The Organisation for Economic Co-operation and Development (“OECD”) issued a guidance document on 18 December 2020, providing much-needed clarification and support on the application of transfer pricing rules in respect of periods impacted by the COVID-19 pandemic. The priority issues covered by the guidance document relates to the impact of the pandemic on comparability analysis, losses and the allocation of COVID-19 specific costs, government assistance programmes and advance pricing agreements.
To be frank, it hasn’t been business as usual for most. In fact, the guidance issued by the OECD suggests that we are living in such unprecedented and unique times that one should take caution in comparing it to previous periods of crises, such as the global financial crisis of 2008/2009, when performing a transfer pricing analysis. Many enterprises are facing significant cash flow constraints, experiencing wide swings in profitability and disruption to their supply chains which have forced them to change their ways of conducting business. Given the latter, it became evident that although the arm’s length principle has been working effectively in the vast majority of cases, the unique economic conditions we are currently experiencing on a global level and the responses by governments are resulting in a number of practical challenges when applying the arm’s length principle.
The OECD notes that it remains important not to lose sight of the main objective, which is always to find a reasonable estimate of an arm’s length outcome. It states that this will require an exercise of good judgment on the part of taxpayers and revenue authorities. The OECD furthermore highlights that the guidance issued by it should be regarded as an application of the existing OECD Transfer Pricing Guidelines (“TPG”) to the unique facts arising from the pandemic and should not be regarded as an expansion or revision thereof.
The guidance directly impacts those South African (“SA”) businesses which have transactions with cross-border related parties. The main take-outs from the OECD’s guidance document and the impact thereof on SA businesses are briefly summarised below.
When conducting a comparability analysis for transfer pricing purposes, agreements entered into between third parties are often considered when determining whether a transaction between related parties has been entered into based on arm’s length terms. Given that the third party agreements and other financial data only become publicly available after some time has elapsed, the tax year being analysed and the year to which the third party data relates often differs. Usually, the difference in periods would not cause irregularities in establishing an arm’s length price, however, given the impact of COVID-19 additional considerations have to be made when determining the arm’s length nature of prices agreed upon by parties since the dawn of the pandemic.
The OECD notes that any form of additional information regarding the effect of COVID-19 on the business, industry and controlled transaction would be relevant and lists a number of sources which could support the estimation of the effect of the pandemic on the prices when conducting an analysis. The sources referred to include:
- An analysis of how sale volumes have changed, the change in the capacity of the group to conduct its operations and specific information in respect of exceptional costs borne as a result of the pandemic;
- The extent to which government assistance has been received and details regarding government interventions that have affected the pricing;
- Macro-economic information such as country-specific gross domestic product data or industry indicators;
- A comparison of internal budgeted/forecasted data relating to sales, costs and profitability, compared to actual results;
- An analysis of the effects on profitability or on third party behaviour observed in previous recessionary periods; and
- Any data which is available in respect of the current year, even if partial.
The guidance document specifies that timing issues may be most pronounced when applying the transactional net margin method (TNMM) when conducting a transfer pricing analysis. The latter is based on the fact that comparable data in respect of 2020 will typically only become available from mid-2021. The OECD, however, mentions that there may be situations where the TNMM could be applied without having to include 2020 data, such as in the case where a long-term arrangement has been in place which protects the tested party from risks related to the pandemic.
Interestingly the guidance also encourages revenue authorities to apply practical approaches in light of the lack of reliable benchmarks, in order to minimise disputes where taxpayers are making good faith efforts to determine arm’s length prices. In this regard, the OECD notes that revenue authorities should allow the use of reasonable commercial judgement and supporting data to reasonably estimate an arm’s length price.
The guidance document further mentions that the use of multiple year data and the use of averages remain applicable. It is however also noted that in some cases separate testing in respect of periods most impacted by COVID-19 may be more appropriate, whilst in other cases, the use of combined periods (including years impacted and years that have not been impacted) may improve reliability. It is furthermore provided that price adjustments may provide flexibility whilst ensuring an arm’s length outcome, although these adjustments should be conducted with great care given the further implications which could result from them.
The OECD’s guidance also refers to the need to review and revise an existing set of comparable companies, based on updated search criteria, where a taxpayer rolls forward an existing set of comparables to cover 2020. The document provides some examples indicating the situations where these updates would be most appropriate.
Given the limited availability of African-specific comparable data, SA businesses often make use of European data when performing comparability analysis. Although the principles referred to above would apply equally to the SA context, consideration should be given to determine whether the timing difference between the SA and European COVID-19 peaks and lockdowns could result in additional adjustments being required.
Losses and the allocation of COVID-19-specific costs
The OECD’s guidance provides three general principles with respect to the allocation of losses between related parties. The general principles are:
- The allocation of risks between the parties will affect the arm’s length allocation of profits or losses resulting from the transaction;
- Exceptional, non-recurring operating costs resulting from the pandemic should be allocated based on an assessment of how independent entities operate under comparable circumstances; and
- Related parties may consider whether force majeure clauses could be applied, whilst they can also consider revoking or revising their intercompany agreements.
The guidance reiterates the importance of accurately delineating a transaction to identify the party with the responsibility to perform those activities which resulted in exceptional costs as well as the party which assumes the risks in respect of these activities. The OECD also states that some operating costs may not be viewed as exceptional or non-recurring where the costs relate to permanent or long-term changes in the operations of the businesses.
It is confirmed that exceptional costs should generally be excluded from the financials of the tested party and the comparables when conducting an analysis. Where the delineation of the transaction however indicates that the costs incurred relate specifically to the controlled transaction it should be considered whether the costs should be treated as pass-through costs. It should also be noted that adjustments may be required in order to ensure consistency in respect of how exceptional costs arising from COVID-19 have been accounted for. The latter is specifically mentioned in light of the fact that some taxpayers may account for these expenses as operating costs, whilst others may account for it as non-operating costs.
The OECD also provides guidance with respect to the question of whether entities operating under limited-risk arrangements can incur losses. In this regard, the OECD emphasises the necessity to consider the specific facts and circumstances and refers to the fact that although these entities are not expected to generate losses for a long period of time, these entities may incur losses in the short run, such as in the case of a pandemic.
In respect of the modification of existing intercompany arrangements, the OECD raises caution by noting that these modifications should be well-supported by documentation providing clear evidence that third parties dealing at arm’s length would have done the same.
Another important issue which has been addressed by the OECD relates to force majeure clauses. In this regard, the guidance notes that it shouldn’t be automatically assumed that parties which are contractually bound by a force majeure clause, would be allowed to invoke such clause on the basis of the COVID-19 pandemic. The document also encourages revenue authorities to carefully consider cases where force majeure clauses have been invoked and consider it against the accurately delineated transaction and the economically relevant circumstances of the transaction.
Given that many SA businesses have had to incur additional costs as a result of the pandemic and as many have had to invoke force majeure clauses despite the SA president’s appeal to large businesses to not resort to force majeure, the guidance above would also directly impact SA businesses.
Government assistance programs
The guidance notes that government assistance programs related to COVID-19, such as grants, subsidies, forgivable loans, tax deductions, or investment allowances, and the economic impact thereof should be considered as part of a transfer pricing analysis.
Some of the key issues covered by the OECD in this regard, which would also impact SA businesses given the interventions made by the SA government by way of the Solidarity Fund, relates to the following:
- The extent to which the receipt of government assistance would constitute an economically relevant characteristic may vary;
- Government interventions should be treated as conditions of the market, as set out as a general rule in the OECD TPG;
- The effect of government assistance on the price agreed upon between related parties will depend on a number of factors, such as the economically relevant characteristics, the accurate delineation of the transaction and the performance of a comparability analysis;
- Government assistance provided to a related party should not change the allocation of risk in a controlled transaction for transfer pricing purposes; and
- Government assistance will affect the comparability analysis as it may impact how the related parties price their transaction and set their commercial or financial relations.
Advance Pricing Agreements (“APAs”)
The South African Revenue Service (“SARS”) recently indicated its intention to have an APA system introduced in SA. Introducing such a regime in SA would allow SA taxpayers to take on a collaborative and transparent approach with SARS, by raising COVID-19-related issues to them in advance. Such an approach has been encouraged by the OECD in terms of the guidance issued, in which some other important aspects relating to APA’s have also been addressed. The other important aspects include the following:
- Revenue authorities and taxpayers would still be bound by existing APAs unless a critical assumption has been breached;
- Whether the change in economic conditions resulting from COVID-19 constitute a breach of a critical assumption should be considered on a case-by-case basis;
- Where a critical assumption has been breached, the parties should consider either revising, cancelling or revoking the APA;
- Taxpayers should notify revenue authorities of the failure to meet critical assumptions as soon as practically possible;
- Taxpayers should document the failure to meet critical assumptions by collecting and providing revenue authorities with details in respect of the business segment forecast and actual profits of the business segment, information on third party behaviour, etc.; and
- Revenue authorities should approach a situation of non-compliance by a taxpayer on a similar basis than a potential breach of a critical assumption would be considered.
Regarding APA’s which are under negation, the OECD advised parties to adopt a flexible and collaborative approach in order to minimise delays and to determine how to account for the current economic conditions when agreeing on an APA.
Although the above would not directly impact SA businesses at this stage, given that no APA system is in place as of yet, the guidance does provide some insight which would be valuable where the group of which a SA company forms part has entered into APAs in other jurisdictions and where the group at large has been severely impacted by the pandemic.
The guidance issued by the OECD provides a number of valuable contributions when it comes to the implication of the pandemic on transfer pricing. The overarching notion is however that taxpayers and revenue authorities should apply a flexible and collaborative approach and that situations will have to be considered and analysed on a case-by-case basis. The guidance consequently reiterates the importance of having transactions entered into between related parties properly analysed and documented for transfer pricing purposes. Given the recent guidance, such an analysis would have to take account of the impact of the COVID-19 pandemic on the business, make use of the appropriate sources to analyse the impact and provide a conclusion on the outcome of the analysis which is in line with the OECD’s guidance.
If the pandemic has had an extreme effect on your business activity, and most of your transactions are with cross-border related parties, please do not hesitate to contact us so that, given the circumstances you are operating in, we can find an appropriate solution supported from a transfer pricing perspective.