OECD Guidance on Covid-19 Transfer Pricing Implications: a China Perspective

The book is closed for the year 2020 but for taxpayers around the world, the pages are still not finished. Especially for multinational companies (MNCs) with a large volume of related party transactions, the uniqueness of fiscal year 2020 created a daunting challenge for them to navigate through the unprecedented economic environment, connect the dots between market situation and transfer pricing regulations and policies, and ensure—and convince the tax authorities—that the pricing of intra-group transactions aligned with the arm’s-length principle.

Providing much-needed answers to various practical questions, the Organization for Economic Co-operation and Development (OECD) released “Guidance on the transfer pricing implications of the COVID-19 pandemic” (the Guidance) on December 18, 2020.

The Guidance focuses on how the arm’s-length principle and OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations apply to issues that may arise or be exacerbated by the Covid-19 pandemic. In the Guidance, the OECD acknowledged that the economic impact of the Covid-19 pandemic varies widely across economies, and thus the appropriate application of the arm’s-length principle could not be achieved without consideration of the uniqueness of the economies in which a certain taxpayer operates.

China is a unique economy under the impact of the Covid-19 pandemic. It was the world’s first major economy struck by the pandemic, while it also appeared to be the first to recover from it. After its economic activities halted under a strict lockdown policy at the end of January and early February 2020, the Chinese government managed to contain the spread of the virus, and businesses have gradually got back on track since late February 2020. By the second quarter of 2020, China’s gross domestic product (GDP) achieved positive growth, so that by early mid-December its overall 2020 GDP exceeded 100 trillion renminbi ($15.5 trillion) for the first time, with year-to-year growth of 2.3%, becoming the only major economy to achieve positive economic growth in the world for year 2020 .

Further, although the Chinese transfer pricing rules are based on the arm’s-length principle, there are many unique concepts and approaches in local practices. To consider together with the economic reality in 2020, we expect the following questions will need to be answered as Chinese taxpayers are closing the 2020 accounting books and preparing for the year’s tax returns and transfer pricing documentation:

• could the local entity bear the exceptional costs incurred during the pandemic, and if not, how to treat those expenses in transfer pricing analysis;
• considering the uniqueness of the year and the economy, whether and how to adjust strategies in comparability analysis;
• how to deal with limited-risk entities’ “abnormal” financial results (losses or high profit) in an abnormal year;
• how to deal with various forms of government subsidies received during the pandemic;
• how would the pandemic affect China advance pricing agreements (APAs) signed or in negotiation?

Combining the view of the Guidance and the unique reality of the Chinese economy, this article will discuss these key issues faced by Chinese taxpayers in transfer pricing management, ranging from documentation to APAs.

Treatment of Exceptional Costs Incurred During the Pandemic

China was the first economy to be seriously affected by the pandemic in January 2020. The strict lockdown policies imposed by central and local government forced businesses to stop operations for weeks, resulting in unrecoverable fixed costs. Later on, with the easing of the lockdown and reopening of businesses, pandemic prevention expenditures were incurred for taxpayers to build a safe working environment. Many companies also introduced work-from-home mechanisms, which led to extra expenditure on IT and telecommunications infrastructure.

According to the discussion on exceptional costs in Chapter II of the Guidance, the allocation of exceptional costs among related parties during the pandemic should be determined by considering how these costs would be allocated between independent parties under comparable circumstances (paragraphs 47–50). In other words, if there is no evidence showing that the independent parties under comparable circumstances would charge the exceptional costs caused by the pandemic to their unrelated customers, in controlled transactions these costs should have stayed with the party in which the cost is incurred.

Bearing such costs, however, would potentially have a significant impact on the company’s financial results, which is an important consideration in a transfer pricing analysis.

From a China practice point of view, if Chinese taxpayers do have sufficient reasons and evidence to prove that exceptional costs have a significant impact on their financial results, they shall first consider how these expenses and risks should be allocated between related parties, based on accurate delineation of the transaction by looking into the functions performed and risk assumed by each party, and taking into consideration the group transfer pricing policies and existing related party transaction agreements, etc.

As for exceptional costs that should be borne by a local company, it may consider treating such costs as special factors so as to make reliable adjustment to the impact of these expenses when calculating the profit level indicator (PLI) and conducting the comparability analysis.

At the same time, to support the special factor treatment, taxpayers should keep a record of identification and quantification of the expenses, and collect supporting evidence on how independent parties would deal with such expenses under comparable circumstances, in order to stay prepared for potential inquiries from the Chinese tax authorities.

It is also worth noting that if taxpayers are able to obtain contemporaneous comparable data of 2020, the comparable companies are likely to bear similar exceptional costs. In this case, such special factors adjustments should not be unilaterally performed to the tested parties or transactions.

Comparability Analysis for the Pandemic Period

As mentioned above, the Chinese economy was on a unique trajectory in 2020. In addition to its status as the only major economy to achieve positive GDP growth, the economy also presented the following characteristics:

• Strong performance of the manufacturing sector: starting in February 2020, as China started to contain the spread of virus and regain its economic growth, the rest of the world was hit hard. As a result, although some advanced economies—especially the U.S—have sought to “decouple” and reduce their dependence on Chinese exports in recent years, the pandemic and the resulting stoppage of production elsewhere in the world has caused a resurgence of China manufacturing activities. According to China National Bureau of Statistics data published at end of December 2020, the Purchasing Manager index, and Comprehensive PMI Output index of China’s manufacturing activities were above the boom and bust line for 10 consecutive months since March 2020 ; while the Import and Export index has continued to expand for four consecutive months.
• Industries that could be benefiting from the pandemic: in China, there are some industries feasting on business opportunities created by the pandemic. Such industries include healthcare equipment, telecommunications services, takeaway foods, e-commerce and online entertainment, etc. In addition, due to restricted outbound travel as a result of the pandemic, industries such as luxury retail in China are also growing (“The ups and downs of luxury industry in 2020: Chinese market stands out and shows a new trend of digitalization and rejuvenation,” 21st century economic report, December 29, 2020).

The above characteristics of the Chinese economy in 2020 have raised questions for Chinese taxpayers applying the transactional net margin method (TNMM) on how to identify proper comparable companies for the year 2020, and which period of data of the selected comparables is to be used.

Consideration of Comparable Periods

Paragraph 14 of the Guidance clearly points out that the most reliable data for a comparability analysis should come from the same period as the controlled transaction. Moreover, quarterly financial data (paragraph 11) or separate testing periods (paragraphs 27–29) may be appropriate to solve the problem of data comparability to a certain extent.

Although 2020 was an up-and-down year for most Chinese companies, in the end many of them managed to close the year with positive growth thanks to a strong comeback in the second half of the year. Companies can therefore first analyze their own financial positions in 2020 and compare them with the normal budget data and growth plan in the pre-pandemic period, so as to determine whether a special consideration of transfer pricing analysis should be taken for the year.

If the analysis of taxpayers’ own financials shows that the relatively strong performance of later 2020 is adequate to offset the months of operation stoppage in January and February, resulting in generally normal fiscal year results, they may consider adopting a similar approach as in previous years (the common practice in China will be to use weighted average data of the three-year period prior to the taxable year due to the data lag in the database).

If a company’s financial position in 2020 was significantly different from its normal plan due to the impact of the pandemic (including both unfavorable and favorable situations, subject to specific industries), other methods should be considered. For instance, using the comparable data of 2020, quarterly data, making special factors adjustment to tested party data in order to make it comparable with pre-pandemic comparable data, conducting regression analysis, etc.

Consideration of Geographic Factors

The Guidance mentions that the effects of Covid-19 in different markets or the geographical differences of diverse government assistance may be key factors in a comparability analysis that should be considered; and whether there is a need to adjust other factors in the comparability analysis should also be taken into account (paragraphs 32 and 84).

Market comparability issues may emerge if taxpayers use TNMM analysis and selected comparable companies from other jurisdictions in the past. In this regard, taxpayers need to pay attention to the comparison of domestic and overseas comparables’ financial performance in the same period of 2020, and verify whether such geographic market differences have economic relevance to the taxpayers’ specific industries. If differences do exist, the search criteria may need to be revised to give potential Chinese comparables more consideration.

It is worth noting that consideration of geographic comparability factors does not mean other pivotal comparability factors such as function and risk should be ignored. For example, a listed Chinese company with the High New-Technology Enterprise qualification should not be regarded as comparable to a simple function Chinese company which does not own any non-routine intangible assets.

Finally, if it is indeed impossible to find ideal comparable companies (or transactions) from a geographic perspective, taxpayers may have to make certain comparability adjustments to make it feasible to adopt a more traditional approach when conducting the comparability analysis.

Losses and Transfer Pricing Adjustment

The Chinese tax authorities have always held the position that companies with simple functions and limited risks should maintain a reasonable profit level. (Article 28 of the Administrative Regulation for Special Tax Audit Adjustment and Mutual Agreement Procedure (Bulletin of the State Administration of Taxation [2017] No. 6):

“Enterprises engaged in a simple manufacturing activity such as toll processing or contract manufacturing, simple distribution, or contract R&D activities for overseas related parties, in principle, are expected to maintain a reasonable level of profit. If the aforementioned enterprise makes a loss, it should prepare a contemporaneous Local File for the loss years, regardless of whether it reached the thresholds prescribed in the “Bulletin on Issues to Improve Reporting of Related-party Transactions and Administration of Contemporaneous Documentation” (Bulletin of the State Administration of Taxation [2016] No. 42) or not. The tax authorities will focus on the review of Local Files of the aforementioned enterprises to strengthen monitoring and administration. If the aforementioned enterprise assumes risks and losses due to wrong decision making, under-utilization, sluggish sales, R&D failure, etc. which should be assumed by related parties, tax authorities have the right to conduct special tax adjustments.”

Such companies may include limited-risk distributors, contract manufacturers, toll manufacturers, and contract R&D service providers. If these types of companies should incur losses, they could be scrutinized as a key target of tax administration and potential audits by the Chinese tax authorities.

In contrast, paragraph 40 of the Guidance discusses whether “limited-risk” entities can have losses during the pandemic period, and holds that the key to addressing this issue is accurate delineation of the function and risk of the related party transactions.

In the context of the Covid-19 pandemic, it will be interesting to see the Chinese tax authorities’ position on this issue, given the unique and unprecedented nature of the pandemic’s impact on China taxpayers’ businesses.

Losses Incurred by Chinese Limited-Risk Companies

If a Chinese entity defined as “limited-risk” makes a loss in a controlled transaction, it shall fully demonstrate in its transfer pricing documentation whether the risk factor causing the loss should be borne by the entity itself according to accurate delineation of the transaction; for example, any factor that may be classified as “force majeure” in the inter-company agreement and thus to be borne by local entity.

On the other hand, if a limited-risk Chinese entity does suffer losses due to risks it should not bear, the company can seek transfer pricing adjustments to be compensated by its related party according to the arm’s-length principle.

It is worth noting that the compensation for limited-risk entities does not necessarily mean to ensure a fixed profit margin at entity level. For example, in contract manufacturing transactions between independent parties, the buyer may sometimes instruct the contract manufacturer (e.g., an original equipment manufacturer, OEM) to shut an under-performing production line, and compensate for the latter’s loss. Usually, such compensation will be arranged as a one-off reimbursement, rather than to augment the price of other product lines—which are still in normal operation—by allocating the losses of the shut product line and increasing other product lines’ cost pools.

Similarly, under the arm’s-length principle, the additional costs incurred by a party in controlled transactions could be compensated by its counter-party in a one-off transaction, but these costs are not to be added into the cost base of other products so as to reach an abnormally high price for products under normal operation.

Likewise, limited-risk distributors may have purchased inventories based on quantities and prices decided by related parties before the outbreak of the pandemic and then the pandemic occurred, which may have caused impairment risks for these stocks.

According to the arm’s-length principle, such impairment losses can be compensated by related party sellers, but as in a similar situation between independent parties the compensation is not to be conducted through future product transactions which could make the price abnormally low.

Transfer Pricing Adjustments of Losses or Abnormal Profits

Based on accurate delineation of the transaction, if a Chinese company’s financial results are affected by risks that it should not have borne, transfer pricing adjustment would be suggested to be performed so as to ensure the company earns an arm’s-length return in 2020. In the Guidance, the OECD recommends tax authorities maintain certain flexibility and allow taxpayers to make transfer pricing adjustments based on comparable data available after the tax return period (paragraphs 22–23)

On the other hand, it is also possible that Chinese limited-risk companies may have achieved extra profits in 2020 compared to normal years, for various reasons: for example, the Covid-19 pandemic caused disruption to some multinational groups’ overseas production, resulting in their Chinese manufacturing subsidiaries taking more orders; or domestic sales of some industries (e.g., luxury goods) increased due to inaccessibility to foreign markets caused by travel restrictions.

According to transfer pricing policies commonly seen, this kind of excessive profit earned by truly limited-risk entities should be remitted back to the principals through transfer pricing adjustment. However, under current Chinese regulations and practice, unless a company can prove that the excessive profit is caused by improper pricing in specific transactions (e.g., the import price of goods and materials), in practice, it could be difficult for Chinese companies to make the retrospective adjustment to lower local profit.

It may therefore be especially important for MNCs in these situations to carefully monitor the profitability of Chinese entities. The tax authorities may even view excessive profits of these limited-risk Chinese entities as a potential signal of the existence of location specific advantages (LSAs).

Transfer Pricing Treatment of Chinese Government Assistance Policies During the Pandemic

During the pandemic period, Chinese central and local governments issued a series of assistance policies to help companies survive the pandemic and maintain normal operations. According to the discussion in paragraphs 67–69 of the Guidance, Chinese government assistance such as rent relief, turnover tax and social security relief, loan discount, may be viewed as policies with economic relevance, and therefore need to be taken into account in the transfer pricing analysis.

For Chinese taxpayers, the main risk associated with government assistance programs is in comparability analysis. In other words, in 2020 and future years that may be affected by the pandemic, taxpayers should consider the impact of government assistance in different jurisdictions and industries when conducting comparability analysis to ensure that the analysis results truly reflect the pricing or profit level under the arm’s-length principle.

As discussed in the comparability analysis section above, if it is possible for taxpayers to select the data of a Chinese comparable company (or transaction) in the comparability analysis, the impact of government assistance can be relatively limited. Further, whether some specific items of government assistance should be included in the calculation of profit level indicator should be aligned with the treatment of comparable data, and a relevant adjustment should be conducted if necessary.

In addition, it should be noted that if taxpayers had made adjustments caused by special costs during the pandemic when calculating the PLI (see discussion above “Treatment of Exceptional Costs Incurred During the Pandemic”), it would be proper for them also to adjust for impact of government assistance items with economic relevance during the same period, so as to ensure the fairness and consistency of the comparability analysis.

Impact on Advance Pricing Agreements

In recent years, China’s tax authorities have encouraged MNCs to sign APAs and increased the resources input in APA negotiations, and the number of successfully concluded APA cases has increased (source: China State Taxation Administration (STA), Advance Pricing Arrangement Annual Report (2019), published October 29, 2020). The Covid-19 pandemic would not significantly hinder this trend, as the State Taxation Administration as well as the relevant local tax authorities will continue to drive the APA signing process via online and other means, so as to provide strong support for taxpayers to effectively manage transfer pricing risks and avoid double taxation.

As the OECD discusses in the Guidance, for fiscal years affected by the pandemic, Chinese taxpayers with existing APAs should consult with the tax authorities in charge in a positive and cooperative manner on whether the pandemic affects critical assumptions, and seek appropriate remedies on implementation of the APA (paragraph 96 of the Guidance). For situations where it is necessary to revise the APA, the revision should still be focused on the accurate delineation of the controlled transaction, as well as the proper application of the comparability analysis (which has been discussed above).

For taxpayers that are still in the APA negotiation stage, the impact of the pandemic should be considered as an important factor during negotiations, and it is in the interest of taxpayers to reach agreement with the tax authorities on the transfer pricing treatment of periods affected by the pandemic.

We have also recently become aware that some local tax authorities are discussing and exploring a simplified procedure for unilateral APAs (UAPAs). We suggest relevant taxpayers with potential intent to sign a UAPA watch out for future updates on this.

Looking Forward

Overall, taxpayers should keep in mind that the arm’s-length principle, which is based on accurate delineation of controlled transactions and proper application of comparability analysis, remains the keystone of transfer pricing analysis and risk management. In the meantime, the pandemic provides a unique perspective on an MNC group’s global transfer pricing positions, as companies can take the pandemic as an opportunity to further establish a risk control mechanism to tackle issues such as unclear risk-bearing obligations, severe fluctuations of controlled entities’ profit margins, and difficulty in obtaining reliable comparable information.

Further, the pandemic has also shed light on some views and concepts advocated by Chinese tax authorities under the OECD base erosion and profit shifting (BEPS) framework. For example, do Chinese entities be assigned more functions and thus make contribution to the group supply chain from the value chain analysis perspective? Does the uniqueness of the Chinese economy signal potential existence of LSAs and warrant usage of local comparables? If interruption of some overseas supporting services did not significantly hamper the operation of the local entity, does this raise questions on the benefit and necessity of such services?

These questions need to be further answered by taxpayers and tax authorities for 2020 and future years that may be affected by the pandemic.

This column does not necessarily reflect the opinion of The Bureau of National Affairs, Inc. or its owners.

Any errors or omissions are the authors,’ and this article is written in the personal capacity of the authors. Neither the authors nor the global Deloitte organization—nor any of its member firms—can accept the responsibility for any loss related to any person acting on the information in this article.

Lian Tang He is a National Managing Partner of Deloitte China Transfer Pricing Services, based in Beijing; Mandy Yu is a Director and Andre Lu is a Senior Manager of Deloitte China Transfer Pricing Services, based in Shanghai.

The authors may be contacted at: lhe@deloitte.com.cn; manyu@deloitte.com.cn; andlu@deloitte.com.cn

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