Transfer pricing: risk assessment: transfer pricing risk indicators: losses over a number of years
One possible area of concern is a group company which consistently makes losses. Any claims that such continued losses are arm’s length should be considered carefully. It might be that these losses are the result of a group’s commercial policy, rather than being a transfer pricing issue. For instance, the group may be trying to break into a new market or introduce a new product by selling at a loss in order to gain market share. It will be necessary to assemble evidence as to what an independent trader would do in these circumstances, but it is unlikely that at arm’s length this would persist for a number of years. The group would also have to show that this strategy was deliberate and intended to reap rewards for the UK company in the longer run.
The introduction of a new product will often involve initial heavy marketing expenditure to establish the brand in the market. Depending on what functions and risks the distributor takes on, initial losses might be acceptable, but an independent distributor would expect to move into profit as quickly as possible. There are no set guidelines here but the situation should always be examined from the point of view of an independent business. It will also matter whether the distributor already has a range of established products to cushion the costs of a product launch.
Although by definition a pattern of losses is only something that would emerge over a number of years, it is still important to understand the reasons for a company’s loss in any given year. It is preferable to tackle and prevent non-arm’s length losses from accumulating as early as possible rather than allowing them to build up before using the discovery provisions to make a retrospective challenge. Where losses are discussed at an early stage then the guidance on real time working at INTM480040 should always be observed.
Other business activities making losses
Some businesses, for example a new manufacturing concern, might have significant depreciation charges, training costs, initial teething problems with the production line and other costs which may prevent it making a profit for the first year or so.
On the other hand, some business activities might be expected to make profits from the outset. For example, a company engaged in commercial contract research and development would expect to move into profit shortly after starting to trade. Similarly, a company providing services in the form of technical assistance would expect to charge for those services so as to make a profit more or less straight away. Again there are no firm guidelines here - each case must be considered on its own facts, within the context of wider economic issues (such as a turndown in a particular sector of business). Is the company doing a lot of what is meant to be its main activity, but making losses nonetheless, or is it failing to get off the ground but having to carry costs while attempting to do so? Why hasn’t it given up?
There may be a problem with the way the business is financed. Does it have more debt than it can sustain, or is it lending out to group companies for little or no reward, or both? Consider whether the company is thinly capitalised (INTM413000) or lending on a non arm’s length basis (INTM501000), or both. Financial transfer pricing may make it difficult for a company to trade profitably at any activity.
New companies are not inevitably loss makers. A search using a commercial database for a particular business sector may indicate that, in general, companies in start-up phase are profitable. Undertaking such research will be worthwhile in significant cases and will help to decide whether a case should be selected for enquiry.