Arm’s Length Principle in Transfer Pricing
The Arm’s Length Principle is an international standard established by OECD members for the determination of transfer prices in the tax field. This principle refers to the application of the international consensus regarding the valuation of goods and services and establishes that the price in a transaction between two associated parties must be the same as the price established in a comparable transaction between independent parties.
Specific Analysis for Companies with Recurring Losses
In the case of companies with recurring operating losses, there is an inconsistency with the economic reality, which must be particularly analyzed. Chapter I of the OECD Guide recommends a specific transfer pricing analysis when an associated company experiences this situation while the rest of the multinational group records profits.
Causes of Losses in Associated and Independent Companies
A company’s losses may be due to high start-up costs and unfavorable economic circumstances, among others. In the case of associated companies, they can continue with their activity if it contributes to the growth of the multinational group, whereas independent companies are not willing to bear losses indefinitely.
Control Risks for Declared Losses
When a company has carried out transactions with related parties and presents losses in the year in which it is obliged to declare Transfer Pricing, the probability that it will be subject to an audit process by the tax administration is quite high. Because of this, Transfer Pricing analyses are very important, in order to demonstrate that the prices agreed between related parties are made at market values without causing prejudice to the tax authority.
Key Factors in Loss Analysis according to the OECD Guidance
When a company has carried out operations with related parties and presents losses in the fiscal year in which it must declare transfer prices, the probability that it will be subject to an audit process by the tax administration is quite high. Due to this, transfer pricing analyses become very important to demonstrate that the prices agreed between related parties are made at market values without generating prejudice to the tax authority.
Documentary Support for Operating Losses
For this purpose, paragraph 1.131 of the OECD Guide indicates that the factor to be considered for the analysis of losses is the existing difference in the business strategies of the different multinational groups for historical, economic, and cultural reasons. For evidencing the losses, all the documentation supporting the negative results of the tested Company are not due to the prices agreed in related party transactions must be available. Likewise, the underlying causes must be identified and it must be demonstrated that the prices agreed upon in transactions between related parties are in line with the arm’s length principle. It is important to review the contracts and the functions performed by each party in the transaction, as well as to ensure that the functions, risks, and assets are allocated in a manner consistent with the arm’s length principle, even if losses are involved.
It is important to document everything that has generated the operating losses, such as the stage of the Company’s life cycle and investments in research and development, among others.