A short guide for transfer pricing and tax professionals on force majeure clauses in intercompany agreements and other key legal points to consider when revising transfer pricing policies in response to COVID-19

The OECD’s evaluation of the impact of COVID-19 containment measures on economic activity (as updated on 14 April 2020) suggests that “the initial direct impact of the shutdowns could be a decline in the level of output of between one-fifth to one-quarter in many economies, with consumers’ expenditure potentially dropping by around one-third. Changes of this magnitude would far outweigh anything experienced during the global financial crisis in 2008-09.” (The full report can be accessed here.)

As a result, many multinational groups are finding that their existing transfer pricing policies no longer work in this new, altered environment. Disproportionate profits may be accruing in certain entities, and unforeseen losses in others. The need to revise transfer pricing policies does not just relate to groups which are adversely affected by the current coronavirus pandemic – some multinational enterprises are experiencing an unexpected upturn in revenues and profits or are able to thrive by adapting their business models. Those groups may also need to make radical revisions to tax and transfer pricing compliance strategies.

Of course, updating transfer pricing policies is not simply a matter of reviewing the economic analysis and comparables and replacing the existing TP policy documents. It also involves (amongst other things) considering the current legal structure of the group and its intercompany agreements, designing an appropriate future structure (whether this is intended to be temporary or ongoing as the ‘new normal’), and considering how to make the transition from the current state to the future state in a manner which is consistent with both the arm’s length principle and the legal duties of directors.

A number of the transfer pricing professionals with whom we work globally, have asked for guidance on how force majeure clauses work, whether those clauses can justify terminating existing legal agreements and replacing them with new terms, and what other key legal considerations apply when revising the legal implementation of transfer pricing.

This article provides an overview of:

a. Force majeure clauses, how to read them and what impact they have in practice;

b. Other legal grounds which may potentially entitle a party to terminate an intercompany agreement or suspend performance; and

c. A suggested framework for considering the revision of intercompany agreements from a wider legal perspective.

A. Force majeure clauses

The term ‘force majeure clause’ may be used to describe any contractual provision which anticipates that there may be some sort of event beyond the control of the parties, which inhibits the parties’ ability to perform the contract and which justifies modification of their respective obligations as a result. A force majeure clause does not necessarily need to be labelled as such.

In many common law jurisdictions, the term ‘force majeure’ has no defined legal meaning, and the effect of these clauses is largely a matter of contractual interpretation. Other legal systems may have a separate body of law which applies to relieve parties of obligations on the occurrence of unforeseen events, even if no express contractual provision exists.

The anatomy of a typical force majeure clause

A typical force majeure clause can be broken down into three elements:

• The Trigger Event: this is the definition of the external event which triggers the operation of the clause.
• The Hurdle: this defines how severe the disruption caused by the event must be, in order for the consequences specified in the clause to apply (see the following bullet point). A high hurdle may require the trigger event to ‘prevent’ performance or make it ‘impossible’ to perform a party’s obligations. A lower hurdle may, for example, require it to be ‘unreasonable’ or ‘impracticable’ for the relevant party to perform, or may merely require performance to be ‘hindered’.
• The Consequences: this element of a force majeure clause prescribes the impact on the parties’ obligations, if the specified conditions apply (i.e., the trigger event and the hurdle). This generally includes extending time for performance and excluding liability for non-performance (or delayed performance). The specified consequences may also include enabling a party to terminate the agreement early if the interrupting event continues for a specified period of time, subject to the relevant party complying with any prescribed processes as regards the service of notice to terminate and, in some cases, the transition of services.

For example, breaking down a typical force majeure clause:

The Trigger Event: “Notwithstanding any other provision hereof, should the manufacture, supply, despatch or delivery of the whole or any part of the Goods be interrupted or prevented or hindered by …

The Hurdle: …any cause or causes whatsoever beyond the Seller’s control (for which purpose and without limiting the generality of the foregoing strikes, lockouts, breakdown of machinery, terrorist activity, insurrection, acts of war, flood, fire, pandemics, failure of IT systems or power supply or other utilities, failure or delay in delivery of goods and/or materials by third parties shall all be deemed beyond the Seller’s control) …

The Consequences: … the Seller shall be entitled to postpone or suspend any manufacture, supply, despatch or delivery or deliveries of the Goods until (in the Seller’s sole judgement) such cause or causes has or have been remedied and without prejudice to its rights to payment for any Goods already delivered. The Seller shall be under no liability whatsoever to the Customer for any loss or damage thereby suffered directly or indirectly by the Customer.”

In this example:

• The Trigger here is widely defined as “any cause or cause … beyond the Seller’s control”;
• The Hurdle is also widely defined as anything which ‘interrupts, hinders or prevents’ the ‘manufacture, supply, despatch or delivery’ of the goods; and
• The Consequences effectively provide for suspension of performance and exculpation from non-performance.

The limitations of force majeure clauses

Force majeure clauses do not typically apply to payment obligations (unless, for example, the performance of the contract has become illegal).

Importantly, these clauses also do not usually excuse a party from non-performance if its own conduct has prevented it from performing the contract, or if the contract has simply become unprofitable (or loss-making).

The construction of force majeure clauses tends to be very fact specific, and also highly sensitive to the interpretation and application of relevant laws.

Practical impact of force majeure clauses in intercompany agreements and transfer pricing

To the extent that existing intercompany agreements contain force majeure clauses, the interpretation and impact of those provisions constitutes an important part of the contractual allocation of risk: a key aspect of transfer pricing analysis.

However, force majeure clauses may be less relevant in practice than might first be assumed. This may be for two main reasons. Firstly, such clauses tend to be less common in intercompany agreements. Secondly, even where an intercompany agreement does contain a force majeure clause, that clause is only relevant if the conditions regarding the ‘trigger event’ and the ‘hurdle’ are satisfied, which may not be the case if the principal impact of COVID-19 for the group concerned relates to market demand.

B. Other potential legal grounds which may entitle a party to terminate an intercompany agreement or suspend performance

Invoking a force majeure clause is just one ground on which a party to a contract may seek to terminate or suspend performance of contractual obligations. Other possible legal grounds for the non-consensual termination or suspension of an agreement may include the following:

• Invalidity of the agreement, for example, due to lack of legal certainty in pricing clauses (this argument should of course be approached with caution, as it may undermine transfer pricing policies and documentation for previous periods).
• Non placement of orders or refusal to supply (depending on whether the relevant contract obliges the relevant party to make or accept supplies, or whether instead the contract merely provides a framework which governs the terms on which supplies may be made).
• Illegality of performance of the contract (this may relate to the governing or applicable law of the contract, or the law of the jurisdiction or forum, or the place of performance of the relevant obligations).
• Frustration of the contract (‘frustration’ is a legal concept which may apply, broadly speaking, where circumstances have arisen such that performance of a contractual obligation has become something radically different from that which was contemplated by the contract).
• Termination on notice without cause (if the contract provides for this).
• Termination for breach / non-performance / defective performance.
• Termination for insolvency or other events of default affecting the relevant party (i.e. the party not seeking to terminate the contract).

C. A suggested framework for considering the revision of intercompany agreements from a wider legal perspective

The question of whether one party has a unilateral right to terminate or suspend performance of a contract is just one factor in the process for planning a transition in legal arrangements. As between unconnected parties, even where no such right exists and the parties are ‘locked in’ to a long-term contract, it may be in both parties’ interests to renegotiate or restructure the business relationship.

The OECD’s Transfer Pricing Guidelines recognise this. For example, at para 9.4 / page 366 of the 2017 edition of the Guidelines it is stated that: “business restructurings may be needed to preserve profitability or limit losses, e.g. in the event of an over-capacity situation or in a downturn economy.”

In this respect, there is a substantial convergence between transfer pricing considerations (such as the ‘options realistically available to the parties’) and considerations arising from principles of corporate governance and the legal duties of the directors of the individual legal entities concerned. It is beyond the scope of this article to consider corporate governance issues in any detail, but for more commentary on this, see chapter 3 of our book ‘Intercompany Agreements for Transfer Pricing Compliance – A Practical Guide’.

The following points are suggested as a framework for considering the revision of intercompany agreements from a legal perspective.

1. Identify which legal entity or entities within the group need to be restructured (e.g. because they are accruing inappropriate profits or losses within the internal supply chain).
2. In relation to each such entity, identify which are the key intercompany transactions, which contribute to the unintended and inappropriate result.
3. For each such intercompany transaction type, identify the terms of the intercompany agreements in place (whether express or implied).
4. Consider how the relevant terms operate in the current environment. This includes:

• Pricing clauses;
• The presence or absence of contractually guaranteed returns; and
• Contractual allocation of risks such as inventory risks and credit risks.

For example, in cost plus type arrangements for the provision of services by local entities to the parent or entrepreneur, a key question is whether the definition of ‘cost’ is such that additional causes relating to the coronavirus are include in the costs recharged, or are outside the recharge mechanism (and are therefore borne by the service provider).

1. Within that context, consider which party is seeking to terminate, suspend or renegotiate the agreement (or, importantly, would be seeking to do so, if the parties were not related parties). This is usually the party which is considered to be paying ‘too much’ or receiving ‘too little’ for the goods, services or intangibles (intellectual property rights) in question.
2. Identify what legal grounds exist which that party may rely on to terminate or renegotiate the arrangements. (Including the considerations listed in parts (A) and (B) of this article.)
3. Consider if the termination of contractual arrangements may entitle one party to compensation or indemnity, whether from a legal perspective or from an economic perspective.
4. Consider whether the proposed restructuring of contractual arrangements (if required) entails or implies a movement of people or assets. From a legal perspective, implementing such actions without proper consideration of third party elements (such as potential impact on defined benefits pension schemes) may trigger statutory liabilities which are far in excess of the value of the assets involved.

Concluding remarks

In principle, the legal considerations when reviewing and revising intercompany agreements in response to COVID-19 are no different to any other exercise for reviewing intra-group legal structures in connection with the revision of transfer pricing policies and business restructurings. As always, intra-group agreements need to be considered from a holistic perspective (including considerations of regulatory compliance, VAT, customs duties, intellectual property licencing and protection and other asset protection) in addition to governance and transfer pricing.

Finally, it should be remembered that for the purposes of managing personal liability risks of directors, the process by which legal intra-group arrangements are restructured is as important as the outcome. For this reason, and in order to comply with the principle of informed consent, in all but the simplest restructurings it is important to brief directors on what they are being asked to approve, why, and what the actual and likely implications are.