Most of the Transfer Pricing literature focuses on when to exclude a comparable that is losing money. There is a different, and often more delicate, question: what to do when it is the tested party itself—not a potential comparable—that consistently reports losses, while the group as a whole is profitable.
Why This Pattern Almost Automatically Attracts Attention
An entity performing routine, low-risk functions—a limited-risk distributor or a contract manufacturer—would, in theory, be expected to earn a stable level of profitability, even if modest. When that same entity reports sustained losses over several fiscal years while the group as a whole remains profitable at the consolidated level, this creates an apparent inconsistency with its stated functional profile: if the entity truly assumes limited risk, it should not be expected to bear recurring losses.
Legitimate Explanations That May Support the Result
Not every recurring loss is indicative of a transfer pricing issue. Genuine business circumstances may justify such losses, including a start-up phase involving significant initial investments or a deliberate market penetration strategy that prioritizes market share over short-term profitability.
Losses may also result from adverse macroeconomic conditions affecting the entire industry in that jurisdiction or from identifiable operational inefficiencies unrelated to the transfer pricing policy. For example, poor cost management could similarly affect an independent third party in the same circumstances.
Why the Burden of Proof Rests with the Entity, Not the Tax Authority
When the entity under review shows recurring losses inconsistent with its low-risk functional profile, the tax authority does not need to prove that a problem exists: the inconsistency itself is sufficient to justify a more in-depth review. Therefore, it is up to the entity to substantiate, with specific and quantifiable evidence, which of the legitimate explanations applies to its specific case, and why that circumstance does not invalidate the low-risk functional characterization it maintains in its study.
What Documentation Supports That Defense
A contemporary business plan that anticipated losses during a startup phase, evidence of actual investment in market development, a comparison with industry trends in that specific jurisdiction during the same period, or an analysis showing that the losses stem from factors identical to those faced by comparable independent entities—these are elements that support the claim that the loss is consistent with the declared risk profile, and not a sign that the entity’s compensation is undervalued.
At TPC Group, when an entity under review reports recurring losses, we evaluate the consistency of that situation with its stated functional profile, as well as the supporting documentation required to defend it before the tax authority.
Sources: