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Understanding Losses in Related Party Transactions
30 Apr 2025
Persistent losses by a related company can alert tax authorities to potential transfer pricing issues. While genuine business losses are possible, independent companies wouldn't sustain such losses indefinitely. If a loss-making entity continues to operate, especially within a multinational enterprise, it might indicate inadequate compensation, suggesting a deviation from the arm's length principle.
The Bureau of Internal Revenue (BIR) may scrutinise these losses if they persist beyond what is reasonable or comparable to independent companies, potentially leading to a transfer pricing adjustment.
Key points
- Economic Reality: Losses should reflect the economic reality of the transactions between associated enterprises. This means that losses should be allocated based on the actual functions performed, assets used, and risks assumed by each entity involved in the transaction.
- Consistent Treatment: The treatment of losses should be consistent with the treatment of profits. If an entity is expected to bear certain risks and perform specific functions, it should also be expected to incur losses when those risks materialize.
- Comparability Analysis: A thorough comparability analysis is essential to determine whether the conditions of controlled transactions are consistent with the arm's length principle. This analysis includes examining the functions, assets, and risks of the parties involved.
- Documentation: MNEs must maintain robust documentation to support their transfer pricing policies and the allocation of losses. This documentation should provide a clear rationale for the allocation of losses and demonstrate compliance with the arm's length principle.
- Avoiding Artificial Shifting: The guidelines emphasise that losses should not be artificially shifted to high-tax jurisdictions to minimize the overall tax burden. The allocation of losses should be based on the genuine economic activities and risks undertaken by the associated enterprises.
(Chapter I [D.3.], Losses, OECD Transfer Pricing Guidelines and Section B.3 [b.5], Revenue Memorandum Order No. 1-2019)
To manage transfer pricing risks related to losses, review your transfer pricing arrangements with related parties to ensure fair compensation. Maintain comprehensive transfer pricing documentation to support the losses and provide clear economic and rational justifications for such losses.
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