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Transfer Pricing Considerations for Pre-revenue or Loss-making Companies (Part II)

This is the second part of a multi-part series on transfer pricing for pre-revenue or loss-marking companies. Please see the first part here.

Taxpayer: “We want to maintain flexibility”

Often, pre-revenue companies haven’t ironed out the exact details of how the business will operate once they commercialize. In light of this, they can be reluctant to set up a transfer pricing policy because things could change and they don’t want to be beholden to any previously-established intercompany arrangement.

Note this: the lack of a transfer pricing policy IS a transfer pricing policy. Tax authorities look to how related parties function and deal with each other, now and historically, to determine whether the transfer pricing is in line with the arm’s length standard. The arm’s length standard is the governing principle behind most countries’ transfer pricing rules. Let’s look at another example.

A US company decides to establish a subsidiary abroad to help develop the market for its product outside of the US. The company’s product has not been commercialized yet. At this point, the US parent has little or no revenue, and is recording a significant loss due to its product and business development costs. The new foreign sub will have some business development people, and will be a cost center in the pre-commercial stage. The company does not want to put a transfer pricing policy in place during the pre-commercialization stage because it is not sure what the future state will look like and it wants flexibility later on.

Once commercialization rolls around, the company decides that the foreign subsidiary will sell the company’s product in the foreign subsidiary’s local market. At this point, the company looks into determining an appropriate transfer pricing policy for the new intercompany dealing.

The company is hoping to set up the foreign sub as a limited-risk distributor. Because the foreign subsidiary took on losses in the pre-commercialization stage, however, the local tax authority is unlikely to accept a limited-risk distributor designation. The tax authority may instead determine that the subsidiary is entitled to excess or residual profits above what might be considered a routine return.

Companies can and should address transfer pricing at each stage of their operations. Transfer pricing specialists can set up policies that maintain flexibility and that can change as the business changes. In fact, transfer pricing policies are supposed to change as businesses change. Transfer pricing policies are based on functions performed, risks assumed, and assets employed. These items change as companies move from pre-revenue to revenue generating. An appropriate transfer pricing policy allows companies to maintain control of their tax planning options.