As we move towards the last quarter of an exceptional financial year and several other countries step into their next financial year amidst the ‘new normal’, the OECD released last week a Guidance on the Transfer Pricing Implications of the COVID-19 Pandemic (‘Guidance Note’). A critical aspect elucidated in the Guidance Note pertains to losses incurred by Multinational Enterprises (‘MNEs’) due to COVID-19.
What the Guidance Note lays down and how it impacts India
MNEs with operations in India are actively trying to fathom the risk of transfer pricing challenges in the wake of sudden changes in revenues, negative/low profitability, and the impact of unexpected costs incurred amidst the pandemic. Whether a limited risk-bearing entity can incur losses? Can intercompany agreements be renegotiated to address current challenges? Can costs incurred due to COVID 19 be considered exceptional? These are some of the nagging questions that OECD’s Guidance Note has sought to address.
Given the presence of sales & distribution centres, R&D centres, and back-offices / shared services centres of numerous large MNEs in India, the key question is whether reporting losses or lower mark-ups in low-risk entities could pose a transfer pricing risk. In the pre-COVID regime, it was often argued that a limited risk-bearing entity should not incur losses, and the return on their cost incurred while rendering their services/activities to their associated enterprises should be at arm’s length.
Accordingly, inter-company agreements are drawn up to demonstrate the distribution of risk between associated enterprises, more importantly, to spell out who has control over the risks. Most of the common risks like market / financial / credit risk etc. are very low or negligible in the case of a limited risk bearing entity.
The Guidance Note provides an overall thought on this issue and some-where concludes that it may be possible to justify such losses as being triggered by a ‘hazard risk’ that has materialised due to the pandemic, as well as unusual outcomes arising from other ‘economically significant’ risks such as marketplace risk, operational risk and financial risks. Taxpayers should demonstrate consistency in risk profiles of such entities pre and post COVID-19 and re-allocation of risks should be substantiated by sufficient facts and business rationale.
These risks mainly pertain to collapse in demand, disrupted production and supply chains, increased borrowing costs and bad debts. MNEs should identify the specific risks to which their losses during the pandemic are attributable and assess whether their low-risk entities have been historically profiled to assume any of these risks (directly or indirectly). A critical factor mentioned here is ‘consistency’. Further, in case taxpayers do choose to report losses in low-risk entities, accurate comparable companies should be selected to substantiate the extent of loss that can be considered as “arm’s length”.
The Guidance Note recommends tax authorities to view renegotiation of intercompany arrangements in light of market conditions and any similar changes in pricing or other key terms of third-party contracts. It is possible for independent parties to extend relaxations, as also ask for concessions to keep up with current hardships. For example, pre-COVID-19, an Indian associated enterprise that is considered to have low risk is assured of receiving payments within a stipulated time irrespective of the time taken by ultimate customers to pay the overseas entrepreneurial associated enterprise.
However, it is possible that during the pandemic, payments from the ultimate customers are more severely affected. Such renegotiations in turn impact intercompany arrangements that are above or below in the value chain. However, taxpayers should substantiate the arm’s length testing of such revisions through robust comparability analysis and adequate evidence. The observations in the Guidance Note are similar on losses arising due to the invocation of force majeure clause in intercompany agreements, with due importance also given to the specific language of this clause in the respective agreements.
What the Indian Government and taxpayers should do
It is highly recommended for taxpayers to take the following immediate actions: (a) relook at their intercompany agreements; (b) revisit their historical transfer pricing documentation minutely to ensure that functional and risk profiles of group companies, financial and contractual obligations are appropriately spelled out and are consistent with financial decisions taken in COVID-19 context; and (c) identify whether and to what extent hazard risk and other significant risks have impacted their current risk profile.
Robust documentation to support the above and an in-depth industry analysis covering geographical and related business impacts should be captured in the transfer pricing documentation maintained during the pandemic years. These activities should not be pushed towards the end of the year and should be continuously monitored and updated.
In order to avoid unnecessary transfer pricing litigation, the CBDT should provide India-specific perspectives on this Guidance Note as well as their layout ‘risk areas’ for conducting transfer pricing audits for pandemic years. Another essential action would be for tax authorities to provide their perception of arm’s length or an acceptable level of losses if incurred by taxpayers on account of the pandemic.