When conducting a transfer pricing (TP) review of distribution transactions, practitioners often encounter scenarios where the distribution entity – whether purchasing from a trading hub, an entrepreneur, or a manufacturing entity – is deemed to be on the low-risk end of the transaction chain. In such instances, these distributors are commonly referred to as low-risk distributors or limited risk distributors, relative to other entities involved in the transactions.
Usually, when a local distributor characterised as a limited/low-risk distributor incurs a loss, the following possible situations should be examined:
Is the profile correct – does the distributor indeed have a limited/low-risk profile?
Does the distributor correctly apply the TP model?
What are the reasons causing the loss?
Who had the possibility to control the risk causing the loss?
Who contributed to the occurrence of the risk causing the loss?
Is the loss extraordinary?
Can the loss be supported (or should it be adjusted through an upward TP adjustment)?
Although local distribution entities are often characterised in the TP policies and documentation as limited or low-risk distributors, determining their exact profile can be difficult, because, in practice, behind the same characterisation there are varying degrees of functions performed by, risks undertaken by, and assets involved with those distributors. This variation is one of the reasons why it is challenging to determine whether and when limited/low-risk distributors can bear losses.
Limited risk versus low-risk distributors – is there a difference?
Given the above, before the issue of whether and when losses of limited/low-risk distributors can be supported is addressed, the question should be asked as to whether there is a distinction between low-risk distributors and limited risk distributors and whether the answer to that question could indicate differences in the intensity of their functions, degree of exposure, and level of assets that could help in understanding the circumstances under which distributors can bear losses.
It is sometimes believed that a limited risk distributor, as the name suggests, assumes a narrower range of risks and functions within the distribution chain. They are primarily engaged in routine functions such as inventory holding, order fulfilment, and after-sales support, and do not participate significantly in strategic decision making or development, enhancement, maintenance, protection, and exploitation of intangibles (DEMPE) functions. Their exposure to market-related risks, such as market fluctuations, is limited.
In comparison, some tend to believe that a low-risk distributor is a broader concept that encompasses entities which do take a risk (even if low), with varying degrees of exposure. Their risk profile can differ depending on factors such as market conditions, industry dynamics, contractual arrangements, and the level of control they exercise over key functions.
There could also be a perception that the term ‘limited risk distributors’ is more established than the term ‘low-risk distributors’ and accordingly better defined in the OECD Transfer Pricing Guidelines (the OECD Guidelines). Both terms are used in the OECD Guidelines, but neither term is formally defined or elaborated upon.
The misbelief is probably due to the fact that the term ‘limited risk distributors’ is more frequently mentioned than the other. If we read discussions where ‘limited risk distributors’, ‘low-risk distributors’, or ‘low-risk distribution’ are mentioned, there are enough reasons to conclude that for the OECD Guidelines, ‘limited risk distributors’ and ‘low-risk distributors’ are interchangeable. As such, when analysing the critical question of this article, there does not seem to be a need to be overly critical about which term is more accurate and better explains or justifies which distributors may incur losses.
What is more important is not the ‘label’ used to name a distributor, but the substance of their operations, which should be established through a comprehensive and accurate analysis of the distributor's true functional and risk profile.
For the purposes of this article, the term ‘low-risk distributor’ will be used.
When can low-risk distributors incur substantiated losses?
When distributors have more substantial involvement in market development, marketing activities, brand promotion, or even product customisation, all of which would normally materialise in substantial spending and/or risks, that could lead to losses and become a problem for low-risk distributors, provided that a comprehensive and accurate analysis of the distributor's risk profile and subsequent TP arrangements demonstrates that they are indeed at the low-risk end of the transaction chain.
So what are the practical reasons that contribute to losses in distributors’ operations, and can such reasons be supported if they are low-risk distributors?
Below is a non-exhaustive list of reasons as examples for further analysis:
Market entry and development costs – during the initial stages or when entering a new market, distributors may incur significant expenses in marketing, promotion, advertising, and establishing distribution networks. These upfront costs can lead to temporary losses before the distributor starts generating sufficient revenue. Nevertheless, the level of such initial losses should correspond to the expected level of future profits (losses should be adequately recoverable in the longer term).
Change in market demand and competition, or level of maturity of the market.
Inventory management.
Foreign exchange fluctuations.
Economic conditions – economic downturns, changes in consumer preferences, political events, or unexpected external events (for example, COVID).
Pricing decisions/pricing strategy.
Operational inefficiencies – inefficient processes or inadequate cost-control measures.
Regulatory and compliance costs (for example, the introduction of environmental laws requiring a switch to carbon-neutral packaging).
The reasons listed above are only high-level ones and to validate whether a low-risk distributor should bear losses caused by each reason would require a lot more details for further analysis. Nevertheless, however complicated the issue may seem to be, there should an overarching principle or framework to apply when determining whether a low-risk distributor can bear the losses as a result of a reason, or a combination of reasons, given above.
Can a loss incurred by a low-risk distributor be justified by comparable data?
If we turn to the OECD Guidelines for a clue, we may find this helpful: "An independent enterprise would not continue loss-generating activities unless it had reasonable expectations of future profits. See paragraphs 1.129-1.131. Simple or low risk functions in particular are not expected to generate losses for a long period of time. This does not mean however that loss-making transactions can never be comparable" (paragraph 3.64 of the 2017 OECD TP Guidelines). Very useful guidance can be obtained from it that can be applied when analysing the losses of low-risk distributors: low-risk distributors are not expected to generate losses for a long period.
Drawing on this, albeit that the facts and circumstances may vary and be complicated, if any of the reasons above – for example, pricing decisions/pricing strategy, problems of inventory management, or foreign exchange fluctuations – causes losses for a long period, they appear hard to justify for a low-risk distributor, and sustained losses may prove that it is not a low-risk distributor.
Furthermore, according to the 2017 OECD TP Guidelines, "Generally speaking, a loss-making uncontrolled transaction should trigger further investigation in order to establish whether or not it can be comparable. Circumstances in which loss-making transactions/ enterprises should be excluded from the list of comparables include cases where losses do not reflect normal business conditions, and where the losses incurred by third parties reflect a level of risks that is not comparable to the one assumed by the taxpayer in its controlled transactions" (paragraph 3.65 of the 2017 OECD TP Guidelines).
If we interpret this correctly, we come to another piece of guidance: that, on the contrary, loss-making transactions/enterprises could be included in the list of comparables if their losses reflect normal business conditions and their losses reflect a level of risk that is comparable with that assumed by a low-risk distributor in its controlled transactions.
Taking losses caused by economic conditions as an example, economic conditions affect all players in the market but to different extents for companies in different industries or at different positions along the supply chain for the same industry.
Comparing the low-risk distributor's situation to other companies in similar circumstances provides insights into whether the losses incurred are within an acceptable range. In general, factors such as a downturn in the overall market, changes in consumer preferences, or unexpected external events would impact a company's ability to generate profits. If a comparability analysis shows that independent distributors operating in comparable economic conditions do not incur losses to a similar extent, it is strong evidence that losses incurred as a result of economic conditions cannot be supported in a low-risk distributor.
It is evident that the comparability analysis plays a crucial role in assessing the supportability of losses. Comparing the distributor's situation to other companies in similar circumstances can provide insights into whether the losses incurred are within an acceptable range.
However, the challenge is often undertaken with insufficient information and data of comparable transactions/enterprises. Despite the framework provided above being very useful, in reality, it can be difficult to determine whether a low-risk distributor should bear losses, even when the losses are short term and non-repeated; for example, losses as a result of market entry and development costs. Under these circumstances, it could be recommended to evaluate the distributor's functions and the activities undertaken during the market entry phase.
If the business activities of marketing, promotion, advertising, and establishing distribution networks or a customer base, and significant expenses incurred accordingly, clearly align with the contractual arrangements, and there are clear expected benefits for the low-risk distributor from incurring such upfront costs, which are reflected in the TP arrangement, and not the other way round that such benefits are to be enjoyed by (an)other related party/parties involved in the multinational enterprise group, it is reasonable to argue that such losses are supportable.
Lastly, one of the most important factors impacting the possibility of any related entity (not only a limited risk distributor) to incur losses is the ability to control the risk that could materialise in negative profitability. When answering the question of whether such a loss is acceptable, it should be analysed who had the ability to control the risk causing the loss and who contributed to the occurrence of the risk causing the loss.
Can low-risk distributors bear extraordinary losses?
Another challenge may arise in situations when the operating loss of a low-risk distributor is connected with the materialisation of an extraordinary risk, significantly exceeding the risks which may be reasonably assumed not only by the low-risk distributor but also by the whole group. Recent COVID history provides us with such cases happening in practice to local distributors conducting all their retail distribution operations solely through large shopping centres. Due to the COVID pandemic, all shopping malls in the country of operations were periodically closed down by the decision of the local government, and the local low-risk distributors were not able to cover their fixed costs and suffered losses as a result.
In the given case, it would be difficult to assume that such an extraordinary factor could have been anticipated by the group earlier, allowing the undertaking of preventative measures. It should be discussed, though, to what extent individual risks have been controlled locally or centrally during this difficult time, and how the losses should be borne or split between the low-risk distributor and the other companies in the supply chain. Nevertheless, it definitely should be recognised that losses due to extraordinary situations should be analysed based on individual circumstances.
The above interpretation – i.e., that loss-making transactions/enterprises can be included in the list of comparables (if their losses reflect normal business conditions and their losses reflect a level of risk that is comparable with the one assumed by a low-risk distributor in its controlled transactions) – is applied differently by various national pieces of legislation and tax authorities. Some local pieces of legislation accept the full comparable range, as well as the inclusion of loss-makers. Others, on the contrary, insist on the application of the interquartile range and the exclusion of loss-making companies, without further analysis of whether the losses refer to normal business conditions. In the latter case, substantiation of losses may not be acceptable at the local level and may require local TP adjustment or TP dispute resolution.
Final thoughts
Determining whether losses can be supported in low-risk distributors requires a comprehensive analysis of their functions, risk profiles, and TP arrangements.
While practical reasons for losses could exist, an evaluation of comparables and their normal business conditions is crucial in assessing the supportability of such losses.
Whatever the reason may be, there is no doubt that low-risk distributors should not systematically incur losses. If, however, losses occur in limited periods or under specific circumstances, by ensuring a thorough examination of incurred expenses in alignment with contractual arrangements and the anticipated benefits for the low-risk distributor, a robust validation process could be achieved.
