OECD offers helpful guidance on transfer pricing aspects of the pandemic

By Dr. J. Harold McClure, New York City

On December 18, the OECD published guidance addressing the difficult transfer pricing issues that multinationals may face due to the current pandemic.

The new guidance is helpful as it provides multinationals with enhanced certainty, given that this guidance reflects the consensus view of the Inclusive Framework on BEPS, an OECD-led body comprised of 137 countries.

The guidance has four chapters reflecting comparability analysis, losses, and the allocation of COVID-19 specific costs, government assistance programs, and advance pricing agreements.

Comparability analysis

 The new guidance provides a variety of practical approaches to address the inconsistency of how traditional transactional net margin method (TNMM) models work during normal periods versus how to evaluate arm’s length prices during a period plagued with severe downside risk.

The new guidance provides a variety of practical approaches to address the inconsistency of how traditional transactional net margin method (TNMM) models work during normal periods versus how to evaluate arm’s length prices during a period plagued with severe downside risk

Transfer pricing practitioners often provide benchmarks of routine returns for a multinational’s distribution and contract manufacturing affiliates that contract with a principle affiliate owning valuable intangible assets.

Table 1 provides a simple illustration of this framework, beginning with the financial results during a normal profitable period.

Table 1: An illustrative multinational income statement during normal times

Millions	Overall	Distributor	Principle	Manufacturer
Sales	$100	$100	$0	$0
I/C price 1	$0	$76	$76	$0
I/C price 2	$0	$0	$66	$66
Production costs	$60	$0	$0	$60
Gross profits	$40	$24	$10	$6
Expenses	$25	$20	$5	$0
Profits	$15	$4	$5	$6

A western European distribution affiliate sells $100 million of products sourced from its Swiss principle at intercompany price 1 (I/C price 1). An eastern European contract manufacturer incurs $60 million in production costs and charges the Swiss affiliate intercompany price 2 (I/C price 2).

The distribution affiliate incurs $20 million in selling expenses, while the principle incurs $5 million in expenses related to developing and maintaining the intangible assets.

Consolidated profits during normal periods are $15 million, allocated among the affiliates by the transfer pricing policies. Table 1 assumes that the appropriate distribution operating margin is 4 percent of sales, which has been supported by a TNMM analysis. We have also assumed that the appropriate markup over production costs for the manufacturing affiliate is 10 percent, which is supported by another TNMM analysis.

Table 2 explores a simple example of the difficulties created by the pandemic in terms of addressing the downside risks in a way consistent with the arm’s length standard.

We have assumed that production costs have risen from 60 percent of sales to 66 percent of sales, and total operating expenses have risen from 25 percent of sales to 34 percent of sales, which lowers the consolidated operating margin from 15 percent to zero.

Table 2, Scenario A, assumes that the reduction in profits are allocated to not only the principle but also to the distribution and manufacturing affiliates. These transfer pricing policies would appear to violate the TNMM approaches originally conducted to defend the transfer pricing policies during normal periods.

Table 2: Two approaches to addressing the fall in profits during a pandemic

Scenario A
Millions	Overall	Distributor	Principle	Manufacturer
Sales	$100	$100	$0	$0
I/C price 1	$0	$76	$76	$0
I/C price 2	$0	$0	$66	$66
Production costs	$66	$0	$0	$66
Gross profits	$34	$24	$10	$0
Expenses	$34	$24	$10	$0
Profits	$0	$0	$0	$0
Scenario B
Millions	Overall	Distributor	Principle	Manufacturer
Sales	$100	$100	$0	$0
I/C price 1	$0	$72	$72	$0
I/C price 2	$0	$0	$72	$72
Production costs	$66	$0	$0	$66
Gross profits	$34	$28	$0	$6
Expenses	$34	$24	$10	$0
Profits	$0	$4	-$10	$6

Scenario B is based on the assumption that transfer prices are reduced for the distribution affiliate and increased for the manufacturing affiliate such that they received the profits received during the normal period even though consolidated profits have dramatically declined. Scenario B reflects an extreme version of the limited risk entity concept, which we discuss below.

Multinationals with transfer pricing policies resembling scenario A may find documenting their policies as being arm’s length difficult as such documentation will need to go beyond the standard applications of TNMM.

The guidance recommends the use of any form of publicly available information regarding the impact of the pandemic on the multinational, its intercompany transactions, or general industry considerations.

The guidance recommends the use of any form of publicly available information regarding the impact of the pandemic on the multinational, its intercompany transactions, or general industry considerations.

This information may include how the pandemic affected sales for the distribution affiliates or the capacity utilization of the manufacturing affiliates. This information could include any exceptional costs borne by the affiliate and the impact of government assistance received.

Such information might allow an analysis to rely on internal budgeted sales and expenses rather than actual results for the purposes of a TNMM analysis.

The alternative way to use TNMM would be to consider how the pandemic affects the profitability of the third parties entities used as comparables in the TNMM analyzes.

One concern is that the historical data on the profitability of third party entities used as comparables may not capture the effects of the pandemic on the appropriate profitability under the arm’s length standard.

Practitioners have proposed accounting for the effect of previous recessions on third-party profitability as well as regression analyses to predict the impact of profitability from events that resemble the implications of this pandemic.

While the guidance notes the preference for comparable uncontrolled transactions undertaken during the same period as the controlled transaction, it may be difficult to identify third-party information that has similar profits in this economic environment using currently existing third-party profit margins.

Information from independent comparable transactions or companies from other periods, such as average returns in preceding years, may not provide a sufficiently reliable benchmark for the current period without considering the pandemic’s specific impact on the controlled transactions under review. Part of the problem is that commercial databases have information only on prior fiscal years and not the current year.

The guidance also notes two basic types of transfer pricing analyses. A price-setting or ex-ante approach uses historical data updated to reflect any change in economic conditions through the date of the contract.

An outcome-testing approach incorporates information that becomes available after the close of the taxable year.

The distribution affiliate in our example can be used to illustrate the difference between these two approaches.

A price-setting approach would have set the gross margin for this affiliate at 24 percent on the expectation that its operating expenses would be 20 percent. At the end of 2020, our two scenarios are based on the realization that its operating expenses had jumped to 24 percent of sales.

Under a fixed gross margin or price-setting approach, the distribution affiliates’ profits fall to zero. An outcomes-based approach might insist that the operating margin be maintained at 4 percent, which would require that the principle lower intercompany price 1 from 76 percent of sales to 72 percent of sales.

Analysis of specific costs and contractual relationships

The second chapter focuses on various reasons why a multinational’s consolidated profits may have declined, including a reduction in sales, supply disruptions, and exceptional or non-recurring operating costs.

It discusses three broad considerations, including the nature of commercial arrangements with respect to the allocation of risks, how exceptional costs should be allocated among the various parties involved in producing and selling products, and whether contractual arrangements would be revoked in light of an unexpected event such as this pandemic.

The discussion also notes the tendency for multinationals to treat distribution affiliates and manufacturing affiliates as limited risk entities.

If the multinational has treated its distribution and manufacturing affiliates as limited risk entities during profitable periods, some tax authorities will insist on the transfer pricing that we described as scenario B.

The new guidance, however, accepts the proposition that distributors and manufacturers face certain risks under arm’s length pricing, at least over short-run periods. For example, the guidance notes that while distributors may be insulated from the risk of inventory obsolescence and credit risk, distributors face the risk of temporarily higher selling expenses relative to actual sales when the demand for their product unexpectedly declines.

The guidance notes the tendency for some multinationals to argue for very low routine returns on the basis of the presumption that the affiliate faces no risk during profitable periods but then to argue that the affiliate does face downside risks during periods such as this pandemic. In an earlier blog post, I expressed similar concerns.  

Our example assumed that operating expenses rose from 25 percent of sales to 34 percent of sales with the increase in these operating expenses roughly evenly split between the principle and the distribution affiliate.

The guidance notes that the appropriate allocation of exceptional costs should follow how third parties would address these expenses as well as the risk assumptions in the contractual relationships behind the multinational’s transfer pricing policies.

Our example was based on a very simple fact pattern. The guidance notes that the impact of the pandemic may vary widely across multinationals. As such, the guidance recognizes that each multinational must address its own unique issues as to how to allocate exceptional costs and potentially realign transfer pricing policies to address the impacts of the pandemic.

Transfer pricing implications of government assistance programs

The guidance notes that governments during this pandemic have provided assistance to businesses in the form of wage subsidies, forgivable loans, and other forms of financial support, tax deductions, and investment allowances.

Such assistance may impact transfer pricing if it is provided to an affiliate of a multinational or if it is granted to third parties in which the multinational operates. Whether the assistance is temporary or longer-term in nature is an important consideration.

The guidance explores various issues, including whether the assistance is an economically relevant characteristic. Local market features with respect to the affiliate receiving the assistance are relevant. Such features include whether there is a market advantage for the affiliate as opposed to whether the assistance is passed onto consumers.

The guidance also asks whether the receipt of government assistance affects the price of controlled transactions and whether it modifies the allocation of risk in a controlled transaction. The impact on comparability analysis is explored, which involves the impact on the controlled transaction as well as whether the assistance is provided to the companies selected as comparables.

Advance pricing agreements

Multinationals with advance pricing agreements that cover fiscal year 2020 may wish to alter the terms of their agreements with the relevant governments.

The guidance, however, notes that the terms of existing agreements should be respected unless there is a condition leading to the cancellation or revision of the agreement. Changes in economic conditions would not allow a multinational to disregard its agreements under there was some breach of critical assumptions.

Advance pricing agreements often explicitly describe what constitutes a situation of noncompliance or failure to meet a critical assumption, as well as the consequences arising from it. Domestic law and procedural provisions should be considered by multinationals that are concerned with how the impact of the pandemic on their existing advance pricing agreements.

The economic impact of this pandemic on multinationals has been striking but this period is not the first episode where major economic changes have had significant transfer pricing implications.

The 1990’s witnessed considerable controversy between the Japanese and US income tax authorities over the implications of the tremendous appreciation of the yen with respect to the dollar. The Great Recession led to significant operating losses for multinationals over a decade ago.

While lessons can be learned as to how multinationals and various tax authorities addressed the transfer pricing implications of these economic shocks, the pandemic has led to its own unique challenges.