27 October 2020

The COVID-19 pandemic has made the lives of hundreds of millions of people around the world uncertain, wreaking havoc on all aspects of our daily lives. Governments and taxing authorities are grappling with not only how to keep the broader macroeconomy viable over the short run, but also how to bring the economy back to fiscal balance in the medium and longer term. In an article published by the Gowling WLG Transfer Pricing & Competent Authority Group entitled "CRA Audit Activity: The Calm before the Storm?", it was hypothesized that the Canada Revenue Agency ("CRA") would likely step up audit activity, after the COVID-19 episode is finally behind us, to reign in government deficits.



The added uncertainty that COVID-19 brings will no doubt impact the world of transfer pricing, particularly as it relates to locating reliable third party comparables for comparisons to related party transactions during this economic disruption. Those who work with comparables, practitioners and taxpayers alike, understand that locating comparables is difficult even in the best of circumstances. With the economic issues created by COVID-19, the selection of comparables will become even more difficult for two key reasons. First, COVID-19 will make it harder to infer reliable, arm's length profits to a member of a multinational corporate group based on data from the prior year results of a set of comparables. Second, COVID-19 will make it harder to ensure that costs incurred by the tested party (which directly impacts profits) are sufficiently similar to those of the comparables under consideration. These issues are significant, given the need to ensure consistency in data between the tested transaction and those of the comparables, to infer reliable conclusions on profits.

1. Impact on Comparables Selection

Setting prices and thus the allocation of profits for related party transactions usually involves benchmarking the returns one party (in some cases both) for a particular year against the returns of a set of comparables. Given that the financial data reported by comparable companies is published subsequent to current year transactions, i.e. for example the current period (or period 't') margins will be tested against those of a set of comparables using historical data (say t-1 to t-5). If we determine the profits of a related party in the 2020 taxation year (the year in which COVID-19 will have had a significant impact on profits), we would normally determine the reasonableness of the 2020 taxation year margins by testing them against the margins reported by a set of comparables using data from prior years. Clearly this situation is problematic, as margins reported by the tested party will likely be materially impacted by COVID-19 and the data from the comparables would not incorporate the economics of COVID-19. This mismatch of economic circumstances will continue for many years until COVID-19 is well behind us and when the economic circumstances of the tested party are comparable to the multiple year data provided by the comparables being considered.

How taxpayers and taxing authorities deal with this will not be easy given that COVID-19 will likely impact the economy for many years to come and introduce more uncertainty in what will undoubtedly be a more contentious audit environment. Negotiations during a tax audit on how to infer meaningful data from the comparable data will only add ambiguity to an already uncertain transfer pricing atmosphere.

2. Ensuring Comparability of Margins

With significant subsidies being offered by government bodies (federal, provincial/state, local), another issue that will make finding reliable comparable information more difficult involves how such subsidies are reported. In some cases they be reported as revenues and in other cases as a reduction to costs. Finding comparables often requires locating companies that have the same cost structure as those of the tested party. COVID-19 has resulted in governments around the world offering subsidies and other incentives needed to make corporations economically viable. Given these subsidies and the determination of who gets them is case specific, this could lead to controversy as to how we modify or examine the cost base of comparables, to make them more comparable to those of the tested party. The CRA's Transfer Pricing Memoranda 17 ("TPM") discusses the impact of government assistance on transfer pricing. In essence, the TPM requires that the cost base of the Canadian entity receiving the government assistance not be reduced, for transfer pricing calculations purposes, by the amount of the assistance. How other governments around the world will deal with this issue is not entirely clear and will most likely be resolved only in competent authority negotiations after audit adjustments have been raised.

3. Conclusion

Finding comparables for transfer pricing purposes is challenging in the best of times. The current COVID-19 pandemic will make this even more challenging, especially for the 2020 taxation year. Within a transfer pricing setting, profits of a multinational corporation in a given year are benchmarked against profits reported by selected comparables in previous years.

Companies in many industries will no doubt see 2020 profit materially impaired by COVID-19, while data reported by comparables (which utilized data no earlier than one year prior i.e. 2019) will not. As a result, there will be much more controversy as to where the arm's length profits should fall within the range. Taxpayers can expect greater audit controversy, especially if they have historically reported profits and now expect to incur losses.

Given this unique economic environment, taxpayers will need to defend their transfer pricing, not only through more robust comparables economic analysis, but also via stronger qualitative analysis (such as an industry analysis) to demonstrate that any intercompany prices selected, and thus reported profit, meets the arm's length standard.


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