What is entity characterisation?

Oct 8 / Borys Ulanenko

Multinational enterprises (MNEs) often segregate their business operations into several functional elements that, in combination, form an end-to-end supply and value chain. Since the current international tax regime is based on the separate entity approach, every entity within an MNE should be adequately remunerated for functions, assets, and risks that it contributes to the value chain. When doing functional analysis, we identify economically important functions, assets, and risks, and draw conclusions about (1) the primary role of controlled transaction participants, and (2) the degree of "complexity" of the role they play. The process of labelling entities with high-level "tags" is known as entity characterisation, and these "tags" are sometimes called functional profiles.

Why is it important?

According to the arm's length principle, comparable functions, risks, and assets should be compensated similarly. In practice, however, it is very difficult to evaluate each function and risk separately, and some degree of aggregation and generalisation is necessary. Assigning the entity characterisation "tag" therefore, allows us (1) to have a preliminary feeling about the profit potential of the entity, and (2) to determine which comparable companies or transactions we should look for during the comparability analysis.

If you are going to take the ADIT transfer pricing exam, you also need to bear in mind that entity characterisation is included in syllabus ("Functional analysis" module). Therefore, knowing the main functional profiles and the approach to entity characterisation is crucial for the successful exam sitting.

How to characterise an entity for transfer pricing purposes?

Entity characterisation summarises the functional analysis, therefore it is necessary first to identify economically significant functions, assets and risks of companies participating in the controlled transaction. Then, we need to compare the functions, assets and risks of each party with typical functional profiles (such as "limited risk distributor", or "contract manufacturer"). In real life, of course, it is difficult to find pure functional profiles, and therefore we need to allow for some degree of flexibility. 

Example

Let's assume that during functional analysis, we identified that one party of the transaction is responsible for the manufacturing of products. The manufacturer buys raw materials and takes title to finished goods. The company does not own unique and valuable intangibles, and only uses routine manufacturing know-how and technologies that are widely available in this industry. The manufacturer produces goods on request of the principal, and the principal guarantees to purchase ordered goods from the manufacturer (if they meet quality standards). Based on these facts, we can conclude that the company can be characterised as a contract manufacturer.

Knowing transfer pricing methods and approaches to comparability analysis, we can assume that the contract manufacturer will be selected as a tested party. There is a good chance of using the Transactional net margin method (TNMM) and testing the remuneration of the contract manufacturer on a cost-plus basis (if internal comparables are not available).

 Typical entities in manufacturing are:

•  Toll manufacturers
•  Contract manufacturers
•  Fully-fledged manufacturers

In distribution:

•  Commission agents and commissionaires
•  Limited risk distributors
•  Fully-fledged distributors

Service providers:

•  Low value-adding service providers
•  Classic contract service providers
•  Sophisticated service providers

We discuss the topic in our ADIT transfer pricing course "Functional Analysis in Practice" module, where we have lectures on entity characterisation and typical functional profiles, as well as detailed FAR analysis and entity characterisation demo. Also, check pages 58-67 of our textbook for a detailed description of standard functional profiles.

If you are interested in this topic, we also recommend the book "Transfer Pricing and Business Restructurings: Streamlining All the Way" (IBFD, edited by Anuschka Bakker).  
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