How much do you know about your family member, a friend, a colleague, or a significant other? Is your characterization of a person reflective of his or her real character? Does your characterization of a person affect how you deal with the person?
These same questions apply in business, particularly in the context of transfer pricing. Your knowledge of the nature of a particular business determines the entity characterization. And in turn, the entity characterization influences the direction and tone of a transfer pricing documentation (TPD).
Let’s talk about the fundamentals of entity characterization according to Revenue Audit Memorandum Order (RAMO) No. 1-2019.
What is entity characterization?
In last month’s article, “How FAR are you in transfer pricing documentation?”, it was mentioned that one of the key components of a transfer pricing analysis is the functions, assets, and risks (FAR) analysis, wherein the functions performed, assets deployed, and risks assumed by the related parties involved in the controlled transactions are analyzed.
The result of the FAR analysis becomes the foundation of entity characterization, which sums up the overarching relationship of each function, asset, and risk analysis of the entity and sets the direction in having a meaningful comparison of the price or level of income of the entity in a controlled transaction against the price or level of return from a similar independent transaction.
Entity characterization, in a nutshell, answers the question, “What type of entity is the company to the extent of how the economic risks and profits are distributed in a controlled transaction in the industry in which the company operates?”
How is entity characterization determined?
The first step of entity characterization is completing the FAR analysis. By establishing the FAR of a company, including the structure and organization, and the extent of control or influence, of its transacting related parties, the entity characterization can be determined, following the Organization for Economic Co-operation and Development (OECD) transfer pricing guidelines.
The evaluation of a controlled transaction for entity characterization should be based not only on the terms of the agreement but more importantly, on the actual conduct of the controlled transaction between and among transacting related parties. Essentially, substance over form bears material weight in entity characterization.
What are examples of entity characterization?
Some of the commonly used entity characterizations based on the nature of the business activities are listed below.
Manufacturing: full-fledged, contract and toll manufacturer
Full-fledged manufacturers perform all the manufacturing functions, such as research and development (R&D), product planning, raw materials sourcing, manufacturing process, quality control, distribution and logistics, and after sale functions, and bear their associated risks.
Contract manufacturers, on the other hand, perform limited manufacturing functions and produce the product for their principal generally based on pre-agreed quantities and pre-agreed schedules which the principal guarantees to purchase and generally shoulder limited risks.
Toll manufacturers, contrary to contract manufacturers, perform very limited manufacturing functions for the principal without taking title to the raw materials or finished products and bear limited risks.
Distributor: full-fledged and limited-risk distributor, and commission agent
Full-fledged distributors perform all the sales and distribution functions from marketing to inventory management and bear their associated risks. Limited-risk distributors perform buy and sell functions with limited risks. Commission agents perform as sale representatives, receive commission based on sales and do not take ownership of the products, and bear limited risks.
Service provider: entrepreneurial or full-fledged service provider, and risk mitigated or routine service provider
Entrepreneurial or full-fledged service providers perform all the service functions, from research and development and conceptualization of service to provision of service and warranty, and bear their associated risks. Risk mitigated or routine service providers perform routine support service as dictated by their principal and bear limited risks.
Why is entity characterization important?
By determining the accurate characteristics of the entity’s business, the expected level of price or return by the entity can be known and the selection of reliable comparable can be made.
One cannot compare the price or level of return that a full-fledged manufacturer earns with that of a contract or toll manufacturer. By its very nature, entity characterization is the glue that binds the connection of the benchmarking analysis of the price or return in the entity’s TPD.
For example, a contract or toll manufacturer is expected to maintain a consistent level of profitability because they only carry production as ordered by a related party and they do not perform other functions such as operational strategy setting, product R&D, and sales. Should such manufacturer suffer from losses, it must prove that the losses are not a result of its transactions with a related party but rather a result of justifiable commercial reason.
What is the impact of entity characterization in a transfer pricing audit?
Typically, a transfer pricing audit evaluates three key items, namely: the characteristics of a company with respect to the controlled transaction, the selection of the transfer pricing method, and the application of the arm’s length principle.
The Bureau of Internal Revenue (BIR) can re-characterize a controlled transaction when the economic substance of a controlled transaction differs from its form or when the arrangements made in relation to the controlled transaction, when viewed in their totality, differ from those which would have been adopted by independent parties behaving in a commercially rational manner.
As emphasized in RAMO No. 1-2019, the need to re-characterize a transaction is based on the rationale that the character of the transaction is derived from the relationship between the parties and is not determined by normal independent conditions. As such, there is potential risk that the controlled transaction may have been structured by the company to avoid or minimize tax.
The perceived potential risk is based on the following perspectives: (a) that the related parties can enter into a variety of contracts and agreements compared to independent parties given that the normal conflict of interest, which exists between independent parties, is often non-existent; (b) that the related parties agree on a specific nature of certain transactions that are rarely or not encountered between independent parties; and (c) that the contracts under a controlled transaction are easily altered, suspended, extended, or terminated according to the overall strategies of the group of related parties to the point that such alterations can be made retroactively.
Can entity characterization make or break your TPD?
Yes. Entity characterization is not just a formality in the TPD. It drives the selection of the transfer pricing method, the identification of comparable companies, and the results of benchmarking analysis.
In view of the BIR’s authority to re-characterize an entity’s controlled transaction under certain circumstances, potentially disputing the appropriateness of the comparable companies and the benchmarking results of the TPD, it is in the company’s best interest to take prudent actions in accurately evaluating its characterization. After all, an incorrect assertion on entity characterization could lead to significant implications during a transfer pricing audit.
Stay tuned for our next article as we continue taking you through the other components of the TPD!
Let's Talk TP is an offshoot of Let’s Talk Tax, a weekly newspaper column of P&A Grant Thornton that aims to keep the public informed of various developments in taxation. This article is not intended to be a substitute for competent professional advice.
As published in BusinessWorld, dated 11 October 2022
