In determining whether or not a “limited-risk” entity may incur losses, the risks assumed by an entity will be particularly important. This reflects the fact that at arm’s length, the allocation of risks between the parties to an arrangement affects how profits or losses resulting from the transaction are allocated.23 For example, where there is a significant decline in demand due to COVID-19, a “limited-risk” distributor (classified as such, for example, based on limited inventory ownership – such as through the use of “flash title” and drop-shipping – and therefore limited risk of inventory obsolescence) that assumes some marketplace risk (based on the accurate delineation of the transaction) may at arm’s length earn a loss associated with the playing out of this risk. The extent of the loss that may be earned at arm’s length will be determined by the conditions and the economically relevant characteristics of the accurately delineated transaction compared to those of comparable uncontrolled transactions, including application of the most appropriate transfer pricing method and following the guidance in Chapter II of this note and Chapters II and III of the OECD TPG. In the example provided in this paragraph, the TNMM or potentially the resale- minus method depending on the more detailed facts and circumstances, might be used as the most appropriate method to test the arm’s length nature of the return, and third party comparable distributors might in these circumstances earn a loss, which may, for example, arise if the decline in demand means that the value of sales is insufficient to cover local fixed costs. It should be noted that the comparables chosen should be suitable in light of the accurate delineation of the transaction, in particular with reference to the risks assumed by each of the counterparties to the transaction. However, it will not be appropriate for a “limited-risk” distributor that does not assume any marketplace risk or another specific risk to bear a portion of the loss associated with the playing out of that risk. For instance, a “limited risk” distributor that does not assume credit risk should not bear losses derived from the playing out of the credit risk. For this reason, when determining whether an entity operating under limited risk arrangements can sustain losses the guidance in Chapter I of the OECD TPG, particularly as it relates to the analysis of risks in commercial or financial relations,24 will be particularly relevant.
23 Paragraph 1.58 of Chapter I of the OECD TPG.
24 Paragraphs 1.56 -1.106 of Chapter I of the OECD TPG.