The rapid global scale outbreak of the novel coronavirus (COVID-19) has taken the world by storm. This disease has transformed into a global pandemic disrupting lives, crumbling healthcare systems, crushing livelihood, dwindling financial markets and devastating world economies alike in geometric progression.
The far-reaching, debilitating impact of COVID-19 can be clearly observed across various industries/sectors off late. The companies irrespective of their size of operations are already facing the brunt of multipronged problems emerging due to suspended operations, reduction in revenues, disruption of cash flow position, impact on supply chain management, dipping of profits, furloughed employee redundancies and so forth.
While Liquidity, Operationalization of supply chain (especially for the manufacturing units), and Sustainability remain the immediate focus the Groups will also have to re-look at the existing modus operandi and acclimatize its Transfer Pricing (TP) policy and design to the post-COVID-19 environment. In this integrated and inter-dependent world, cross border Transfer Pricing transactions among group entities, have a far-reaching impact on the global economy, MNE operations, financial flows, as well as each country's tax ecosystems.
While MNEs are looking at reviewing their transfer pricing policies, there is a dire need for Governments and Tax administration to provide clarity and guidance on effectively managing the impact of COVID-19 on their transfer pricing policies.
Towards this end, the Australian Tax Office (ATO) has introduced numerous tax relief measures to assist businesses and individuals experiencing financial difficulty due to COVID-19. The Australian Government has been focused on responding to the implications of COVID-19, and a whole raft of related measures such as guidance on permanent establishment matters, residence status of companies (central management and control), and individuals due to COVIDâ?'19 travel restrictions, etc.
On the transfer pricing front, the ATO has published guidance to help navigate businesses through the economic impacts of COVID-19 and changing related-party arrangements, which have been discussed in the ensuing paragraphs.
This guidance issued by ATO outlines the evidence and analysis that taxpayers should maintain to support their transfer pricing positions, including where they have applied (or are applying) for an Advance Pricing Arrangement. A brief summary of the guidance released by ATO is as follows:
Assessing the economic impacts of COVID-19 on transfer pricing arrangements
ATO has emphasized on gathering evidence to support any changes to, or impacts on, the business as a result of COVID-19 and advised the taxpayers to document the same. Certain parameters to assess the economic impact of COVID-19 on TP arrangements listed by the ATO are:
- Function, Asset and Risk profile of the Australian entity before and after COVID-19;
- Economic circumstances, where the actual economic impacts of COVID-19 on the Australian operations including a broader analysis of how the relevant industry has been affected;
- Changes in contractual obligations between the Australian entity and its related parties;
- Evidence of the impact (if any) of COVID-19 on the specific product and service offerings of the Australian entity and how this has affected the financial results; and
- Evidence of changes in business strategies as a result of COVID-19.
Supporting the arm's length nature of transfer pricing outcomes
The ATO has acknowledged that using comparable analysis may not reliably support arm's length outcomes of continuing transfer pricing arrangements impacted by COVID-19, particularly in the short term. In such scenarios, the ATO has sought to understand the financial outcomes that would have been achieved by the taxpayer, sans the impact of COVID-19, which would include:
- A detailed profit and loss analysis showing changes in revenue and expenses, with an explanation for variances resulting from COVID-19 or analysis of budgeted (pre-COVID-19) versus actual results;
- Details of profitability adjusted to where your outcome would have been if COVID-19 had not occurred - this should consider all factors that have a positive or negative impact on your profits and should be supported by evidence. An example of such evidence would be canceled order requests to demonstrate reduced sales revenue;
- Rationale and evidence for any increased allocation of costs or a reduction of sales (and subsequent changes in operating margins) to the Australian entity, taking into consideration its function, asset and risk profile;
- Evidence of any government assistance provided or affecting the Australian operations.
PCG 2019/1 and COVID-19 impacts
The Practical Compliance Guideline (PCG) 2019/1 addresses the transfer pricing issues related to Australian inbound distribution arrangements. The guideline provides a detailed risk rating of inbound distributors based on their profit level and functional factors. It also outlines the framework followed by ATO to allocate its resources for scrutinizing the TP arrangements of such inbound distributors.
The profit markers developed by ATO for assessing transfer pricing risk are based on the benchmarking exercise conducted using a five year weighted average EBIT margin. Considering the limitation of publicly available data regarding the pandemic's impact, the ATO has explicitly mentioned that it does not seek to review PCG 2019/1 due to COVID-19 currently.
However, a more detailed or updated guidance pertaining to PCG 2019/1 is expected to be released later this year.
Impact on Advance Pricing Agreements due to COVID-19
ATO has proactively encouraged taxpayers to engage with them in
case critical assumptions in the Advance Pricing Agreement (APA)
have been breached or are likely to be breached due to the negative
impact of COVID-19 on businesses. Under such a circumstance, the
ATO has sought to understand the impact on the APA of the breach
and consider appropriate outcomes such as business as usual,
renegotiating the APA over the time period of the demonstrable
impact or suspending/modifying the APA for a set period.
For ongoing APA negotiations, the ATO has stated that standard APA processes and analysis will continue to apply only where the economic performance of the taxpayer is not significantly impacted by COVID-19. If the business is significantly affected by COVID-19, the taxpayer should consider placing the APA application on hold or mutually end the APA process.
Consequent to the above guidance, the ATO has also published a notification intending to monitor tax advantages by changing related party arrangements in the COVID-19 environment. In this regard, the ATO has stated that it will review such changes by examining documentation to assess whether -
- Independent parties dealing wholly, independently in comparable circumstances would have mutually agreed to change the existing related party agreements or arrangements;
- A mismatch between the substance of the actual dealings or relations, and changes made to related party agreements or arrangements;
- Purpose of the changes to the agreements or arrangements was to obtain an Australian tax benefit
- Changes to the related party agreements or arrangements and the commercial justification developed in anticipation of a potential review by ATO originated with a tax adviser.
In addition, the ATO has also recommended taxpayers to inform them about any changes to related party agreements or arrangements due to COVID-19 and encouraged transparency in this regard to avoid future tax scrutiny.
Condonation of delay in preparing Transfer Pricing documentation
The Australian transfer pricing rules require you to prepare compliant transfer pricing documentation by the time your income tax return is lodged. Failure to prepare the documentation in time means you will not have a reasonably arguable position, which may result in the imposition of penalties.
The ATO will work with taxpayers that are affected by COVID-19 and who are unable to get their transfer pricing documentation in order before the lodgment of their current income tax return. In such cases, the ATO will take an administrative approach for penalties whereby ATO may remit the portion of penalties if the following criteria are met:
- Lodgment due date for income tax return was between 1 March and 15 July;
- TP documentation compliant with Subdivision 284-E was in place for the previous income year;
- There has been no material change to related party arrangements since the last income year;
- Completion of TP documentation on or before lodgment due date is otherwise reasonably arguable
The pro-active approach taken by the Australian Government on addressing the economic impact of COVID-19 on transfer pricing arrangements is commendable. The guidance provides clarity to taxpayers with respect to the changes and measures they can undertake on their transfer pricing arrangements to dampen and mitigate the adverse effects on their businesses. It lucidly states the approach taxpayers can adopt for ongoing unilateral and bilateral APA cases. All in all, the ATO emphasizes the need to document the economic impact in all possible ways by the taxpayer to support the arm's length nature of transfer pricing outcomes and demonstrate the need for changing related party agreements.
Additionally, w.r.t. ongoing APAs, the ATO is encouraging taxpayers to proactively engage as soon as the taxpayer becomes aware of any breach of the critical assumptions/terms related to APA or is certain that the breach of terms is likely to occur.
Expectations from Indian Tax Authorities in coming days:
Indian taxpayers are not immune and are scrambling to tide over this unprecedented crisis and stay compliant with their tax obligations, essentially pertaining to the transfer pricing compliance. The arguable point is how to validate the economic analysis to defend the downswing in transfer pricing outcomes during these unprecedented times.
Drawing an inference from the above guidance issued by the ATO, the Indian Tax Authorities can attempt to provide clear guidance to the affected taxpayers on how they should support the arm's length nature of their transfer pricing arrangements due to COVID-19.
Originally published 1 July 2020.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.