Tag: Asymmetrical splits of profits and losses

OECD COVID-19 TPG paragraph 41

When considering the risks assumed by a party to a controlled transaction, tax administrations should carefully consider the commercial rationale for any purported change in the risks assumed by a party before and after the outbreak of COVID-19 (and taking into consideration the accurate delineation of such purported change). In particular, concerns may arise where before the outbreak of COVID-19 a taxpayer argues that a “limited-risk” distributor did not assume any marketplace risk and hence was only entitled to a low return, but after the outbreak argues that the same distributor assumes some marketplace risk (for example, due to changes in risk management functions) and hence should be allocated In this scenario, consideration should be given to re-examining whether prior to the outbreak of COVID-19 the “limited-risk” distributor genuinely did not assume any marketplace risk, whether after the outbreak the “limited risk” distributor did not actually assume any marketplace risk, and/or whether the assumption of this risk following the outbreak ... Read more

OECD COVID-19 TPG paragraph 40

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 ... Read more

OECD COVID-19 TPG paragraph 39

In all circumstances it will be necessary to consider the specific facts and circumstances when determining whether a so-called “limited-risk” entity could incur losses at arm’s length. This is reflected in the OECD TPG which states that “simple or low risk functions in particular are not expected to generate losses for a long period of time”,22 and therefore holds open the possibility that simple or low risk functions may incur losses in the short-run. In particular, when examining the specific facts and circumstances, the analysis should be informed by the accurate delineation of the transaction and the performance of a robust comparability analysis. For example, 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 transaction then such a comparable should be excluded from the list of comparables (see paragraph 3.65 of the OECD TPG). 22  Paragraph 3.64 of Chapter III of the OECD ... Read more

OECD COVID-19 TPG paragraph 38

When performing transfer pricing analyses, the activities performed by an entity may lead it to be characterised as “limited-risk” where it has a relatively lower level of functions and risks. 20 Though the term “limited-risk” is commonly used, since the term is not defined in the OECD TPG, the functions performed, assets used and risks assumed by “limited-risk” entities vary, and therefore it is not possible to establish a general rule that entities so-described should or should not incur losses. It should also be noted that neither the mere labelling of activities as “limited-risk” nor the fact that an entity receives a fixed remuneration means by itself that an entity operates on a limited risk basis in a controlled transaction.21 Further, no supposition should be made regarding the most appropriate transfer pricing method to apply in any set of circumstances without first undertaking a full and accurate delineation of the transaction, which then will help inform the choice of method ... Read more

OECD COVID-19 TPG paragraph 37

Finally, the COVID-19 pandemic has created conditions in which associated parties may consider whether they have the option to apply force majeure clauses, revoke or otherwise revise their intercompany agreements. This may impact the allocation of losses and COVID-19 specific costs between associated parties, and therefore also requires specific consideration in the current economic environment ... Read more

OECD COVID-19 TPG paragraph 36

Second, it will be necessary to consider how exceptional, non-recurring operating costs arising as a result of COVID-19 should be allocated between associated parties.19 These costs should be allocated based on an assessment of how independent enterprises under comparable circumstances operate. Separately, as extraordinary costs may be recognised as either operating or non-operating items, comparability adjustments may be necessary to improve the reliability of a comparability analysis. It is important to keep in mind that the treatment in a transfer pricing analysis of “exceptional,” “non-recurring,” or “extraordinary” costs incurred as a result of the pandemic will not be dictated by the label applied to such costs, but by an accurate delineation of the transaction, an analysis of the risks assumed by the parties to the intercompany transaction, an understanding of how independent enterprises may reflect such costs in arm’s length prices, and ultimately how such costs may impact prices charged in transactions between the associated enterprises (see OECD TPG paragraph ... Read more

OECD COVID-19 TPG paragraph 35

First, it is important to emphasise that the allocation of risks between the parties to an arrangement affects how profits or losses resulting from the transaction are allocated at arm’s length through the pricing of the transaction.18 Hence, the existing guidance on the analysis of risks in commercial or financial relations will be particularly relevant for determining how losses are allocated between associated parties. 18 Paragraph 1.58 of Chapter I of the OECD TPG ... Read more

OECD COVID-19 TPG paragraph 34

During the COVID-19 pandemic, many MNE groups have incurred losses due to a decrease in demand, inability to obtain or supply products or services or as a result of exceptional, non-recurring operating costs.17 The allocation of losses between associated entities can give rise to dispute and hence is an issue that requires consideration given the probable increase in the frequency and magnitude of losses in the current economic environment. When considering the issue of losses and the allocation of COVID-19 specific costs, three issues warrant specific discussion. 17 For example, this might include expenditure on personal protective equipment, on IT infrastructure required to implement a “test and trace” system, measures to reconfigure office space to implement physical distancing requirements, or on other health-related safety equipment ... Read more

TPG2018 Chapter II paragraph 2.115

References to “profits” in this section should generally be taken as applying equally to losses. That is, where a transactional profit split method is determined to be the most appropriate method, it should generally also apply, and apply in the same way, regardless of whether the transaction(s) result in a relevant profit or loss. Asymmetrical splits of profits and losses (i.e. where the parties apply different considerations depending on the results of the transaction) might be arm’s length, but should be used with caution and appropriately documented ... Read more