Exceptional economic circumstances
The COVID-19 pandemic has created exceptional economic circumstances with significant uncertainty remaining over the depth and duration of its effects. Impacts on specific sectors and businesses have varied substantially. Some have experienced severe reductions in revenue, extraordinary costs and adverse profit outcomes. For others the impact has been relatively minor or even positive. Transfer pricing issues arising are also wide-ranging and vary considerably between businesses and across jurisdictions.
Arm's length principle
Transactions must continue to be conducted in accordance with the arm's length principle during the COVID-19 pandemic. Existing guidance continues to be relevant, including the OECD's Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations - July 2022. This guidance has been further supplemented by the OECD Guidance on the transfer pricing implications of the COVID-19 pandemic.
Documenting COVID-19 impacts
We recognise that practical difficulties in the applying the arm's length principle may arise during this time. It is critical to have contemporaneous documentation recording specific facts and circumstances businesses face and their compliance with the principle.
In documenting their specific facts and circumstances in light of COVID-19, businesses are encouraged to:
- identify and collate evidence to document the nature, duration and extent of any material COVID-19 related impacts on the group and local business
- document relevant group and local business responses to the pandemic, including for example, any changes in business strategies, changes in the characteristics of product or service offerings and so forth
- identify and explain any changes in group and local business functions, assets and risks during the impacted period, including how these relate to the business’ exposure to, or mitigation of, COVID-19 impacts
- identify and explain any changes in intra-group transactions and contractual terms
- document the supporting rationale for any changes to intra-group transfer prices, including why they are considered to be arm's length in the circumstances
- identify the impact of COVID-19 on the overall profitability of the MNE group and the local entity.
As with all documentation, it is the quality of the content that is important, as opposed to the quantity.
Arm’s length support for financial outcomes
In exceptional economic circumstances, identifying reliable comparable data to support the arm’s length nature of financial outcomes may be difficult, particularly in the short term. A pragmatic approach, in the absence of comparable data, is to refer to pre-COVID-19 expectations and analyse variances that have arisen due to COVID-19 impacts, both positive and negative. This includes quantifying the financial consequences of the identified COVID-19 impacts, providing supporting evidence for the analysis and explaining in detail:
- why local sales are lower than expected
- why local expenses are higher than expected
- any unusual financial items
- any government assistance received
- the impact of any amended intra-group transactions and
- any adjustments made.
Limited risk arrangements and losses
Although in transfer pricing it is commonplace to use labels such as “limited risk”, there is no replacement for a full analysis to determine arm’s length outcomes. The extent to which an entity would be expected to earn profits or bear losses at arm’s length can only be determined through the accurate delineation of the transaction and a robust comparability analysis.
Importantly, it is not appropriate for an entity to bear losses associated with risks that it does not assume. For example, if a distributor is classified as a limited risk distributor because it does not assume inventory risk, it should not bear any losses associated with inventory obsolescence.
If it is purported that an entity has always assumed a risk that has materialised during the COVID-19 pandemic, we would expect the entity to have been compensated for assuming that risk in prior periods. We will be carefully considering the rationale for any purported change in risks assumed before and during the period impacted by the COVID-19 pandemic.
Further guidance is contained in subsection 2, Chapter II of the the OECD’s Guidance on the transfer pricing implications of the COVID-19 pandemic.
Treatment of Wage Subsidy
Where the Wage Subsidy, including the Wage Subsidy Extension and Resurgence Wage Subsidy, was received by an eligible multinational operating in New Zealand the benefit of the subsidy is generally expected to be retained by that entity.
In analysing the impact of the subsidy, if any, on the price of a controlled transaction regard must be had to the following factors, as outlined in subsection 4, Chapter III of the OECD’s Guidance on the transfer pricing implications of the COVID-19 pandemic.
Nature of the subsidy
The Wage Subsidy was a temporary support payment available where, after having taken active steps to mitigate the impact of COVID-19 (e.g. engaging with the bank, drawing on cash reserves as appropriate, making an insurance claim), an entity suffered the required decline in actual or predicted revenue. The subsidy has to be repaid in a range of circumstances, including if the eligibility criteria were breached; the funds were not used to pay the wages and salaries of the named employees; or insurance proceeds were received for the costs covered by the subsidy.
The subsidy supported the payment of wages and salaries but provided no competitive or market advantage. A distressed business in these circumstances would not have been expected at arm’s length to amend its arrangements with independent suppliers or customers upon receipt of the subsidy.
Allocation of economically significant risks
The analysis of economically significant risks must be viewed in the context of a specific controlled transaction.
However, as a general observation, the Wage Subsidy is specifically linked to the employment-related risks borne by the New Zealand recipient entity. As such, the benefits of the subsidy are generally expected to be retained by that entity.
Broader economic circumstances may impact the extent to which an entity would, at arm’s length, amend the pricing of its transactions with unrelated customers or suppliers. Observations of independent party behaviour will be useful in this respect, particularly considering the high uptake of the subsidy in the New Zealand market.
Taking these factors together, absent reliable comparables and other information, the receipt of the Wage Subsidy would not generally be expected to impact the price of a controlled transaction.
Care must be taken to avoid adopting mechanistic approaches to the application of transfer pricing methodologies without proper analysis as this could result in non-arm’s length pricing.
For example, assume a New Zealand entity who has received the Wage Subsidy provides management services to a non-resident associated party and applies the cost-plus method to establish the price of the services. Following the analysis of the Wage Subsidy above, it would not be appropriate to offset the subsidy received against wages and salary costs in the application of the cost-plus method as this would undervalue the services provided resulting in a non-arm’s length outcome.
As a further example, assume a New Zealand entity who has received the Wage Subsidy purchases goods from a non-resident associated party and applies the transactional net margin method to establish the price of the goods. Following the analysis of the Wage Subsidy above, it would not be appropriate to offset the subsidy received against wages and salary costs in the application of the transactional net margin method as this would result in a non-arm’s length outcome.
For further general guidance on government assistance, refer to Chapter III of the OECD’s Guidance on the transfer pricing implications of the COVID-19 pandemic.