When Limited Risk Isn’t So Limited: Why Some LRDs Can Report Losses

In transfer pricing, the question of whether a limited-risk distributor (LRD) can legitimately report a loss is one that keeps tax practitioners and regulators alike scratching their heads. The very title, "limited-risk," implies a nearly guaranteed profit, often rendering the concept of an LRD operating at a loss as something almost heretical. Tax authorities generally frown upon losses for LRDs—after all, if risk is limited, why should profit be, too? That’s the consensus in tax audits around the world: if an LRD reports a loss, expect some serious eyebrow-raising and possibly some hefty transfer pricing adjustments to ensure it falls back into the black.

However, as with many things in transfer pricing, the world isn’t always black and white. While rare, there are indeed scenarios where an LRD might incur losses that are justifiable and—gasp!—even legitimate. Think market upheavals, natural disasters, or geopolitical dramas, all of which can disrupt even the best-laid transfer pricing arrangements. For instance, the COVID-19 pandemic did not discriminate; it hit high-risk and low-risk entities alike, throwing otherwise steady LRDs into financial chaos. During the pandemic, several countries acknowledged that the economic downturn, supply chain disruptions, and lockdowns impacted even low-risk entities. For example:

• France and the Netherlands allowed LRDs to report losses if they could demonstrate that the pandemic's economic impact significantly disrupted their operations. In these cases, tax authorities accepted losses as long as they were documented with solid evidence of market disruption.
• Germany issued guidance that allowed entities to adjust transfer prices temporarily due to pandemic-related losses, provided there was evidence showing that independent companies in similar industries were also incurring losses.
• Japan also released COVID-specific guidance indicating that LRDs affected by reduced demand and extraordinary costs due to the pandemic could report temporary losses without immediate adjustments, aligning with the OECD’s guidance on exceptional circumstances.

Situations like natural disasters or major logistical disruptions have led some countries to accept temporary losses for LRDs. For example:

• Following the 2011 tsunami in Japan, the Japanese tax authority accepted that affected LRDs, which incurred costs for inventory loss, logistics breakdown, and market contraction, could report losses for that fiscal year, given the clear external impact.
• The Suez Canal blockage in 2021 created significant disruptions for some LRDs involved in logistics or manufacturing, impacting inventory and sales. In some cases, tax authorities in countries like Germany, the UK, and Italy acknowledged the situation, accepting temporary losses as long as the LRDs could substantiate the impact on operations.

But market disruptions aren’t the only potential culprits. Consider an LRD venturing into a new market: the startup phase often comes with a wave of initial investments, promotional spending, and restructuring that can all erode profits.  Some countries, such as Australia and Canada, accept that an LRD entering a new market may incur short-term losses due to upfront investment, promotional activities, and operating costs associated with establishing a presence. For example:

• Australia has allowed LRDs to report losses during a defined "startup period" in a new market, as long as the entity could demonstrate that losses were due to market-entry expenses and that an independent third party in a similar position might reasonably incur such costs.
• In India, tax authorities have shown flexibility during the startup phase for LRDs if they could prove that the losses were tied to expenses required to establish a customer base or gain market share, typical in an arm’s-length scenario.

At the other end, exit costs from closing a market presence can have similar effects. And then there are those delightful restructuring costs within the multinational group—system overhauls, redundancies, and any “rebranding” initiatives that headquarters decides are suddenly essential—all of which can cause losses to trickle down to the LRD level. Certain tax authorities are open to accepting one-time losses for LRDs if they can demonstrate that the loss is due to a corporate restructuring or reorganization.

• For instance, Ireland and Luxembourg have accepted that LRDs undergoing restructuring (like moving operations or integrating new systems) may report losses in the transition period if these costs are well-documented.
• In Belgium, LRDs that incur costs due to group-wide restructuring events, such as integrating new IT systems or redundancies, may receive leniency, provided the LRD can demonstrate these are one-off, non-recurring costs outside of normal operations.

Another source of LRD losses, albeit one that no one likes to discuss too loudly, is transfer pricing errors. Yes, transfer pricing mistakes happen, and if an LRD hasn’t been adequately compensated for the functions it performs or the risks it shoulders, losses can and do appear on the books. It’s a practical reminder of the importance of getting the transfer pricing right—especially for LRDs whose profitability is meant to be a sure bet.

That said, any reported losses for an LRD require serious documentation and a defensible position. Tax authorities will undoubtedly question how a “low-risk” entity ended up in the red, so building a credible story is key. This story should align with transfer pricing principles and economic reality, showing that these losses aren’t arbitrary but reflect genuine business challenges or extraordinary circumstances. One handy line of defense? Consider whether a third-party distributor, under similar contractual arrangements, would reasonably shoulder such losses. After all, if independent distributors accept short-term losses under specific conditions, there’s a case to be made for the LRD’s predicament.

Of course, all of this must tie back to the intercompany agreements. Transfer pricing is as much about contract as it is about calculation. Agreements should reflect the genuine risk profile of the LRD, and they should be reviewed to ensure that the risk allocation between the LRD and the principal is appropriate. Arbitrarily shifting risks to the LRD—because, let’s face it, tax authorities are paying close attention—could be deemed non-arm’s length, opening the door to potential disputes.

In the end, while the idea of an LRD reporting losses may seem counterintuitive, there are circumstances where it can be justified. The key is in the documentation, the rationale, and, of course, the contract. And if all else fails, let’s just hope the principal has a decent legal team on standby.