By Gagandeep Nagpal and Bhrigu Dhingra
Given the scale of disruption caused by COVID-19, many businesses are posed with a serious risk of dislocation of their supply chains and inability to meet business obligations, resulting in potential breach of legal contracts. Business owners have started assessing their contracts to understand the extent of their rights and obligations, and the remedies available. This has brought the force majeure clause in business contracts to the spotlight. This clause has equal relevance in related party business arrangements as well. Below, we will discuss the peculiarities of this clause, and its relevance in the context of transfer pricing.
What is a Force Majeure clause?
The French term ‘force majeure’ is a clause in a contract to regulate the rights and obligations of contracting parties and its legal effect, when an extraordinary event or circumstance beyond the control of parties occurs. Force Majeure creates a kind of exception to foundational contract law principles, and contracting parties are usually absolved from performing their contractual obligations on its invocation, which otherwise is construed as a breach of the contract. An application of the force majeure clause would depend on the facts and circumstances of each case. Besides this, a contract may itself provide the course of action to be followed in the event force majeure triggers.
A sample force majeure clause reads as below:
“Neither party shall be liable for any delays or non-performance resulting from circumstances or causes beyond its reasonable control, including, without limitation, acts or omissions or the failure to cooperate by the other party (including, without limitation, entities or individuals under its control, or any of their respective officers, directors, employees, other personnel and agents), fire or other casualty, act of God, epidemic, strike or labour dispute, war or other violence, or any law, order, or requirement of any governmental agency or authority.”
There are differences between the legal basis to establish force majeure in common law and civil law countries. Under common law, there is no definition of force majeure; a party may only be able to rely on the principle of frustration to avoid performing the contract. Whilst in civil law countries, the general law defines and provides remedies for force majeure, which may be in addition to what is provided for in the contract. So where civil law applies, if the contract does not provide for force majeure, the party that is impeded or unable to perform its obligations under the contract may still be able to rely on the general law to establish force majeure and obtain relief from the performance of the contract.
Malaysia’s Position on Force Majeure
Malaysia is a common law country and there is no general defined concept of force majeure; however, that does not preclude contracting parties from incorporating such a clause in the legal contract. Section 57(2) of the Contracts Act recognises the concept of frustration of contract by providing that, “A contract to do an act which, after the contract is made, becomes impossible, or by reason of some event which the promisor could not prevent, unlawful, becomes void when the act becomes impossible or unlawful”. Therefore, the party invoking force majeure must establish the relationship between the impossibility of performance and the force majeure event. In case the contract does not contain a force majeure clause, or where the force majeure clause does not cover events such as COVID-19, alternative defences such as material adverse change/effect or the doctrine of frustration can be relied upon.
There are judicial precedents available in Malaysia in this regard. The key considerations and guiding principles emanating from a perusal of these judgments on this aspect can be summarized as below:
- A Force Majeure clause shall not be implied in a contract, i.e. it cannot be relied upon if the parties do not make any provision for it;
- Parties will have to assess the specific circumstances/events mentioned in their agreement that qualify as a force majeure event; and
- The party relying on a force majeure clause must show a causal link between the event and its inability to perform the contract. The alleging party must further prove that there is no other reasonable course of action, which is possible for performance of the contract.
This clause is subject to debate and dispute in transfer pricing as well. Interestingly, in a related party scenario, the invocation of force majeure may be a subject matter of dispute with tax authorities instead of a legal dispute with a contracting party under the Contract Act.
Transfer pricing implications
At the moment, there is limited transfer pricing guidance on this kind of legal aspects. A few relevant prescriptions extracted from the OECD TP Guidelines are –
- Understanding of contractual terms is considered to be the starting point for delineation of transactions under transfer pricing;
- Written contract definitely reflects the intention of the parties at the time the contract was concluded in relation to the aspects of the transaction covered by the contract. However, written contract alone is unlikely to provide all the information necessary to perform a transfer pricing analysis;
- In the context of business restructuring, it has been mentioned that there should be no presumption that all contract terminations or substantial renegotiations should give a right to indemnification at arm’s length, as this will depend on the facts and circumstances of each case. Further, it has been mentioned that the analysis of whether an indemnification would be warranted at arm’s length should be made based on the accurate delineation of the arrangements and the options realistically available to the parties.
With the above limited guidance, we need to apply the general lens of transfer pricing principles and the contract would be expected to be consistent (in terms of substance) with the arm’s length principle and should always be expected to reflect third party behaviour.
Given the COVID-19 situation and government-imposed restrictions, related parties may be unable to meet their contractual obligations. Under such a scenario, it is important to assess whether invocation of force majeure to relieve the transacting related party from performing its contractual obligations is consistent with an arm’s length behaviour. In an endeavour to better understand the transfer pricing implications of force majeure clause amidst COVID 19, the following scenarios have been framed-
Scenario 1 – A contract manufacturer in Malaysia produces auto parts for its related party in Thailand, which further uses these parts in the final assembly of main components. Due to COVID- 19, there was a 70% drop in end customer sales of the Thailand entity and it could not honour the volume committed to the Malaysian entity. This consequentially resulted in significant under-absorption of fixed cost and incremental carrying cost of inventory for the Malaysian entity. These parts are niche parts customised as per the specific requirements of the Thailand entity and the Malaysian entity did not have any options realistically available to sell these parts to any other customer. In such case, can the force majeure clause be invoked by the Thailand entity to absolve itself from the obligation to make good the losses incurred by the Malaysian entity?
Although this situation is arising from COVID-19, which is an unforeseen event, it would be difficult to prove impossibility of performance in such a case as it is merely a situation of financial and economic hardship. Therefore, issues like non-placement of orders due to depressed profits or supply side constraints, such as an alternate expensive route to ship the supplies, cannot be considered conditions for invocation of force majeure. The performance obligated under the contract should be objectively impossible and not merely difficult, more burdensome or economically onerous.
Scenario 2 – A captive service provider based in the Philippines provides accounts payable processing services to its Malaysian affiliate. Due to COVID-19, the Philippines service centre was not operational and could not process the supplier’s invoices for the Malaysian entity. The Philippines entity in such a case may invoke force majeure and may be discharged from its performance obligation and any consequential damages (such as interest levied by the suppliers of the Malaysian affiliate) due to delayed payments. However, in such a situation, can the Malaysian entity also take a position to relieve itself from its obligation to provide assured returns to the Philippines service provider and terminate the contract in entirety? The parties need to show that they have used reasonable actions to prevent or at least mitigate the effects of force majeure; therefore, re-negotiation seems to be a pragmatic response to such situations, considering the options realistically available rather than completely terminating contracts.
The other question to deal with here is whether tax authorities can question the commercial prudence of the taxpayer. Whether force majeure should be invoked or the contract should be renegotiated is a matter of commercial prudence of the taxpayer. Even in a third-party scenario, the transacting party may give concessions or provide flexibility to an extent, if there is a situation of impossibility of performance. Alternatively, parties may agree to less favourable contractual terms, if there are no options realistically available.
Scenario 3 – An oil and gas project is awarded to a Malaysian entity (M1) acting as the project owner, which outsourced part of the contract work to its group entity in Malaysia (M2) engaged in project management. Due to the Movement Control Order, M2 could not complete the project on a timely basis, which led to project delays. Herein, it would be critical to understand whether the party awarding the project to M1 gave any concession in terms of a relaxed timeline to complete the project or any re-negotiation of contract with M1. From a transfer pricing perspective, it would be prudent to replicate the similar modified terms in an agreement between M1 and M2. Such mirroring of an arrangement would help to establish the arm’s length behaviour and would help to defend against any possible scrutiny by the tax authority.
Force majeure is generally invoked in the rarest of rare situations, such as an act of Mother Nature or government actions. Even the recession arising out of a normal economic crisis may not result in invocation of this clause. Therefore, there are not many precedents available, especially in the context of transfer pricing.
In one of the interesting transfer pricing judgements in the past, the Danish National Tax Tribunal allowed relief to a Danish company on its transfer pricing adjustment taking into consideration the force majeure clause in the contract. The case concerns a Danish company that had a royalty claim from one of its subsidiaries, which, due to special circumstances in its home country, was unable to make payment of this royalty. The Danish Tax Authority increased the taxable income of the taxpayer on the ground that the Danish company was entitled to receive interest for this receivable. The taxpayer, however, disagreed with this view, since the disbursements were made impossible because of special circumstances in the subsidiary’s home country. The Danish National Tax Court found that the claim had risen solely because of the special circumstances of the subsidiary’s home country and the restrictions imposed by the authorities therein. These restrictions were considered to be beyond the reasonable control of the taxpayer and its subsidiary, and therefore, fell within the force majeure clause in the licensing agreement.
Malaysia is a hub for many contract manufacturers, captive service providers and limited-risk distributors, and discussion on this legal aspect from the transfer pricing perspective would certainly be relevant. Therefore, the following safeguards would be helpful for Malaysian taxpayers to effectively deal with transfer pricing implications arising from the force majeure clause –
- Define with specificity – Within the same group, related parties may not have enough motivation to define the contractual terms with specificity, as they are not so worried about protecting their own interest, unlike third parties. However, any vague contractual terms without specificity could give room to the tax authority to interpret the contract to their advantage. Therefore, defining the force majeure clause with specificity in the inter-company agreement is critical, viz. list out all possible events, define severity of disruption which should be caused by the event, and define the consequential rights and obligations of the transacting parties;
- Take necessary steps before its invocation – Invocation of force majeure should not be automatic. Give a reasonable notice period to the transacting related party and evaluate all options realistically available, before invoking the force majeure clause;
- Well supported documentation – There is a need to have adequate supporting documentation in regard to the interactions carried out with the transacting related party at the time of invoking the force majeure clause and documentation to establish that there is really a situation of impossibility of performance and further, that the same has arisen due to circumstances beyond the control of the transacting parties;
- Try to mirror third party behaviour – Keep a close watch on competitors or identify any close comparable or similar situation to mirror third party behaviour, as it would assist to ease the burden in establishing arm’s length behaviour;
- Assess the need for indemnification – Regardless of the presence of a force majeure clause or the applicability of alternative legal remedies, before seeking to terminate and/or renegotiate intercompany agreements for relief of non-performance, it is also critical to consider if the resulting economic impact may require that indemnification be given to the party who gets adversely affected due to non-performance;
- Contract vs conduct – Conduct should always be aligned to the contract and any re-negotiation of contractual terms reflected in the contract;
- Consistency in approach – Invocation may invalidate the consistency of TP positions, and therefore, TP documentation should be appropriately amended; and
- Signing and stamping – Intercompany contracts should be signed and stamped (may have possible stamp duty implications otherwise).
COVID-19 is certainly creating novel transfer pricing issues for taxpayers and tax administration, and the OECD has recently announced that the Inclusive Framework is exploring the option of developing guidance on these issues. Hopefully, some light will be shed on these legal aspects as well in the near future; however, until that time we need to find a solution based on the general principles of transfer pricing.
Gagandeep Nagpal is Director of Transfer Pricing, Deloitte Malaysia and Bhrigu Dhingra is Senior Manager of Transfer Pricing, Deloitte Malaysia.
The content in this article is the personal view of the authors and does not purport to reflect the views of Deloitte.