COVID-19 and Transfer Pricing
2020 Documentation: The End of the LRD?

By: Jonathan Lubick and Lior Haddad*

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 term is low risk distributor (LRD) or low risk service provider (LRSP). This specific theory states that LRDs and LRSPs cannot ever lose money. COVID-19 and the present economic downturn warrant a review of this axiom.

The idea behind these terms was and is that LRDs and 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” began an undercurrent in which both transfer pricing tax practitioners and tax authorities deduced that the LRD and LRSP can never lose money. Such was never the intention of the original terms. COVID-19 and the economic downturn have brought this misconception to the forefront. So indeed, the question remains: Can such entities lose money during economic downturns?

Let us first ask a more basic question: What differentiates an LRD or 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. Adjustments are made 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, a 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. It should be noted, however, that we have seen very few studies where this additional adjustment is made. If this adjustment has not been made, it could be that the LRD or 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 or LRSPs bear some market risk, 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 LRSP 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. Rather, the following issues need to be considered and made 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 the factors that 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 noted herein 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 stock options are included in the cost base, they should be repriced in the transfer pricing analysis based on the present conditions in the 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 should be documented. For example, declines in industry metrics (revenues, sales, values, etc.) or in specific companies which 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. We note that 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, redraft the intercompany contract. In particular, a new contract should ensure that the characterization of the entities is appropriate (i.e., no longer calling the entity expressly an LRD). We also recommend including clauses in the contract pertaining to both times of economic distress and times of economic prosperity.
7. In redrafting the legal contract, consider including a force majeure clause. Force majeure is a clause that includes unforeseen events like natural disasters or man-made disasters. This type of clause usually is used to invalidate a contract or, at a minimum, force a renegotiation.

It should be noted that even when documenting all these issues, an aggressive tax examiner could argue that the 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 potentially be “positive risks” with a value in the future. 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.

On a somewhat related note, there has been much written prior to the COVID-19 economic downturn about the Organization for Economic Co-operation and Development’s (OECD’s) new Pillar One approach. Per Pillar One, larger multinationals are to be taxed on the revenues generated in a given local country, even if such multinationals had no nexus in that country. Pillar One was to be applied according to one of three different approaches. The first, “formulary” approach, was a direct tax of a fixed percentage on revenues generated in the local country (“fixed” margin). An alternative approach was to perform a profit-split analysis. Simply stated, the profit split approach was to be used when there are presumably above normal profits generated in the local country. A question now arises: Can a profit split analysis be done to accrue a loss in the local country due to COVID-19 economic circumstances? Can that loss be used in the future as a carryforward loss to be used when profits will be earned in that local country? Further, perhaps indeed even in the case of the “fixed” margin approach, economic circumstances, such as COVID-19, imply that there is a loss in the local country. These issues should likely now be reassessed. Today’s environment highlights the weaknesses of formulary approaches or “deemed” formulary approaches such as the LRD/LRSP concept.

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.

*The views expressed herein are those of the authors and have no connection with the Company through which this article is transmitted. Such Company does not validate or invalidate the views expressed in this article.