The Role of Distributors in Transfer Pricing: Exploring Profitability and Loss-Making Entities in OECD and US Transfer Pricing Regulations

Introduction

Transfer pricing plays a crucial role in determining profit and loss allocation within multinational enterprises (MNEs). One of the more frequently assessed analyses is the profit level a related party distributor should earn. A prevailing assumption in the field holds that related-party distributors, which are typically designated as “low-risk distributors” (LRDs), must maintain consistent profitability. However, during economic downturns or other material economic events, the question arises whether an LRD can lose money. This question is usually first assessed by seeking to define what precisely an LRD is, as contrasted to other types of distributors. This article seeks to examine both the characteristics of an LRD and, if a distributor is not defined as an LRD, what this means regarding the “consistent profitability” presumption.

Through analysis of regulatory frameworks, market evidence, and case studies, we demonstrate that the assumption of guaranteed distributor profitability is an unnecessary oversimplification. The function, asset, and risk (FAR) profile of a related party distributor must be assessed, among other assessments we will highlight herein.

Understanding Transfer Pricing in the Context of Distributors

Transfer pricing refers to the pricing of goods, services, and intangible property between associated enterprises within an MNE. Distributors serve as essential intermediaries between manufacturing entities and end customers in MNE supply chains. In transfer pricing practice, the norm is to presume that all distributors are LRDs. According to this “LRD norm,” the related party distributor will operate with a

limited risk profile and a modest profit margin. The inherent assumption is that the LRD faces no risks.

We note, at the same time, that both the OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations (OECD Guidelines) and the US Transfer Pricing Regulations follow the arm’s length principle according to which profits should be allocated based on the functions performed, assets used, and risks assumed (FAR). Therefore, automatically assuming that a distributor should always be profitable and bear no risks may be a false narrative. Neither the OECD Guidelines nor the US Transfer Pricing Regulations indicate a particular bias towards positive profits for distributors, especially if such distributors bear some level of risk. The US Transfer Pricing Regulations Section 1.482-1(2C) emphasizes:

(1) In general. The arm’s length result of a controlled transaction must be determined under the method that, under the facts and circumstances, provides the most reliable measure of an arm’s length result. Thus, there is no strict priority of methods, and no method will invariably be considered to be more reliable than others. An arm’s length result may be determined under any method without establishing the inapplicability of another method, but if another method subsequently is shown to produce a more reliable measure of an arm’s length result, such other method must be used. Similarly, if two or more applications of a single method provide inconsistent results, the arm’s length result must be determined under the application that, under the facts and circumstances, provides the most reliable measure of an arm’s length result.

The Internal Revenue Service (IRS) does not show a particular bias towards profit, but instead emphasizes the specific facts and circumstances of a controlled transaction.

Similarly, the OECD Guidelines recognize that enterprises can incur legitimate losses, as noted in Section 1.149:

“Of course, associated enterprises, like independent enterprises, can sustain genuine losses, whether due to heavy start-up costs, unfavourable economic conditions, inefficiencies, or other legitimate business reasons. However, an independent enterprise would not be prepared to tolerate losses that continue indefinitely.

An independent enterprise that experiences recurring losses will eventually cease to undertake business on such terms. In contrast, an associated enterprise that realises losses may remain in business if the business is beneficial to the MNE group as a whole.”

The Function, Asset, and Risk (FAR) Analysis Framework

A comprehensive FAR analysis thus forms the foundation for determining appropriate profit levels within an MNE. The following table outlines key elements typically assessed in a transfer pricing study:

Table 1: FAR Analysis Components

Functions
Research & Development	–
Product Design	–
Sales & Marketing	–
Advertising	–
Invoicing & Collections	–
Corporate Management	–
Human Resources & Payroll	–
Legal	–

Assets
Marketing Intangibles	–
Know-How	–

Risks
Market Risk	–
R&D Risk	–
Manufacturing Risk	–
Inventory Risk	–
Reputational Risk	–
Liability Risk	–
Foreign Exchange Risk	–
Bad Debts Risk	–

This assessment, including appropriately assessing market conditions and the distributor’s business strategies, will determine whether the distributor can be a loss-making entity. The risk portion of the FAR analysis is especially critical to determining the profit/loss result for the LRD.

Assumptions About Distributor Profitability and Risk

As noted above, current practice generally assumes distributors maintain profitability due to their limited risk profile. This assumption typically results in expectations of consistent, modest returns on sales (ROS), supported by contractual arrangements that minimize exposure to market fluctuations and business risks.

However, industry analysis reveals that in some instances, there may be material risks faced by distributors, as evidenced, for example, by 10-K filings of certain “technology-based” distributors:

TESSCO Technologies Incorporated Risks:

• Adverse global and national economic conditions or events (including health epidemics, trade wars, and other outbreaks and events beyond the company’s control)
• Significant competition in the industry
• Customer and supplier contracts – the company’s sales to customers and its purchases from suppliers are largely governed by individual sales or purchase orders, so there is no guarantee of future business; andJ
• Adverse financing terms

PC Connection Inc. Risks

• Market fluctuations (e.g., customer demand, rising interest rates, inflation, supply constraints);
• Price competition, which could result in a reduction of profit margins;
• Loss of vendors; and
• Methods of distributing IT products are changing and can negatively impact the company’s business

Softchoice Corporation Risks

• Business and Industry (e.g., retain customers and expand customer base, competition, dependence on relationships with technology partners, etc.);
• General Operations (e.g., recruiting, training and retaining quality employees, dependence on good employee relations, impact of indebtedness, etc.);
• Legal, regulatory and tax (e.g., lawsuits and regulation, compliance, internal control and risk management systems, maintenance of third-party technology licenses, etc.); and
• Ownership of the common shares (e.g., significant ownership by one shareholder, dilution, fluctuations in the market price, etc.)

As shown above, these technology distributors note material risks to their operations and disclose that these risks can significantly impact their profitability. These risks include competition, general economic market circumstances, legal issues, product supply issues, and even funding issues.

Special Risks and Circumstances Supporting Loss- Making Distributors

As noted above, despite the consensus that distributors are consistently profitable, there are situations in which a distributor may incur losses. We note specific market situations highlighted in transfer pricing regulations or the Guidelines.

1. Market Penetration Strategies

Distributors may legitimately operate at a loss when implementing market penetration strategies. The OECD Guidelines explicitly acknowledge this in paragraph 1.135:

“A taxpayer seeking to penetrate a market or to increase its market share might temporarily charge a price for its product that is lower than the price charged for otherwise comparable products in the same market. Furthermore, a taxpayer seeking to enter a new market or expand (or defend) its market share might temporarily incur higher costs (e.g. due to start-up costs or increased marketing efforts) and hence achieve lower profit levels than other taxpayers operating in the same market.”

Furthermore, in paragraph 1.151 of the OECD Guidelines, it states:

“Recurring losses for a reasonable period may be justified in some cases by a business strategy to set especially low prices to achieve market penetration… However, especially low prices should be expected for a limited period only, with the specific object of improving profits in the longer term.”

The US Transfer Pricing Regulations similarly support temporary losses for market penetration. Under Section 1.482-1 it states:

(4) Special circumstances—(i) Market share strategy. In certain circumstances, taxpayers may adopt strategies to enter new markets or to increase a product’s share of an existing market (market share strategy). Such a strategy would be reflected by temporarily increased market development expenses or resale prices that are temporarily lower than the prices charged for comparable products in the same market. Whether or not the strategy is reflected in the transfer price depends on which party to the controlled transaction bears the costs of the pricing strategy. In any case, the effect of a market share strategy on a controlled transaction will be taken into account only if it can be shown that an uncontrolled taxpayer engaged in a comparable strategy under comparable circumstances for a comparable period of time, and the taxpayer provides documentation that substantiates the following:

1. The costs incurred to implement the market share strategy are borne by the controlled taxpayer that would obtain the future profits that result from the strategy, and there is a reasonable likelihood that the strategy will result in future profits that reflect an appropriate return in relation to the costs incurred to implement it;
2. The market share strategy is pursued only for a period of time that is reasonable, taking into consideration the industry and product in question; and
3. The market share strategy, the related costs and expected returns, and any agreement between the controlled taxpayers to share the related costs, were established before the strategy was implemented.

Both the US and OECD agree that distributors can incur losses for a period of time while undertaking market penetration strategies

2. External Economic Conditions

Distributors may also experience losses due to adverse external economic conditions. During periods of economic downturn, distributors may face reduced consumer demand, increased competition, or rising costs, which can lead to temporary losses. In such cases, assessing whether independent distributors would similarly face losses under comparable circumstances is crucial.

The OECD Guidelines emphasize considering economic circumstances when applying the arm’s length principle. Section D.1.4. of the OECD Guidelines focuses on economic circumstances and emphasizes its importance as it can significantly impact pricing. The following is stated in paragraph 1.130:

“Economic circumstances that may be relevant to determining market comparability include the geographic location, the size of the markets; the extent of competition in the markets and the relative competitive positions of the buyers and sellers; the availability (risk thereof) of substitute goods and services; the levels of supply and demand in the market as a whole and in particular regions, if relevant; consumer purchasing power; the nature and extent of government regulation of the market; costs of production, including the costs of land, labour, and capital; transport costs; the level of the market (e.g. retail or wholesale); the date and time of transactions; and so forth. The facts and circumstances of the particular case will determine whether differences in economic circumstances have a material effect on price and whether reasonably accurate adjustments can be made to eliminate the effects of such differences.”

3. The Allocation of Risk

Another critical factor in determining whether losses for a related party distributor can be validated is the risk allocation within an MNE.

For example, a distributor that assumes inventory, foreign exchange, or credit risks may be more vulnerable to losses if sales do not meet expectations or if the specific market conditions deteriorate.

According to the OECD Guidelines, entities that assume greater risks should be entitled to higher potential rewards but must also bear the potential downside of incurring losses. As stated in paragraph 1.72. of the OECD Guidelines, these are the risks that should be considered when determining the allocation of risk within an MNE:

Strategic risks or marketplace risks;

• Infrastructure or operational risks;
• Financial risks;
• Transactional risks; and
• Hazard risks

However, the OECD Guidelines further note that:

“The following non-exclusive list of sources of risk is not intended to suggest a hierarchy of risk. Neither is it intended to provide rigid categories of risk, since there is overlap between the categories. Instead, it is intended to provide a framework that may assist in ensuring that a transfer pricing analysis considers the range of risks likely to arise from the commercial or financial relations of the associated enterprises, and from the context in which those relations take place.”

Therefore, the OECD Guidelines indicate that other risks may be considered and should be taken into account when assessing the risk exposure within the MNE.

Similarly, the US Transfer Pricing Regulations detail their list of relevant risks to consider when allocating the entity’s risk within an MNE:

• Market risks, including fluctuations in cost, demand, pricing, and inventory levels;
• Risks associated with the success or failure of research and development activities;
• Financial risks, including fluctuations in foreign currency rates of exchange and interest rates;
• Credit and collection risks;
• Product liability risks; and
• General business risks related to the ownership of property, plant, and equipment

Furthermore, the US Transfer Pricing Regulations state that in considering the economic substance of a transaction, the following facts are relevant:

1. Whether the pattern of the controlled taxpayer’s conduct over time is consistent with the purported allocation of risk between the controlled taxpayers; or where the pattern is changed, whether the relevant contractual arrangements have been modified accordingly;
2. Whether a controlled taxpayer has the financial capacity to fund losses that might be expected to occur as the result of the assumption of a risk, or whether, at arm’s length, another party to the controlled transaction would ultimately suffer the consequences of such losses; and
3. The extent to which each controlled taxpayer exercises managerial or operational control over the business activities that directly influence the amount of income or loss realized. In arm’s length dealings, parties ordinarily bear a greater share of those risks over which they have relatively more control.

The OECD Guidelines and the US Transfer Pricing Regulations both stress the importance of identifying risks and allocating them appropriately between the MNE and the distributor. Allocating certain risks to a distributor effectively defines how and when it can lose money or, conversely, earn more than marginal profits.

Empirical Case Studies

Case Study #1: Comparable Distributor Benchmarking Analysis

Companies classified as distributors have reported significant losses in recent years. Scalar performed a screen using the Standard & Poor’s Capital IQ database for distributors that reported two or more consecutive years of losses between 2015 and 2022. Of the 12 distributors included in the screen, five reported two years of consecutive losses, three reported three years of consecutive and four reported five years of consecutive losses. The results are presented in Table 2, Table 3, and Table 4 on the following page.

Scalar performed an additional screen to calculate the ratio of loss-making distributors to total publicly traded distributors. Of the 173 distributors reviewed between 2015 and 2020, approximately 10% or more reported losses each year. The results are presented in Table 5 on the following page.

The magnitude of reported losses, the length of those losses, and the proportion of distributors reporting losses are all material data points. This data contradicts the assumption that distributors are always profitable. In practice, additional FAR analysis and market analysis are needed to identify the reasons for losses, and applicability to the distributor subject to a transfer pricing study.

Case Study #2: Finland vs A Oy (2021)

The Finnish Supreme Administrative Court’s ruling (Case No. KHO:2021:73) validated loss-making distributors.

A Oy, part of the A group, acted as an LRD in Finland for its US Parent corporation. The target return on sales for the distributor was 0.5%. This ROS level was determined based on a comparable benchmarking exercise and a FAR analysis. Due to the low return level, the Finnish tax authorities engaged in an audit that reached the local Supreme Court. The Supreme Court ruled in favor of A Oy and, in its ruling, stated that the tax authority’s attempt to benchmark the tested party by eliminating comparable companies for reporting losses was not an acceptable approach.For clarity, court cases in other countries have found that

LRDs cannot make losses. However, there is no universal, definitive ruling or regulation against unprofitable LRDs. This further underscores the importance of rigorous FAR assessments and consultations with legal and tax advisors.

Table 2: ROS of Distributors Incurring 2 Years of Consecutive Losses

No.	Company Name	ROS FY15	ROS FY16	ROS FY17	ROS FY18	ROS FY19	ROS FY20	ROS FY21	ROS FY22	WA ROS (FY15-22)
1	Newpark Resources, Inc	-2.1%	-10.3%	4.2%	6.8%	1.9%	-14.3%	-2.7%	3.1%	-0.2%
2	PD-Rx Pharmaceuticals, Inc.	4.5%	3.6%	3.7%	3.6%	-0.3%	-1.1%	4.1%	13.9%	4.4%
3	Quarta-Rad, Inc.	6.0%	-4.4%	7.2%	-10.8%	-16.2%	2.9%	9.7%	12.5%	1.8%
4	Taitron Components Incorporated	-6.0%	-41.5%	10.4%	17.3%	10.3%	15.7%	24.2%	26.5%	8.6%
5	Vaso Corporatio	6.9%	2.2%	-5.3%	-5.0%	0.8%	1.1%	3.7%	8.8%	1.6%

Table 3: ROS of Distributors Incurring 3 Years of Consecutive Losses

No.	Company Name	ROS FY15	ROS FY16	ROS FY17	ROS FY18	ROS FY19	ROS FY20	ROS FY21	ROS FY22	WA ROS (FY15-22)
1	Ceres Global Ag Corp.	0.5%	-2.7%	-0.3%	-0.1%	0.3%	1.7%	1.1%	2.3%	0.8%
2	Innovative Food Holdings, Inc.	0.6%	9.4%	11.4%	3.7%	0.3%	-11.1%	-5.8%	-1.3%	0.0%
3	DNOW Inc.	-3.9%	-10.5%	-1.5%	2.3%	1.5%	-6.5%	1.0%	7.1%	-1.0%

Table 4: ROS of Distributors Incurring 5 Years of Consecutive Losses

No.	Company Name	ROS FY15	ROS FY16	ROS FY17	ROS FY18	ROS FY19	ROS FY20	ROS FY21	ROS FY22	WA ROS (FY15-22)
1	ABCO Energy, Inc.	-8.2%	-99.6%	-37.2%	-6.6%	-19.7%	-40.5%	-48.8%	-2.2%	-24.0%
2	ADDvantage Technologies Group, Inc.	7.5%	0.9%	-11.3%	-10.4%	-6.9%	-18.5%	-10.2%	1.2%	-5.3%
3	Boss Holdings, Inc.	4.6%	4.2%	4.1%	-5.2%	-5.3%	-7.4%	-2.4%	-4.5%	-1.4%
4	Sugarmade, Inc.	-148.9%	-45.8%	-66.3%	-54.3%	-118.7%	-283.4%	-112.2%	-125.8%	-118.6%

Table 5: Loss Making Distributors to Total Distributors Year-by-Year Basis

	2015	2016	2017	2018	2019	2020
Loss Making Distributors	18	21	17	17	17	23
Total Distributors	173	173	173	173	173	173
Percentage	10.4%	12.1%	9.8%	9.8%	9.8%	13.3%

Documentation Requirements

Organizations must maintain robust documentation, especially when a distributor begins to lose money, as the “norm” is that a distributor ought to consistently earn money. We note, however, that the transfer pricing regulations, together with market evidence, case studies, and court precedence, have all established that based on an appropriate FAR characterization, loss-making distributors can be a valid result. However, comprehensive documentation to support transfer pricing arrangements is essential, according to the U.S. transfer pricing regulations and the OECD Transfer Pricing Guidelines.

Documentation should explain the business rationale for losses, such as market penetration strategies or external economic factors, and demonstrate that the losses are consistent with the behavior of comparable uncontrolled distributors under similar circumstances.

In the case of market penetration strategies specifically, the MNE should provide evidence of the strategy’s objectives, an expected time frame, and the anticipated future profitability of the distributing entity.

Conclusion

The assumption of guaranteed distributor pro tability oversimpli es complex business realities. While most third- party distributors typically generate steady returns,

legitimate circumstances exist where losses occur. It is then important to establish for the related party distributor whether such circumstances align with its FAR and the legislative examples for losses according to the arm’s length principle. Market penetration strategies, specific economic conditions, and FAR risk allocation are all reasons that can support a distributor’s loss.

The OECD Guidelines and US Transfer Pricing Regulations recognize that losses may be consistent with arm’s length principles, provided appropriate justification exists. MNEs must carefully analyze and document the circumstances surrounding distributor losses to ensure regulatory compliance and defend their transfer pricing positions.

Contact Our Transfer Pricing Team

For more information or to request a client reference, please contact us:

• Samuel Scott
  samuel.scott@scalar.io

• Jared Christian
  jared.christian@scalar.io

• Jonathan Lubick
  jonathan.lubick@scalar.io