Thursday 30 November 2023
By Noboru Ogasa, President of Sumitomo Benelux and BJA Board Member
On 24 December 2020, the UK and EU negotiators signed the Trade and Cooperation Agreement (“TCA”), defining the trading relationship between the two blocs as of 1 January 2021.
The TCA implies that all goods originating from either the EU or the UK will not be subject to customs duties or quotas when imported into the other Party’s territory. This was one of the main points indicated in the negotiating mandate, as failing to achieve it would have led to the imposition of tariffs from 1 January 2021.
However, it is important to understand that only eligible goods (known as “originating”) would benefit from these tariff exemptions. To determine whether goods are eligible or not, provisions on the rules of origin have been agreed. As a summary, products shipped to the other Contracting Party in the TCA will be considered as originating if (1) they are wholly obtained in the EU or in the UK, (2) if they have been produced entirely from materials from the EU or the UK, or (3) if they have been sufficiently processed in the EU or the UK. The specific rules of origin to be complied with will vary in function of the goods’ typology.
These could for example require a change of Tariff Heading, or require the amount of non-originating material used to not exceed a certain value. Both in terms of general principles as well as product-specific rules of origin, important deviations occur between the TCA and other trade agreements that the EU has concluded; such as those with Switzerland or Norway for example.
For instance, the TCA only includes provisions on full bilateral cumulation between the EU and the UK, and not on diagonal cumulation with other trade partners common to both, such as under the Pan Euro Mediterranean (“PEM”) Convention. The specific nature of the TCA makes future integration with the PEM Convention rather unlikely.
Moreover, the practical application of the TCA preference system may require traders to apply processes and procedures that differ from those applied to date.
For instance, preference status can be claimed based on importer knowledge, or a Statement on origin issued by the exporter, who needs to be REX-registered for this purpose if the consignment has a value exceeding EUR 6,000.
The TCA provides certainty to a range of businesses impacted by Brexit, and allows tariff free trade to those who can comply with the formal and material origin requirements. To do so, companies willing to benefit from preferential treatment will have to determine whether their products are originating, based on the TCA’s rules of origin, and apply for a REX number if they want to issue Statements on origin for exports from the EU to the UK.
On 18 December 2020, the OECD released a report outlining guidance on transfer pricing aspects related to the COVID-19 pandemic. This guidance focuses on how the arm’s length principle and OECD TP Guidelines apply to issues that may arise, or be exacerbated in the context of this crisis.
More specifically, the following four priority issues are discussed: (i) comparability analysis, (ii) losses and allocation of COVID-19 specific costs, (iii) government assistance programmes, (iv) and advance pricing agreements (“APAs”).
As the OECD recognises that the unprecedented change in the economic environment will create unique challenges in applying the arm’s length principle, it provides guidance on how this should be applied to issues that may arise in the context of COVID-19, and under which circumstances that a change in TP policy would be acceptable. In this context, it would be important to first understand how the COVID-19 crisis affected economic circumstances and market conditions in which MNEs operate, in order to determine whether a company can be considered eligible for COVID-19 related TP adjustments. To determine whether the company would be eligible for such change, it will be important to demonstrate the impact of COVID-19 on the industry in which the MNE, the Group concerned and individual entity level operate, taking into account options realistically available to assess whether it would be fair to expect a review of current TP policy as the most realistic and attractive option for the parties concerned.
If a company would be eligible for such TP policy change, taking into account the above considerations and a quantification of the specific COVID-19 impact on the business, it will be important to prepare the necessary transfer pricing documentation; the OECD stipulates in its report that “Taxpayers should undertake reasonable and appropriate due diligence in evaluating the likely effects of the COVID-19 pandemic and in implementing changes in their transfer prices.”
This would hence be achieved by preparing the relevant transfer pricing documentation, which would entail a factual (or qualitative) and an economic (or quantitative) analysis. The factual analysis will consist of reviewing legal agreements in place, and reviewing the functional and risk profile before and after COVID-19 adjustment, taking into account the impact of government grants on TP policy. Following this, third party behaviour should be observed to confirm whether they would act in a similar way. For the economic analysis, the OECD recommends using multiple TP methods to support the need to change the TP policy, and using statistical methods (such as a regression analysis) to predict the impact of COVID19 on the financials of comparables. The mere adjustments to historical TNMM analyses without any substance behind them (in terms of comparability) are not sufficient and at times not even recommendable (e.g. inclusion of previous economic crises (2008) data in current set of TNMM comparables, use of LQ of current TNMM analysis, inclusion of loss making comparables with different risk profile than tested party).
Given the document’s release date, taxpayers that have not yet included such price adjustment mechanisms in their controlled transactions can still make use of these mechanisms for FY2020, through adjusted invoicing or intercompany payments made in a later period (e.g. FY2021), as far as domestic law allows.
Losses and allocation of COVID-19 specific costs
Since many MNE groups incurred losses due to a decrease in demand, and have faced an inability to obtain or supply products or services because of exceptional, non-recurring operating costs, the OECD discusses three issues that require specific guidance when considering the issue of losses and allocation of COVID-19 specific costs.
First of all, it will be important to note that the allocation of risks between parties to an arrangement affects how profits or losses resulting from a transaction are allocated at arm’s length. The OECD notes that it will be necessary in all circumstances to consider the specific facts and circumstances when determining whether a so-called “limited-risk” entity could incur losses at arm’s length. The OECD TP Guidelines contain a possibility for simple or low risk functions to incur losses in the short-run. Such determination should be done based on the transaction’s accurate delineation and on the performance of a robust comparability analysis.
Secondly, exceptional and non-recurring operating costs consequent to COVID-19 should be allocated based on an assessment of how independent enterprises under comparable circumstances would operate. The OECD notes that it is important to keep in mind that the treatment of such “exceptional, non-recurring, extraordinary” costs, incurred because of the pandemic, will not be dictated by the label applied to such costs but by an accurate delineation of the transaction, an analysis of the risk assumed by both parties to the transaction, how independent enterprises may reflect such cost, and finally, how such costs may impact prices charged in transactions between associated enterprises.
Finally, the pandemic created conditions in which associated parties may consider whether they have the option to apply force majeure clauses, and revoke or revise their intercompany agreements. However, it cannot be automatically assumed that, when such force majeure clause is included in the agreement, the COVID-19 pandemic is sufficient for that party to that contract to invoke force majeure. Nor can it be assumed that, in absence of such provision, the agreement’s renegotiation would be inappropriate from an arm’s length perspective. Whether COVID-19 constitutes force majeure in a specific case will depend on the plain language used for the force majeure provision, on the parties’ conduct, and on the accurate delineation of the controlled transaction itself. An analysis of the commercial arrangement’s economic circumstances will be crucial to determine whether - at arm’s length - a party would decide to invoke such force majeure clause.
Government assistance programmes
For government assistance programmes, the availability, substance duration and take-up of these programmes can have potentially broad transfer pricing implications. The OECD notes that the extent to which government grants are an economically relevant characteristic can vary. Particular attention should be paid to the competitiveness and price elasticity of the relevant market when determining whether an associated party would be able to retain such government assistance, as this would typically influence the behaviour of third parties to retain benefits derived from such government assistance.
Advance pricing agreements
Finally, as for APAs, the OECD states that the pandemic and the consequently dramatic economic and market conditions are likely to qualify as a breach of critical assumptions in an APA, provided that the impact for the taxpayer can be demonstrated by numerous factors. However, whether there has been a breach in a critical assumption should be analysed on a case-by-case basis, taking into account the taxpayer’s individual circumstances and the commercial environment. It is important to note that the OECD recommends taxpayers to notify the relevant tax administrations as soon as possible, regarding any material change in economic conditions that could lead to the breach of one or more of the critical assumptions embedded in an existing APA. Finally, the OECD mentions that where taxpayers and tax administrations are negotiating APAs aimed at covering FY2020, all parties are encouraged to adopt a flexible and collaborative approach in determining how to account for current economic conditions. For example, consideration could be given to agreeing a short period APA covering the period affected by the COVID-19 pandemic, and a separate APA covering the post-COVID period.
Impact of this OECD guidance
Based on this guidance, it is recommendable for MNCs to perform a detailed analysis of the pandemic’s impact on current group TP policy, and proceeding with the necessary pricing adjustments where needed, while taking into account government assistance programmes as well as any potential and exceptional costs arising. In addition, taxpayers should closely monitor the impact of COVID-19 on critical assumptions that affect their APAs, if applicable. Please note that a critical review of COVID-19’s impact on the current transfer pricing policy’s application cannot be considered as optional from an arm’s length perspective, given that third-party comparables will typically perform the same exercise. Although we are already early 2021, it is not yet too late to perform such a critical review. However, the time for companies to act is now. Japanese MNCs with an 31 March financial year-end could still consider necessary pricing adjustments where needed during the current financial year closing on 31 March 2021.