One of the highly contentious areas during a Transfer Pricing (TP) audit is the characterisation of related entities based on the functions performed, assets utilised and risks assumed (commonly referred to as an FAR analysis) relating to a controlled transaction. The functional characterisation of the entity informs the expected returns that should be earned and the expected taxes to be paid.
Functional characterisation can be contentious because in practice, businesses in the same industry may have different functional profiles, or the same business may restructure, resulting in a change in functional characterisation. Further, sometimes, the tax authorities may disagree with the taxpayer's functional characterisation of its business. Since functional characterisation impacts the treatment and expected returns of an entity, changes or disagreements on this could potentially pose a significant TP risk exposure to a taxpayer. As such, this article sheds light on this major TP risk area and suggests some measures to help mitigate the risk.
Technical Appreciation of Functional Characterisation
Central to the application of the Arm's Length Principle (ALP) is the concept of comparability analysis. An FAR analysis plays a key role in performing comparability analyses.
Regulation 11(4)(b) of the Nigeria TP Regulations (NTPR) states that "In determining whether two or more transactions are comparable, the following factors shall be considered to the extent that they are economically relevant to the facts and circumstances of the transactions... (b) The functions undertaken by the persons entering into the transaction taking into account the assets used and risk assumed."
Thus, depending on the type of transaction being analysed and the TP method applied to demonstrate the arm's length nature of the transaction, an FAR analysis and the resulting characterisation of the transaction and/or the entities involved in the transaction can be significantly important in achieving reliable results.
Next, we review two forms of intra-group business structures relating to the purchase/sale of tangible products that tend to face functional characterisation disputes during TP audits.
The Distributor-Marketer versus Limited Risk Distributor
Distribution arrangements are a major source of functional characterisation issues, usually arising when a group entity manufactures a product and sells to its related party for distribution. To illustrate this issue, let us assume we have two (2) related entities, Nigeria Co, that purchases finished products from its offshore related party, Foreign Co, for distribution in the Nigerian market. Nigeria Co has been loss-making for the last few years.
An FAR analysis determines that Nigeria Co licenses the trademarks and trade names associated with the globally well-known products and is responsible for performing both distribution and marketing functions to create market awareness of the branded products. Nigeria Co therefore bears the market risks associated with the success or failure of the distribution of the products as an entrepreneur in the Nigeria market. As a result, it is entitled to all the net profits or losses that it generates from the marketing and distribution of the products, while ensuring that it makes the necessary arm's length payments for the products it purchases from Foreign Co, royalty payments to its related party and any other related party transactions.
To demonstrate the arm's length nature of the purchase of the branded products from its related party, where reliable data does not exist to compare the price charged for a comparable transaction under similar circumstances between two independent parties, a one-sided profit-based test is usually employed. This typically involves selecting the most appropriate method that would yield the most reliable result and the least complex entity involved in the controlled transaction, based on the characterisation of both entities from the FAR analysis.
In this scenario, considering that Nigeria Co is an entrepreneur performing significant functions and bearing significant market risks, it is likely to be the more complex entity compared to Foreign Co, which may be performing a contract manufacturing function for Nigeria Co. As such, a one-sided profit-based method such as the Transactional Net Margin Method (TNMM) could be applied to test the reasonableness of the net profit markup that Foreign Co should charge Nigeria Co for the contract manufacturing function, while Nigeria Co enjoys the resulting profits or suffers the resulting loss from its operations as an entrepreneur.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.