Handling Loss-Making Comparables in Transfer Pricing Benchmarking
Borys Ulanenko
CEO of ArmsLength AI
TL;DR - Key Takeaways
OECD Guidelines state loss-making comparables should not be rejected on the sole basis that they suffer losses—investigate the cause first.
Exclude loss-makers when losses stem from abnormal conditions, different risk profiles, or persistent failure (3+ consecutive years is a common audit threshold, particularly in Germany).
Include loss-makers when losses reflect industry-wide downturns, start-up phases, or market conditions that also affect your tested party.
Germany: Administrative Principles expect profitability over 5 years; GAufzV documentation rules require recording causes and measures if losses persist more than 3 consecutive years.
If your tested party is loss-making, including loss-making comparables may be essential to demonstrate the result is still arm's length.
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Quick Answer: Handling Loss-Making Comparables
Loss-making comparables require investigation, not automatic exclusion. The OECD states that loss-making comparables "should not be rejected on the sole basis that they suffer losses" (¶3.65). Instead, analyze the cause of the losses and whether those causes are relevant to your tested party's situation.
Decision Framework:
Loss Situation
Action
Rationale
Industry-wide downturn affecting tested party
Include
Loss reflects normal market conditions
Start-up phase (if tested party also in start-up)
Include
Comparable business stage
One-year anomaly with otherwise healthy performance
Include (use multi-year data)
Smooths out volatility
Persistent losses (3+ consecutive years)
Generally exclude
Common audit threshold; often indicates failing business or different risk profile
Losses from restructuring or extraordinary events
Exclude
Not reflective of normal business conditions
Tested party profitable, comparable persistently loss-making
When selecting comparables for a TNMM or CPM analysis, loss-making companies create a fundamental question: do their losses reflect normal business outcomes that could apply to the tested party, or do they indicate something fundamentally different?
The Core Tension
Including loss-makers:
May better reflect economic reality during downturns
Avoids "cherry-picking" only favorable data
Essential when the tested party itself has losses
Excluding loss-makers:
Removes potentially non-comparable companies
Avoids distorting the arm's length range downward
Reflects that independent parties don't indefinitely tolerate losses
The OECD's position (¶3.65): "A loss-making uncontrolled transaction should trigger further investigation to establish whether or not it can be a comparable"—not automatic rejection.
Why This Matters
Including inappropriate loss-makers can:
Artificially lower the arm's length range
Make non-arm's length results appear compliant
Introduce companies with fundamentally different risk profiles
Excluding appropriate loss-makers can:
Appear as cherry-picking to tax authorities
Fail to capture legitimate market conditions
Make it impossible to defend a loss-making tested party
Types of Losses: A Classification Framework
Not all losses are equal. Understanding the type of loss helps determine whether to include or exclude a comparable.
Loss Classification Table
Loss Type
Description
Comparability Impact
Cyclical Losses
Losses during economic or industry downturns; profits return in up cycles
May include if tested party faces same cycle; use multi-year data to capture full cycle
Start-up Losses
Initial years of heavy investment, low revenue, market-building pricing
Include only if tested party is also in start-up phase; losses should be temporary (2-3 years for distributors)
Restructuring Losses
One-time costs from plant closures, severance, write-downs
Generally exclude unless tested party underwent similar restructuring; consider adjusting financials if data available
Market Exit Losses
Losses from winding down operations, liquidating inventory
Losses in 3+ consecutive years with no return to profit
Strong case for exclusion—indicates failing business or non-arm's length conditions
One-Time Anomaly
Single bad year from isolated event; profitable in other years
May include using multi-year averages; investigate the cause of the bad year
How to Use This Classification
When you encounter a loss-making comparable:
Classify the loss using the categories above
Check if your tested party has similar circumstances
If aligned → the loss may be relevant and includable
If misaligned → the loss indicates non-comparability
When to Include Loss-Making Comparables
Primary Justifications for Inclusion
1. Industry-Wide Downturn
If the losses occurred during a period of broad economic stress affecting the entire industry, and your tested party was also impacted, including loss-makers provides a realistic arm's length range.
Example: Many companies had losses in 2020 due to COVID-19. If your tested party also had a loss that year, excluding all loss-making comparables would artificially raise the benchmark and make the tested party's result look non-arm's length.
2. Tested Party Also Loss-Making
This is the most compelling reason to include loss-making comparables. If the tested party is incurring losses, you need to demonstrate that independent comparables under similar circumstances also accepted losses.
If you excluded all loss-makers while your tested party has a loss, the arm's length range would only show profits—undermining your position that the tested party's loss is arm's length.
3. Single-Year Anomaly
If a comparable has one off-year of loss but is profitable in other years, and its multi-year average is positive, you may include it using multi-year analysis. OECD ¶3.77 supports using multiple-year data to understand the conditions affecting results, including business cycles.
4. Comparable Economic Circumstances
If the loss arose from the same market factors affecting the tested party—and you can document this parallel—inclusion strengthens the argument that the tested party's strategy and resulting losses are commercially rational.
Documentation is critical: When including a loss-maker, explicitly state: "Company X had a loss in 2020 due to the pandemic, which also affected the tested party. Including Company X reflects market conditions."
When to Exclude Loss-Making Comparables
Clear Exclusion Scenarios
1. Losses Not Reflective of Normal Conditions
Exclude when losses result from extraordinary events unrelated to routine business—major strikes, natural disasters, fraud, or one-off legal settlements.
2. Different Risk Profile
Exclude when the comparable undertook risks the tested party doesn't bear. For example, a comparable that lost money on speculative R&D ventures isn't comparable to a stable distribution subsidiary.
3. Persistent Losses (3+ Years)
If a company has losses in all years of your analysis period, it suggests a failing business or non-arm's length support. An independent business wouldn't tolerate indefinite losses without restructuring or exit (OECD ¶1.149).
Practical threshold: Three consecutive loss-making years is a common heuristic used by practitioners and tax authorities (particularly in Germany, where it triggers documentation requirements). This is not a universal rule, but a reasonable audit-defense threshold.
4. Tested Party Profitable, Comparable Not
If the tested party was profitable throughout the period while the comparable consistently lost money, the comparable's situation is clearly different—exclude on grounds of different economic circumstances.
5. Restructuring or Exit Scenarios
Companies undergoing major restructuring, winding down, or exiting markets have distorted financials that don't reflect ongoing business operations.
The Persistence Test (Practitioner Heuristic)
Years of Losses
Typical Treatment
1 of 5
Often acceptable if explained
2 of 5
Borderline—investigate cause carefully
3 of 5
Commonly excluded; triggers German documentation requirements
4+ of 5
Generally excluded absent strong justification
Note: These thresholds reflect common practice and German guidance. The OECD does not prescribe specific cutoffs—investigation is always required.
Regulatory Guidance: OECD and Key Jurisdictions
OECD Transfer Pricing Guidelines (2022)
The OECD's core position on loss-making comparables:
"Generally speaking, a loss-making uncontrolled transaction should trigger further investigation to establish whether or not it can be a comparable." (¶3.65)
"Loss-making comparables that otherwise satisfy comparability criteria should not … be rejected on the sole basis that they suffer losses." (¶3.65)
The OECD also emphasizes (¶1.149-1.151) that independent enterprises don't indefinitely tolerate losses—a key principle when evaluating persistent loss situations.
United States
US Treasury Regulations §1.482-1 don't explicitly forbid loss-making comparables but emphasize reliability. Where not all material differences can be reliably identified and adjusted, US rules often use the interquartile range (25th–75th percentile) as the arm's length range (§1.482-1(e)(2)(iii)). This can reduce the influence of extreme results—including large losses—depending on the dataset, though that is an effect rather than the stated purpose of IQR.
Germany
German authorities have specific expectations, drawing from two sources:
Administrative Principles (2024):
Start-up losses should normally not exceed ~3 years
Routine entities are expected to show total profitability over a ~5-year horizon
GAufzV Documentation Regulation:
If an entity reports losses from related-party dealings for more than three consecutive years, documentation rules require recording causes of losses and measures taken to eliminate them
This combination creates a practical expectation that persistent losses will trigger scrutiny and require robust justification.
India
India has no explicit rule excluding loss-makers. Courts have established the general principle that FAR (Functions, Assets, Risks) differences—not profit levels—should drive comparable exclusion. The ChrysCapital case (Delhi HC, 2015), while primarily addressing high-profit comparables, established symmetrically that profit level alone is not a basis for exclusion; instead, Rule 10B(3) comparability analysis must identify specific functional or risk differences.
China
China is strict for limited-risk entities. SAT Announcement [2017] No. 6 (Article 28) indicates that "single-function" (routine) manufacturers, distributors, and contract R&D providers should in principle maintain reasonable profit. If they incur losses, they must prepare local files and may be a focus of special tax adjustment review. The practical assumption: a low-risk entity shouldn't have losses.
Australia (SNF Case)
The landmark SNF Australia case (FCAFC 74, 2011) demonstrated that losses alone don't prove non-arm's-length pricing. The ATO argued that no independent distributor would tolerate sustained losses, but the Full Federal Court accepted the taxpayer's evidence that losses were due to market conditions and that transfer prices were arm's length. This case reinforces that the cause of losses matters more than the fact of losses—investigate why before concluding anything about comparability.
Practical Screening Process
Step-by-Step Decision Tree
START: Comparable shows loss in one or more years
Q1: Are losses explained by industry-wide factors?
YES → Does tested party face same conditions?
YES → May INCLUDE
NO → EXCLUDE
NO → Continue to Q2
Q2: Is this a one-year anomaly or persistent (3+ years)?
One-year → Is multi-year average positive?
YES → May INCLUDE (use multi-year data)
NO → Lean toward EXCLUDE
Persistent → Generally EXCLUDE
Q3: What's the business reason for losses?
Clear reason (restructuring, start-up, extraordinary) → Does this reason apply to tested party?
YES → May INCLUDE
NO → EXCLUDE
No clear reason → EXCLUDE (can't defend comparability)
Q4: Sample size impact?
If excluding leaves too few comparables → Consider broadening search
If sufficient comparables remain → Exclude and document
"2020 loss attributed to COVID-19 impact on retail sector"
Tested party comparison
"Tested party also experienced losses in 2020 due to pandemic; recovered in 2021"
Decision
"Included—loss reflects industry conditions affecting tested party; 3-year average margin is positive"
Accept/Reject Matrix Template
Company
Years of Losses
Loss Cause
Decision
Rationale
Company A
2021-2023 (3 years)
Persistent; no turnaround
Excluded
Persistent losses not reflective of normal conditions; tested party profitable
Company B
2020 only
COVID-19 downturn
Included
Industry-wide downturn affecting tested party; multi-year average positive
Company C
2022-2023 (2 years)
Market exit mode
Excluded
Not going-concern comparable
Special Case: Loss-Making Tested Party
When the tested party itself has losses, special considerations apply.
Red Flags for Tax Authorities
A consistently loss-making affiliate while the broader MNE group is profitable is a major audit trigger. Tax authorities will ask: is this entity adequately compensated by the group?
Justifiable Loss Scenarios
Scenario
Acceptable?
Documentation Required
Start-up phase (2-3 years)
Yes
Business plan showing path to profitability
Economic downturn
Yes
Industry data showing independent firms also had losses
One-off adverse event
Possibly
Evidence that event was extraordinary and temporary
4+ consecutive years
Very difficult
Robust justification; expect scrutiny
Documentation Requirements
Prepare a "Loss Justification Pack":
Economic analysis: Market/industry trends showing the downturn
Internal projections: Budgets showing losses were anticipated as part of strategy
Comparables data: Evidence that independents also had losses
Recovery plan: When and how profitability will return
Functional analysis review: Did the tested party bear unexpected risks?
Key question: Would an independent party in the tested party's role ever agree to this outcome? If the honest answer is "rarely, if ever," you may need a transfer pricing adjustment or restructuring.
Should I automatically exclude all loss-making comparables?
No. OECD Guidelines state that loss-making comparables "should not be rejected on the sole basis that they suffer losses" (¶3.65). Each loss-making comparable should be investigated, not reflexively eliminated. If the loss arose from normal business risks or market conditions relevant to the tested transaction, you may retain it. If it arose from factors that don't affect the tested party, exclude it. The decision should be case-by-case, not a blanket rule.
How many consecutive loss years justify exclusion?
Three or more consecutive loss-making years is a common practitioner heuristic that raises serious concern. This threshold is explicitly anchored in German guidance (where GAufzV documentation rules are triggered after 3+ consecutive loss years), and aligns with the expectation that start-up losses shouldn't exceed ~3 years. However, the OECD does not set a specific numeric cutoff—it requires further investigation, not automatic exclusion at any number. One or two loss years may be acceptable if explained; three or more usually indicates exclusion unless the tested party has a similar multi-year loss pattern.
Can I include a loss-making comparable if my tested party is also losing money?
Yes—this is exactly when you might need to. If your tested party has losses, including comparables that also suffered losses (from the same economic conditions) can support the argument that the tested loss is arm's length. However, ensure the comparables' losses stem from similar causes as the tested party's. Document the parallels carefully.
What if excluding loss-makers leaves me with very few comparables?
Options include: (1) broaden your search criteria geographically or by industry to find additional profitable comparables, (2) use multi-year data to retain comparables with only one loss year, or (3) keep borderline loss-makers with heavy documentation. As a practical workflow consideration (not a regulatory minimum), if excluding all loss-makers leaves fewer than ~5 comparables, explain why those remaining are the only reliable ones and consider supplementing with alternative approaches. The OECD does not prescribe a minimum number of comparables.
How do I document the decision to exclude a loss-making comparable?
Don't just state "it was loss-making." Provide comparability-based reasons: "Company X had three consecutive loss years indicating circumstances not comparable to the tested party (which was profitable). Per its annual report, losses resulted from a major restructuring—a situation the tested party did not experience." Tie the exclusion to recognized comparability factors (functions, risks, conditions) and reference OECD ¶3.65.
Do loss-making comparables affect the IQR calculation?
Yes. Loss-making comparables typically produce results at the lower end of the distribution and may fall outside the IQR (below the 25th percentile) depending on the dataset. However, IQR is designed to address reliability when material differences can't be adjusted—not specifically to exclude losses. If many comparables have losses (e.g., during a downturn), the median and even quartile boundaries may shift into negative territory. This could be appropriate if the industry truly experienced widespread losses—but it makes the analysis more difficult to defend.
What's the difference between a "failing business" and a "loss-making comparable"?
A failing business has persistent losses with no viable path to profitability—it's essentially exiting the market in slow motion. A loss-making comparable may have a temporary loss due to market conditions, start-up phase, or one-off events, but is otherwise viable. The distinction matters: failing businesses aren't reliable benchmarks for ongoing operations; companies with temporary losses may be.
How should I handle loss-making comparables during economic crises like COVID-19?
During widespread crises, many companies have losses. The OECD's COVID-19 guidance (2020) stated that loss-making comparables should not be rejected solely because of losses in affected periods—provided comparables assume similar levels of risk and were similarly impacted by the crisis. Include loss-makers from crisis periods if your tested party was also impacted and faced comparable risks; document that the period was extraordinary and that both tested party and comparables were affected. Consider testing 2020 separately rather than averaging it with normal years.
