Strategy #5: Characterize your Business
After identifying the functions each entity is assuming, the risks each entity is assuming, and the assets each entity contributes, the next step is to characterize the businesses so that the tax authorities understand their purpose. Characterizations for sales might range from “sales agent” to “full-fledged distributor.” For manufacturing, characterizations might range from “full-fledged manufacturer” to “toll manufacturer.”
Since the functional analysis is performed during the planning phase as part of a broader margin analysis, your transfer pricing analysis will benefit from those characterizations. If you have a tested party that is a limited-risk distributor, then guess what you’ll be looking for in your benchmarking analysis? Not other limited-risk distributors to the point that it will trigger a profit-based analysis. Those characterizations will also shed light on the most appropriate transfer pricing method for each transaction and if it’s a profit-based analysis, the profit level indicator. Ultimately, a complete transfer pricing analysis—all based on facts uncovered in the functional analysis–drives the amount of arm’s-length compensation that each entity can claim, and therefore, the tax dollars each jurisdiction can collect.