The OECD’s guidance issued on 18 December 2020 on the Transfer Pricing implications of Covid (the ‘Covid Guidance’) may not have offered up any real surprises. Certainly that seems to have been the intention, and para 5 of the Covid Guidance states that it should be regarded as an application of existing guidance, and not an expansion or extension of the 2017 Transfer Pricing Guidelines.
Nevertheless, this Covid Guidance is to be welcomed as providing helpful commentary. It also contains interesting observations on the role of Intercompany Agreements and other legal considerations in the context of transfer pricing analysis and compliance.
This article examines some of the key points raised in the Covid Guidance from a legal perspective.
1. Keep in mind the key TP and legal objectives
The Covid Guidance states in para 5 that ‘it is important not to lose sight of the objective to find a reasonable estimate of an arm’s length outcome’ and, in para 6, that ‘businesses should seek to contemporaneously document how, and to what extent, they have been impacted by the pandemic.’
This key TP objective should be seen in parallel with the corresponding fundamental legal objective, which is that intercompany transactions must be consistent with the legal obligations of the participating legal entities and their directors, whether before, during or following the pandemic.
This means that a proper understanding of the legal as well as the operational environment is essential.
The Covid Guidance cites an example of this, when it states that ‘government assistance may be subject to a number of legal conditions that could limit or even prevent the capacity of the party receiving the assistance from modifying the pricing of its transactions with other parties across the value chain’ (see para 75).
2. Pay attention to the timing and duration of Intercompany Agreements
The Covid Guidance reiterates that ‘it is important to emphasise that the allocation of risks between the parties to an arrangement affects how profits or losses resulting from the transaction are allocated at arm’s length through the pricing of the transaction’ (para 35).
As pointed out in the 2017 TP Guidelines, the concept of ‘risk allocation’ is only meaningful when it takes place and is legally implemented in advance, and not when risk outcomes are known.
This means that the timing of the conclusion of intercompany agreements is significant, as is their duration and the contractual notice periods for termination for convenience (i.e., without cause).
The Covid Guidance gives the example of a pre-existing intercompany agreement which was concluded in 2018 for a term of five years, and which therefore covered 2020 and the period of the Covid pandemic. That arrangement may have been accurately delineated at the time, and priced by reference to comparables contemporaneous with the negotiation of the arrangement. In that case, it may be appropriate to allow that allocation of risk to ‘play out’, and it may not be necessary to perform a separate comparability analysis for FY 2020 (see paras 10 and 17).
The position would have been different if, for example, the transactions had been priced on an annual basis (see para 10).
3. Check the risk allocation in your Intercompany Agreements, especially for so-called ‘limited risk’ arrangements
Contractual assumption of risk through Intercompany Agreements is the starting point for the TP analysis of any controlled transaction (see, for example, Section D1 of the 2017 TP Guidelines). However, it is particularly important in so-called ‘limited risk’ arrangements and in considering the question of how losses should be allocated.
The Covid Guidance reminds us that the description ‘limited risk’ has no particular meaning in the OECD TP Guidelines, and that ‘no supposition should be made regarding the most appropriate transfer pricing method … without first undertaking a full and accurate delineation of the transaction.’ (See para 38 of the Covid Guidance).
Contractual terms in agreements between unconnected parties rarely use terms such as ‘credit risk’, ‘inventory risk’, ‘product liability risk’ or ‘marketplace risk’. Instead, the contractual allocation of those risks (if present) is a function of a combination of various contractual terms. Those terms may include warranties, indemnities, exclusion clauses, hurdles for claims and price adjustment mechanisms.
Exactly the same principles apply to Intercompany Agreements between related parties, although the contractual provisions should usually be simplified. In addition, it is often helpful to make explicit reference to the intended effect as regards the allocation of the key risks involved. This helps with contractual interpretation by key stakeholders within the group and, importantly, when the agreements are reviewed by tax authorities.
In situations where business models are under stress, it becomes even more important to be clear about contractual allocation of risks (and rewards). Bald, unsubstantiated statements in TP documentation that certain risks are not assumed by particular entities are unlikely to suffice.
If groups have not already carried out an analysis of their Intercompany Agreements in this level of detail, now is the time for them to do so, and to consider whether their agreements may need to be renegotiated and updated (see item 6 below).
4. Review pricing clauses and price adjustment mechanisms in Intercompany Agreements
The specification of contractual prices goes hand-in-hand with the contractual allocation of risk; one is meaningless without the other. In fact, when it comes to ‘marketplace risk’, the allocation of that risk is often primarily effected through pricing clauses.
The Covid Guidance contains an interesting discussion of the inclusion of ‘price adjustment mechanisms’ in controlled transactions, as a potential approach for allowing flexibility, while also maintaining an arm’s length outcome (see para 30).
The only way to ‘include’ such a mechanism in a controlled transaction is to incorporate legally binding clauses in the relevant Intercompany Agreements. In general, those clauses need to operate with legal certainty in order to be binding. This is not just key for transfer pricing analysis, but is also fundamental in order for the directors of participating entities to comply with their legal duties when considering the terms of intercompany transactions and whether they should be approved or negotiated further.
Again, groups which have not already ensured that the pricing provisions contained in their Intercompany Agreements are aligned with their transfer pricing objectives, should take the opportunity to do so now.
5. Exercise caution before seeking to invoke force majeure clauses
The Covid Guidance rightly reminds us that the application of force majeure clauses and related doctrines is entirely fact-dependent, and that ‘the agreement and underlying legal framework within which force majeure may be invoked should form the starting point of a transfer pricing analysis’ (para 57).
The following example is given in the Covid Guidance:
‘For example, assume that Company G in jurisdiction G provides manufacturing services to Company H under a long-term manufacturing services agreement that includes a force majeure clause. The government in jurisdiction G mandates the closure of the manufacturing facility for a certain specified short-term period, which may be extended depending on the duration of the pandemic. Given the lack of clarity on the extent of the disruption, it would be important to analyse the contract to see if the disruption qualifies as a force majeure event and consider whether, at arm’s length, Company G or Company H would seek to invoke the clause. Assuming that a clause may be legally invoked under the relevant legal framework, given the long-term nature of the relationship and the short-term nature of the disruption, it may be the case that neither company would invoke the clause, even if it did qualify as a force majeure event. If the disruption was for a longer period, then the circumstances may be different, and force majeure may be more likely invoked.' (Para 58).
This example is possibly not the best illustration of the meaningful invocation of force majeure clauses. In many cases in a group context, a provider of manufacturing services such as Company G, will have no revenue other than the fees payable under the relevant manufacturing services agreement. For Company G (as service provider) to rely on a force majeure clause to suspend or terminate that agreement would therefore be equivalent to an employee asking for voluntary redundancy or to take a period of unpaid leave. It is difficult to envisage circumstances in which the directors of Company G could properly approve such course of action.
Force majeure clauses between unconnected parties rarely operate to relieve a party from payment obligations on the grounds of financial hardship. So, from the perspective of a service recipient such as Company H, force majeure may also not be a useful legal tool to realise such an outcome.
It is submitted that in most cases, force majeure clauses should best be regarded as part of the context within which the renegotiation of Intercompany Agreements may take place, rather than a mechanism by which to give effect to price adjustments or to amend other terms agreed between related parties.
6. Establish ongoing processes for periodic review of whether legal entities should renegotiate and update their Intercompany Agreements
This is perhaps the most significant aspect of the Covid Guidance from a legal perspective.
The guidance reminds us that ‘unrelated enterprises may opt to renegotiate a contract to support the financial survival of any of the transactional counterparties given the potential costs or business disruptions of enforcing the contractual obligations, or in view of anticipated increased future business with the counterparty’ (para 43).
The word ‘negotiate’ (or ‘renegotiate’) is significant here – Intercompany Agreements are not fictional contracts which exist merely for the purposes of TP documentation and compliance requirements. They are a legally binding expressions of the arrangements entered into by separate legal entities with separate interests and obligations.
In para 45, the Covid Guidance states that ‘Determining whether a renegotiation of a commercial arrangement (including pricing under the arrangement going forward and any potential compensation for the renegotiation itself) represents the best interests of the parties to a transaction requires careful consideration of their options realistically available and the long-run effects on the profit potential of the parties.’
In the context of the current pandemic or, for that matter, any other material change in the economic or other environmental factors impacting the relevant business, allowing an existing arrangement to continue is just as much a decision as entering into a new arrangement. The reasons for the decision need to be documented in the same way, both for the purposes of transfer pricing compliance and also for the purposes of legal defence files to protect the relevant directors from personal liability in each relevant jurisdiction.
This is therefore an important reminder of the need for periodic reassessment and review of Intercompany Agreements and the corporate governance processes and decisions made by related parties on a contemporaneous and prospective basis, and not merely as part of processes for the preparation of corporation tax returns.