2020 Pricing Implementation and TP Documentation Topics
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April 30, 2020




Hi There!,

As transfer pricing documentation requirements have become pervasive globally, certain transfer pricing positions have also become widespread. Due to the economic downturn caused by COVID-19, at least some of these common transfer pricing positions should be reassessed. One specific position that appears to have become a globally accepted axiom is the term low risk distributor (“LRD”) or low risk service provider (“LRSP”). This specific axiom states that LRDs and LRSPs cannot ever lose money. COVID-19 and the present economic downturn warrant a review of this widely accepted view.

The LRD and LRSP terms first emerged in transfer pricing cases in the early 1990s. During this time, the Internal Revenue Service in the United States was engaging in a large array of transfer pricing examinations. These transfer pricing examinations pertained not only to large multinationals, but also to smaller companies with cross border transactions. Tax practitioners, in an attempt to reduce future exposures of transfer pricing examinations for these small multinationals (as well as the large multinationals), adopted these terms: i.e., the LRD and LRSP.

The idea behind these terms was and is that LRDs/LRSPs perform limited and/or routine activities, and more importantly, bear low levels of risk or no risk whatsoever. As such, their returns, i.e., profits, should remain quite low. Over time, these terms and their “definition” evolved into a given by both transfer pricing/tax practitioners and tax authorities that the LRD/LRSP cannot ever lose money. Such was never the intention of the original terms. COVID-19 and the economic downturn has brought this misconception, i.e., that LRDs/LRSPs cannot lose money, to the forefront. So indeed, the question remains, can such entities lose money during an economic downturn?

Let us first ask a more basic question: What differentiates an LRD/LRSP from a distributor bearing minimum risks, or from a distributor bearing normative risks? The answer is less than straightforward. In theory, it will be the contractual terms that are signed between the companies engaging in the transaction. However, it also may be in the returns that the distributor earns (though not always).

In a standard transfer pricing Comparable Profits Method (“CPM”) or Transactional Net Margin Method (“TNMM”) analysis, the main “risks” are adjusted for through the use of working capital adjustments, i.e., adjustments for differences in the level of accounts receivable, inventory, and accounts payable between the taxpayer and the comparable firm. Once these risks are adjusted for, the transfer pricing practitioner needs to determine if there are other risks that can be quantified.

In theory, one other quantifiable risk would be the difference in market risk between the comparable firms and the taxpayer (or tested party). Such an adjustment would effectively eliminate most, if not all, of the market risk borne by the taxpayer. In practice, however, we have seen very few studies where this additional adjustment is made.  Why not?  It could be that the LRD/LRSP was earning returns above the return that it should have been earning.  This additional profit could, therefore, potentially validate a zero profit or loss during the current economic environment.  As the LRDs/LRSPs bear some market risk, then there is validation for an LRD or LRSP to lose money or earn zero profits during an economic downturn, subject to the points we raise below.[1]

Simply placing an LRD or LSRP to a margin of zero or to a loss, will not be an adequate approach to determine arm’s length returns during the COVID-19 downturn for transfer pricing purposes. Rather, the following issues need to be considered and performed where appropriate:

  1. Determine which entity is requesting the transfer pricing change. Is it the parent company or is it the subsidiary, or both? Highlight this fact and the reasons for the change;
  2. Determine and measure quantitatively the factors which are causing the pricing change. Factors could be (a) a decline in sales or in sales forecasts, (b) costs associated with releasing or firing workers, and/or (c) costs related to unused office space or others. Note that the cost elements identified above will not be part of the transfer pricing analysis when determining the appropriate arm’s length return. These costs will be classified as extemporaneous or one-time expenses and be recorded after the transfer pricing benchmark is established;
  3. If one is relying on a net cost-plus analysis and if stock options are included in the cost base, they likely ought to be repriced in the transfer pricing analysis based on present conditions in the appropriate stock market, or the economy at large. The difference between the previous price and the present price would be an expense that would not be incorporated into the cost base for the cost-plus markup;
  4. With respect to the three bullet points above, external benchmarks pertaining to industry metrics or market information ought to be documented. For example, declines in industry metrics (revenues, sales, values, etc.) or in specific companies who are deemed competitors should be highlighted to provide validation of the above analytics;
  5. Assess whether the intercompany contract allows for renegotiation of pricing terms. If it does, assess the ability for the LRD or LRSP to earn a zero profit or lose money.  Some intercompany contracts expressly state a numeric return which should be earned, while others state merely that the return should be arm’s length.  The latter is obviously preferable;
  6. If possible, redo the intercompany contract. This would be our recommendation. In particular, a new contract ought to ensure that the characterization of the entities is appropriate (e., no longer calling the entity expressly an LRD), and we recommend including in the contract clauses pertaining to both times of economic distress and times of economic prosperity;
  7. In redoing the legal contract, consider including a force majeure clause which invalidates or calls for a renegotiation in the event of unforeseen natural disasters such as earthquakes or man-made disasters such as a war or nuclear event.

It should be noted that even when documenting all the above issues, an aggressive tax examiner could argue that the above changes represent a change or transfer of risks, and as such, a “Business Restructuring” in which intangibles or risks have been transferred. While the risks presently are “negative” risks, they will in the future potentially be “positive risks” with a value. Strong and timely documentation should be adequate to negate this argument together with additional quantitative work that would not be pertinent to a standard transfer pricing study.

The COVID-19 crisis has had widespread and profound effect on many aspects of the global economy, international businesses and the supply chain.  Companies with low risk entities in their structure should consider the effect of the pandemic on their business models. We are ready and willing to be of assistance to you. Thank you. 


Jonathan Lubick

Jonathan Lubick
Senior Economist

Haddad Lior

Lior Haddad
Senior Economist


Christtina Mauad
Senior Manager
Moore Doeren Mayhew


[1] It is our recommendation that use of the terms LRD and LRSP be considered more judiciously going forward.  Our tendency is to merely outline the risks borne but to not provide such a limited definition for the distributor which these terms tend to create.

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