110. 12. See para. 1.111. 13. Another aspect to potentially consider in performing a transfer pricing analysis is the financial aid countries grant stakeholders. 14. Para. 1.71. 15. Para. 1.71. 16. The essential features were ultimately incorporated in the 2020 version of the International Chamber of Commerce (ICC) Model Force Majeure Clause. See 17. See M Winkler, Practical Remarks on the Assessment of Covid-19 as Force Majeure in International Contracts, available here: 18. The OECD TPG specifies that natural disasters could fall within the category of hazard risks, which can often be mitigated through insurance. 19. See V Horrocks, United Kingdom - Transfer Pricing Practice in an Era of Recession, International Transfer Pricing Journal, 2009 (Vol.e 16), No. 6. 20. The possibility to share the extra losses/profits appears to be at least invokable against the tax authorities of countries (Germany and France) that are foreseeing temporary regulations to reform contractual obligations to tackle the Covid-19 crisis. 21. OECD Tax Talks, 4 May.
MNEs will need to act fast to avoid significant year-end adjustments [...] and to prepare robust documentation ready for future tax audits (and to avoid double taxation)MNEs will need to act fast to avoid significant year-end adjustments [...] and to prepare robust documentation ready for future tax audits (and to avoid double taxation)