By Guillermo Narvaez, Tax Partner at Kreston FLS Mexico
The OECD guidance on the transfer pricing implications of the Covid-19 pandemic (referred to as the “Guidance”) was issued in December 2020. The idea was to give light to taxpayers and tax administrations on what to do about intercompany operations and how to apply the methodology of transfer pricing determined in the OECD TP Guidelines (“OECD TPG”) due to ‘fact patterns that may arise commonly in connection with the pandemic’.
There is a permanent discussion in transfer pricing related to ‘limited risk’ distribution operations and how to deal with this kind of transaction. A point to stress is whether a limited-risk distribution business could afford losses or these businesses are not ‘entitled’ to generate them.
There is neither a rule in the OECD TPG nor the Guidance related to losses generated by limited-risk distribution operations. Moreover, the term ‘limited risk’ is not defined in the OECD TPG. However, what is expected is that distributors with low risks have profits regularly and if losses are generated these should be part of an isolated fact not frequently repeated; however, this is only convention. When a subsidiary has full support from its related parties to make the distribution of products with moderate risks, the least expected thing is to deal with risks that could finally drive operating losses.
The fact is that a limited-risk operation can indeed generate losses, and this matter should not be a concern for the taxpayer nor the tax authority as long as the risks associated with the distribution operation and borne by the distributor, including the financial risk, are assumed by the latter.
If the terms of the agreement between related parties were those that independent businesses would have agreed and the negative operating result of the distribution operation is directly coming from applying such terms, the loss will probably make sense. Note that risks during a pandemic may be exacerbated. Nonetheless, the contractual terms should not be necessarily modified because of force majeure.
The Guidance is clear when it states that ‘It is important to emphasize that in the absence of clear evidence that independent parties in comparable circumstances would have revised their existing agreements or commercial relations, the modification of existing intercompany arrangements and/or the commercial relationships of associated parties is not consistent with the arm’s-length principle’.
Each case should be analysed to understand the background and effect of the pandemic on the specific operation accurately to get conclusions on what to do when a loss is incurred by a low-risk distribution operation.
Another matter is that the pandemic does not suffice to change the transfer pricing method applied in previous years. The Guidance is clear with regard to fostering the OECD TPG aims without modifying the arm’s length principle and its rules, all of them determined in the OECD TPG.
The Guidance is focused on giving light on what is needed to do in an extraordinary event like the pandemic suffered since the beginning of 2020 but in some cases with a very general view.
For More Information, Please Contact Us