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Form C YA 2022 - Characterisation of Entities for Transfer Pricing Purposes: Distribution Activities

Updated: Nov 8, 2022

Photo: 廖秋容
Functional Analysis ("FAR")

The necessity to carry out a Functional Analysis, which determines whether controlled and uncontrolled transactions are equivalent, is an essential part of the Arm's Length Principle.

This functional analysis aims to identify and compare the economically relevant activities and responsibilities (i.e. Functions) that were carried out by the parties to the transaction, as well as the assets that were utilised and the risks that were absorbed by them (see para 1.51 of the OECD Transfer Pricing Guidelines).

Recent changes were made to Form C by the Inland Revenue Board in preparation for the YA 2022. One of the most critical changes is for those businesses participating in transfer pricing arrangements. As a result, the disclosure items have been significantly expanded to cover new areas.

These new areas include, among other things, stating the characterisation of your company by reference to its functional profile, the business restructuring undertaken by the group during the year, whether or not your company engages in cash pooling activities, performs any research and development activities or owns any intellectual properties.

Form C Requires Additional Disclosures

The taxpayer is NOW obligated to provide an entity characterisation concerning its business activities, specifically its manufacturing, distribution, and service activities; for instance:

  • Whether manufacturing activities are carried out as a toll manufacturer, contract manufacturer, full-fledged manufacturer, or any other form of manufacturing;

  • Whether distribution activities are carried out as a full-fledged distributor, commissionaire distributor, agent distributor, limited risk distributor, licenced distributor or any other form of distribution;

  • Whether service activities are carried out as a management-service provider, IT service provider, treasury or any other form of service.

The accurate definition of the entity is critical, and it must be decided based on an analysis of the transfer pricing functions, assets, and risks (FAR).

Functional Analysis Interviews

After completing the preliminary Transfer Pricing Interviews (also known as Functional Analysis Interviews), it is time to move on to the next step, characterising the taxpayer's business model in detail.

Why is Characterisation of the Business Model of an Entity Important?

When calculating an Entity's profits for the sake of transfer pricing, how an entity is characterised from the point of view of functional analysis is one of the factors that will be considered.

Using the OECD Transfer Pricing Guidelines, a company's categorisation can be determined by determining its functions, risks, and assets, as well as the structure and organisation of its group and how these factors influence the environment in which the company operates (see para 1.51).

Characterisation of the Business Model (Operational Framework) of the Entities

It is common practice to regard an entity's sales function as its final function in the value chain. The sales force is the one that interacts directly with the end user. This function can range from purely logistical or distributional activities to tasks more closely tied to marketing activities.

According to the information provided in Section A of the Appendix of Form C for YA 2022, the following is a list of some of the most common business models used by current sales and distribution entities.:

  1. Full-Fledged Distributor;

  2. Commissionaire Distributor;

  3. Agent Distributor;

  4. Limited Risk Distributor;

  5. Licenced Distributor;

  6. Others

This entails differentiating the functions carried out, the assets utilised, and the risks taken on by the entities engaged in intercompany transactions to ensure that the transactions are under one of the various business models the tax authorities have outlined.

The IRBM does not define any of the terms listed above. It is strongly advised that a comprehensive explanation be provided for each of the respective terms of the characteristics mentioned in Form C concerning manufacturing, distribution, and service activities.
Performing a FAR Analysis
  • The contractual terms.

  • The conduct that actually carries out.

  • Where are the contracts signed, and by whom

  • What are the responsibilities of the distributors and the principal, for example:

    • Providing demonstration to the client

    • Promotional activities to the general population.

    • To identify customers' needs.

    • Negotiating the contract:

      • Providing the buyer with detailed information regarding the prices.

      • The authorisation of discounts.

      • The approval of exceptional terms for the credit.

    • Is there any other entity on the local market that exclusively markets the products or services and is not a related party? Does the entity only provide logistics services?

    • Who is accountable to the customers for the sales from their point of view?

    • What is the level of difficulty of the product that is being sold?

    • Who performs customer integration at customers.

    • The ratio of the distributor's total number of employees to its annual revenue from sales

    • What are the risks of the transaction, and who actually bears them?

    • Which assets are used in the transaction, and to whom do they belong?

After completing the FAR, you can differentiate between the taxpayer's various business models. The potential profit for distributors is categorised as follows according to their functional risk profiles:

Agent Distributor

An agent is someone who communicates with customers and negotiates sales deals, but he can't sign contracts in his name or on his behalf.

The agent needs to develop a sales team, identify and qualify new customers and maintain the sales relationships.

However, the agent is not involved in negotiating the terms and conditions of the agreement, which takes place outside his sphere of expertise.

The principal not only provides their clients with the products they purchase and send them invoices for those purchases, but they also set their prices and other terms of sale.

The agent does not take ownership of the goods that are sold. He is willing to be compensated regularly for his services.

Commissionaire Distributor

A Commission Distributor is an example of a distributor within an intra-group with limited responsibilities and exposure to risk.

Unlike the Limited Risk Distributor, the Commission Distributor undertakes fewer operational functions and does not assume ownership of the goods being traded (the Commission Distributor executes contracts on his behalf but on account of another person within a group).

Commission Distributor typically is not involved in any strategic or marketing activities.

Sales are usually not recorded on the books of the Commission Distributor, except for the sales expenses.

As payment for his service, the principal gives him either a proportion of the sales generated or a margin added to the costs incurred. Thus, Commission Distributor's revenue is limited to the Sales Commission.

Limited Risk Distributor

Typically, a group of companies will establish a distributor with limited risks to distribute the goods that the group of businesses manufactures.

The group can decide on the pricing at which Limited Risk Distributor buys and sells.

The material difference between an agent or Commissionaire Distributor and the Limited Risk Distributor is that the LRD takes the title of the product, which leads to more significant functions and risks compared with an agent.

Even though the Limited Risk Distributor now owns the goods that were traded, a fully-fledged entity is responsible for most of the strategic business risks.

The primary responsibilities and risks are shouldered by a fully-fledged entity that is part of a group. Limited Risk Distributor acts as a middleman by purchasing goods and then passing them on to clients on his behalf and for his account.

Typical risks a Limited Risk Distributor bears under the agreement with a fully-fledged entity are:

  • inventory (e.g. obsolete stocks are repurchased and debts are offset).

  • trade receivables; and

  • currency risks.

The Limited Risk Distributor is responsible for performing standard sales and marketing duties.

These responsibilities include the formulation of marketing plans, sales forecasts, and the maintenance of customer connections.

Sales are recorded on the books of the LRD, as well as the cost of goods sold.

Licenced Distributor

The Licensed Distributor uses intangible assets he does not own but licenses them.

A license is a formal permission or authority to do something that otherwise would be forbidden, for example, using a brand, patent-protected technology, software or a database.

The Licensed Distributor decides on the quantity of purchased goods to sell it. So he bears inventory and market risk.

A Licensed Distributor performs similar functions and carries similar risks as a fully-fledged distributor.

Full-Fledged Distributor

Generally, a Full-Fledged Distributor (FFD) executes all sales and distribution functions and is responsible for the expenses associated with managing the warehouse, the logistics, marketing, and other sales support, as well as after-warranty service.

In addition, FFD offers after-sales services.

It purchases, holds, and sells goods; sales are recorded on its books.

Full-Fledged Distributor also develops essential marketing intangible assets (such as trademarks).

Because the FFD undertakes operational and entrepreneurial functions relating to the marketing, distribution, and sales activities, they bear the risks associated with them, such as:

  • Price risk;

  • Volume risk,

  • Credit risk,

  • Market risk,

  • Marketing intangibles risk,

  • Risk on unsaleable stock, obsolescence of stocks, reclamation of goods,

  • Currency risk etc.

Hence, FFD has the most potential for making a profit, but its earnings are also the most volatile due to market volatility.

Photo: Jam Win

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