Introduction
The term limited (or low) risk distributor (LRD) is widely used in transfer pricing discussions and is generally understood to refer to a routine entity within a multinational group that earns low, relatively constant returns. Most transfer pricing practitioners and tax authorities agree that an LRD, due to its limited risk profile, should not typically incur losses. However, the definition of an LRD remains ambiguous, particularly regarding the specific risks it bears and how to benchmark its returns appropriately. This article aims to establish broad-based criteria for defining LRDs and to clarify how their returns should be benchmarked.
Defining the Limited Risk Distributor
Neither the U.S. transfer pricing regulations nor the OECD Transfer Pricing Guidelines provide a clear definition of an LRD. The OECD Guidelines (Chapter I, Section D.1.2.1.1, paragraph 1.72) outline a range of risks that may exist within an entity transacting with a related party, including:
- Strategic or marketplace risks
- Infrastructure or operational risks
- Financial risks
- Transactional risks
- Hazard risks
Chapter IX of the OECD Guidelines discusses the conversion of a full-fledged distributor into an LRD, noting that some “going concern” value, such as inventory, bad debt, and market risks, may be transferred. However, the guidelines do not comprehensively specify which risks an LRD bears.
According to U.S. transfer pricing regulations, the risks to be assessed in a typical transfer pricing analysis include:
- Market risks (cost, demand, pricing, inventory fluctuations)
- R&D success/failure risks
- Financial risks (exchange and interest rate fluctuations)
- Credit and collection risks
- Product liability risks
- General business risks related to ownership of property, plant, and equipment
In theory, an LRD could be structured to bear virtually no risks, including market risks. However, practical scenarios and court cases indicate that LRDs may still be exposed to some market risk and, under certain circumstances, can generate losses. The key issue is determining which risks define a distributor as “limited risk” and under what conditions, if any, an LRD can incur losses.
Can an LRD Generate Losses?
The prevailing view is that as long as an LRD bears some degree of general market risk, it can experience losses, though these should not persist over the long term. The OECD Guidelines (Chapter III, paragraphs 3.64–3.65) clarify that:
“Simple or low risk functions in particular are not expected to generate losses for a long period of time. This does not mean however that loss-making transactions can never be comparable. In general, all relevant information should be used and there should not be any overriding rule on the inclusion or exclusion of loss-making comparables.”
Loss-making comparables should not be excluded solely on the basis of losses, provided their risk profile is comparable to the tested party. Recent court cases, such as Finland vs A Oy (Supreme Administrative Court, Case No. KHO:2021:73), have reinforced that tax authorities cannot automatically exclude loss-making comparables when benchmarking LRDs if those comparables are otherwise suitable.
Benchmarking LRD Returns
When benchmarking an LRD using the Transactional Net Margin Method (TNMM) or Comparable Profits Method (CPM), the standard approach is to identify third-party distributors as comparables. However, these third-party distributors typically bear more risks than an LRD and do not self-identify as LRDs. Standard working capital adjustments are made to align the tested party with the comparables, but these adjustments do not account for risk differences.
An analysis of publicly available distributor data (2011–2021) from Standard & Poor’s Capital IQ database reveals:
- 69 distributors had average operating margins below -4% of sales over 10 years.
- 162 distributors had negative average operating margins.
- 175 distributors had average operating margins above 8% of sales.
- Most distributors reported operating margins between 0% and 6% of sales.
- Approximately 15% of distributors lost money over the entire 10-year period.
- About 16% earned robust returns of 8% or more.
This dispersion highlights that loss-making is not uncommon, even among routine distributors.
Example: Reasons for Distributor Profits or Losses
| OM Value (%) | Distributor | Reasons for Losses/Profits |
|---|---|---|
| <-4 | Ramgopal Polytex Limited | Market volatility and competition led to losses. |
| -4 to -2 | Ossia International Limited | Decline in sales due to closure of non-performing outlets and challenging retail climate. |
| -2 to 0 | Northamber plc | Increased administration costs for strategic expansion led to losses despite margin improvement. |
| 0 to 2 | Lawson Products, Inc. | Costs increased due to ERP implementation and strategic shift to larger, lower-margin customers. |
| 2 to 4 | TTA Holdings Limited | Financials reflected restructuring and clearance of aged inventory. |
| 8 to 10 | RS Group plc | Outperformance driven by customer growth and improved customer satisfaction metrics. |
| 10 to 12 | Pool Corporation | Sales growth due to strong demand and effective supply chain management. |
| >12 | MSC Industrial Direct Co., Inc. | Competitive advantage from investments in supply chain and inventory management solutions. |
Almost all distributors, regardless of profitability, cite market or general economic risks as key factors influencing their results. Even distributors with positive average returns may experience losses in individual years.
Adjusting for Risk in Benchmarking
Standard transfer pricing analyses often make working capital adjustments to comparables, but these do not address differences in risk profiles. The key risk not accounted for is market risk, which most third-party distributors bear but an LRD may not. The only reliable way to benchmark LRD returns is to:
- Compute the working capital-adjusted operating margin for comparables.
- Make an additional adjustment for differences in market risk between the comparables and the LRD.
As noted by other transfer pricing experts, and supported by the OECD and U.S. regulations, adjustments for market risk are appropriate when they can be reliably calculated.
Conclusion
A precise definition of an LRD should consider the degree and type of risks borne, particularly market risk. Benchmarking LRD returns requires not only standard working capital adjustments but also a reliable adjustment for market risk differences. LRDs are not inherently precluded from incurring losses, especially if they bear some market risk, but persistent losses over many years are inconsistent with their limited risk profile. Without proper risk adjustments, benchmarking for LRDs remains unreliable.
A forthcoming article will propose a practical methodology for making market risk adjustments in LRD benchmarking.