As the COVID-19 pandemic and its effects on the economy evolve, the analysis of its consequences for transfer pricing purposes has mainly focused on the impact it has had on global supply chains and the profitability of many taxpayers worldwide. Taxpayers will be required to support those consequences in their transfer pricing result for the year 2020 (and possibly onwards), considering the economic impact of the pandemic.
One of the most important questions today is how tax authorities will evaluate extraordinary circumstances in the wake of COVID-19. In principle, we expect tax authorities to become more aggressive, seeking to raise local tax revenues, countering the effects of a shrunken tax base while funding additional government spending.
In an attempt to understand how Latin American authorities may react to extraordinary circumstances and their application for transfer pricing, this article summarizes different approaches taken for transfer pricing tax administration by tax authorities during earlier crisis or difficulty. In the first two cases, we summarize court cases focusing on comparability adjustments performed by taxpayers under extraordinary circumstances and the associated disputes with local taxing authorities. Finally, we provide an example of how a country, not following the OECD guidelines, such as Brazil, has approached extraordinary circumstances from a transfer pricing perspective.
Aventis Pharma SA
On February 26, 2010, the National Tax Court (NTC) decided the case on Aventis Pharma S.A. (Aventis). The Argentine Revenue Services (AFIP for its name in Spanish) objected to one of the comparable companies selected and certain adjustments performed by the taxpayer in the application of the transactional net margin method (TNMM). The intercompany transaction at issue was the importation and resale of products by Aventis’ Argentinian operations from affiliates during the fiscal year 2000. In the years 1998 to 2002, Argentina experienced an economic depression primarily due to the collapse of the currency system and the unprecedented levels of borrowings.
The AFIP challenged one of the selected comparable companies, Bentley Pharmaceuticals, Inc. (Bentley Pharma), due to its recurring losses arguing that losses were a consequence of activities not comparable to those performed by the taxpayer. Furthermore, the AFIP challenged the price adjustments applied to the tested party’s sales, which were affected by the disruption of the supply chain during the crisis.
The NTC validated both the comparability adjustments and the inclusion of Bentley Pharma as a comparable. The NTC rejected the AFIP arguments indicating that they are merely rhetorical and not supported by the evidence, as shown by the analysis presented by the taxpayer. Therefore, the AFIP’s burden of proof was not met. Most importantly, the NTC determined in its assessment that neither the local Argentine regulations nor the OECD Guidelines establish that comparable companies with consistent losses should be rejected solely for the said reason in the application of the TNMM.
Volkswagen Argentina SA
In this case, the AFIP accepted the TNMM as the selected method as well as the proposed comparable companies, including certain adjustments presented by Volkswagen Argentina, S.A. (Volkswagen Argentina) for analyzing its export transactions with related parties for the fiscal year 1999. Specifically, the taxpayer made idle capacity, dismissal compensation and bad debt adjustments to its financial results and compared the adjusted profitability against the range of results obtained by the comparable companies. These adjustments were intended to consider the economic impact of the economic crisis described previously. The AFIP generally accepted the approach to these adjustments; however, it challenged that the same adjustments should have been applied to the comparable companies, arguing that the financial results of the comparable companies would have been likely affected by similar extraordinary events.
On July 12, 2010, the NTC ruled the case in favor of the taxpayer. The NTC recognized the difficulty in obtaining detailed financial results of worldwide comparable companies and proving that the results had not been likewise affected by layoffs, debt defaults and idle capacity. Similar to the Aventis Argentina case, the NTC emphasized the ruling on the burden of proof, indicating that the AFIP had not presented the “compelling arguments” or any method under which they reached their conclusions on adjusting the results of the comparable companies. Therefore, the NTC rejected the challenge imposed by the AFIP and decided that no income tax adjustments should be made in the case of Volkswagen Argentina.
Toyota Argentina S.A.
The AFIP also objected to the transfer prices of another taxpayer in the automotive industry, Toyota Argentina, S.A. (Toyota Argentina), for the same fiscal year 1999. Similar to Volkswagen Argentina, Toyota Argentina was severely affected by the economic crisis. Notably, the AFIP challenged the comparability adjustment made by Toyota Argentina because of its extraordinary level of idle capacity in 1999 relative to the level of the comparable companies. AFIP argued that the taxpayer could not apply the adjustment unless it proved that any extraordinary losses caused by idle capacity were also not present in the financial results of the comparable companies that were not Argentinian residents. Furthermore, the AFIP maintained that the taxpayer should apply the adjustment calculated, based on the difference between the median idle capacity of the interquartile range, established by the comparable companies, and the taxpayer’s level of idle capacity.
On September 2, 2014, the National Supreme Court of Justice validated the ruling of the NTC of April 2011 on the Toyota Argentina case, again in favor of the taxpayer. The court found that the AFIP could not base its argument on mere assertions without providing the burden of proof, with an indication of the level of idle capacity of the comparable companies.
On June 14, 2018, the Colombian Administrative Litigation Chamber of the State Council (the Chamber), resolved an appeal presented by Vidrio Andino S.A. (Vidrio Andino) against the assessment of a transfer pricing adjustment imposed by the Colombian Tax and Customs National Authority (DIAN for its name in Spanish) related to the Vidrio Andino’s transfer prices, during the fiscal year 2006. Vidrio Andino experienced financial difficulties, during 2006, due to its exceptional business events. Specifically, Vidrio Andino had built additional capacity in Colombia, making substantial investments resulting in higher than usual operating expenses for the fiscal year 2006.
Vidrio Andino operates as a manufacturer of a variety of glass products and serves customers in Colombia, Ecuador and Venezuela. Vidrio Andino performed the operating expense adjustment to eliminate the extraordinary costs incurred, during 2006, as part of its transfer pricing study. DIAN rejected the comparability adjustment arguing that operating expenses, such as personnel expenses, generally do not give rise to comparability adjustment as they are considered recurring for companies, including Vidrio Andino and are not extraordinary expenses in nature.
The Chamber, however, had accepted the comparability adjustment applied by Vidrio Andino, indicating that Vidrio Andino incurred extraordinary operating expenses, during 2006, because of the establishment of a new plant. Furthermore, the Chamber rejected DIAN’s reasoning that the comparability adjustments for extraordinary events are limited to “unforeseeable” or “unavoidable” events. Most importantly, the Chamber argued that it is entirely possible to justify comparability adjustments due solely to the taxpayer’s business circumstances, referencing the OECD Guidelines. Colombia’s transfer pricing law and the OECD Guidelines state that economic or market conditions and business strategies, among others, should be considered when determining comparability between the tested party and comparable companies. Second, the Chamber indicated that, although the comparable companies experienced increases in their overhead expenses, these increases were far less than those experienced by Vidrio Andino. Also, the Chamber observed that Vidrio Andino was unable to generate enough revenue to cover the overhead expenses, unlike the comparable companies, due to the implementation of a specific business strategy.
In short, it was confirmed by the Chamber that Vidrio Andino suffered an exceptional economic circumstance that had to be eliminated with a comparability adjustment, as recognized by the local legislation and the OECD Guidelines.
This case did not deal specifically with difficulties generated by an economic crisis but rather dealt with the practice of adjusting for conditions faced by taxpayers relative to those faced by the comparable companies. Therefore, this case may give some indication of how DIAN and the Chamber might view similar adjustments made to deal with the effects of COVID-19.
Brazil had a different approach in addressing transfer pricing uncertainty during economic crises and established a transfer pricing relief program for eligible companies.
Since the 2008 global financial crisis, Brazil’s currency appreciated considerably relative to currencies of important export markets. As such, the companies with significant export transactions were severely affected by currency appreciation. As a result, the Brazilian federal tax authority issued Portaria 563 in 2011, which allowed the application of an adjustment mechanism on the transfer prices on export transactions to related parties for the fiscal year 2011. The adjustment permitted by this guidance was made for purposes of demonstrating compliance with the relevant transfer pricing guidance under the cost-plus approach (i.e., statutory 15% return).
According to these rules, certain exporting companies were allowed to increase their export prices by 11% for transactions conducted during 2011. The objective was to reduce the effect of the appreciation of the Brazilian currency in relation to foreign currencies. In practical terms, by considering such relief, taxpayers would be able to eliminate the need for the transfer pricing adjustment to reach compliance under the cost-plus approach for 2011 in Brazil.
For example, in 2011, if an exporting company had a transfer price of R$100, for calculation purposes, the price increased from R$100 to R$111 (i.e., 100 + 11%) by applying the export price increase allowance. If the comparable price determined under the cost-plus approach was R$110 for the same product, the export price became higher than the comparable price (i.e., R$111 vs. R$110), and as such, no transfer pricing adjustments were required for this transaction.
The Brazilian federal tax authority established this transfer pricing relief program to account for the currency movements during the financial crisis. This was a unique approach taken by the country with specific transfer pricing requirements. Generally, the comparative level of adjustment is required to account for differences, and any adjustments should be clearly explained for the countries that follow the OECD Guidelines.
The issues discussed above are material and relevant for anticipated transfer pricing disputes. The trends we can observe from the Argentine court cases are that the tax authority demands taxpayers to prove that comparable companies do not experience similar extraordinary circumstances. The tax court has sided with taxpayers and shifted this burden of proof on to the tax authority. The case in Colombia tells us that the extraordinary adjustment will most likely be warranted to increase the reliability of comparability between tested party and comparable companies. Most notably, the cases in Argentina and Colombia referenced and quoted the OECD Guidelines as an aid to the local legislation to establish their rulings. The Brazilian federal tax authority may adopt a similar relief program in anticipation of the difficulties that may be experienced by the companies operated in Brazil while it continues its efforts to align its transfer pricing regime with the OECD Guidelines.
In summary, anecdotal evidence shows that tax authorities in Latin America, like Brazil, may enact unilateral relief that may not help everyone but may favor specific industries or transactions. On the other hand, Latin American tax authorities that follow the OECD may resist the application of comparability adjustments for extraordinary circumstances to a TNMM. However, if taxpayers thoroughly document their own fact pattern and circumstances, they may find a concurring voice within the courts, or avoid the discussion altogether.
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