The Functional Analysis—What You Need to Know
No matter what type of transaction you’re documenting—an intercompany loan, a service, a sale—a critical piece of your transfer pricing documentation will be the functional analysis. Why? The functional analysis, or FAR analysis as it’s known, identifies the functions, assets, and risks that each entity contributes to a related-party transaction. Consider this the foundation of your whole documentation package.
Of course, the functional analysis is not a pricing method, but it does drive key components of your economic analysis: By identifying the role of each entity in a given transaction, the functional analysis will help you identify comparables and the most appropriate transfer pricing method. It also provides evidential support that profits are taxed where value is created. The bottom line? You have to get it right. To help, Chief Economist Mimi Song is sharing a few expert strategies. Follow these when constructing your FAR analysis and the rest of your report should fall into place.
Strategy #1: Think Big Picture.
If you’re going to conduct a thorough transfer pricing analysis, you need to understand the multinational enterprise as a whole. This means laying out an organizational chart, including where each entity is located and where it fits in the overall operation. An interview is a good place to start: You’ll want to ask questions about the raw material inputs, manufacturing processes, technology, know-how, and intangibles. Who holds the inventory? What is the operational infrastructure? Ultimately the goal is to see where the business starts and stops in terms of getting the product to market.
Strategy #2. Determine the Functions.
Once you have a big-picture understanding, you can narrow in on the entities involved in the transaction. You’ll want to see which functions each entity contributes to the transaction—not all the functions each entity typically performs. “A functional analysis is very specific to the actual intercompany transaction,” Song explains. “It doesn’t necessarily mean a functional analysis for the whole entity. You have to look at specifically what it is in the transaction that’s being analyzed.”
On your report, mark each function in a straightforward chart by checking the box each entity performs—manufacturing, invoicing, distribution, marketing, advertising, purchasing, and so on–and then summarize the details: How does each function work inside the corporation? Who is responsible for what? Where are the functions taking place? Who manages the process? You’ll also want to address questions related to specific functions. For example, you might ask manufacturers, “Which materials are purchased?” Or, for an entity that conducts research-and-development, you might ask, “How important is the development of patents in the industry?”
An important part of transfer-pricing compliance is to answer questions before tax authorities have a chance to ask them. Be specific and give generous details. The R&D function of a pharmaceutical company, for example, varies significantly from the R&D function of a software company, so never leave it up to generic terms. “It’s one thing to say, ‘This company has an R&D function’—but what does that mean?” says Song. What is R&D relative to that particular company?”
Strategy #3: Determine who owns the Assets.
Now that you know which entity does what, you’ll need to determine what each one brings to the table. In other words, who contributes the most assets to the transaction? Tangible assets include anything from manufacturing equipment to office space to computers. “Tangible assets are easy to identify because they’re on your balance sheet,” Song explains. “They relate to the PP&E—plant, property, and equipment.”
Intangible assets—manufacturing processes, designs, or trademarks–are harder to nail down in terms of ownership. So, for those, you’ll need to determine which entity performs the development, enhancement, maintenance, protection, and exploitation functions, better known as the DEMPE functions. This way, you can determine if the IP owner retains an appropriate level of substance. A functional analysis helps identify and value hard-to-value intangibles, so you can determine if intangibles assets provide an entity with a competitive edge.
Strategy #4: Determine Who is Taking Risks.
As the old saying goes, risk equals reward. Well, transfer pricing is no different. The entity that bears the most risk will reap the most profits. How do you know which entity carries the most risk? The functional analysis, of course.
Risk comes in different forms: There’s credit risk, where an entity might bear the cost of extending credit to customers who can’t pay. There’s foreign-exchange risk, where a company could take a hit due to a change in exchange rates. Market risk could come into play if a company can’t sell or profit in a current market. And don’t forget inventory risk: If inventory expires or becomes obsolete, who bears the cost?
“There are lots of different risk—market risk, operational risk, credit risk—the typical types of risks that you would be looking at in any business context,” Song explains. “And that’s important in a related-party context because you can actually indemnify all the related parties for lots of different types of risks.”
Understanding which entity absorbs the most risk is necessary to construct a reliable comparability analysis—you’ll want to look for comparables absorbing similar risks or make adjustments. And that risk-reward relationship will help determine where profits should be allocated.
Strategy #5: Characterize the Business.
After identifying each entity’s functions, the risks each one is assuming, and the assets each one contributes, the next step is to characterize the business in a way that’s meaningful to tax authorities. Characterizations for sales and distribution functions might be “sales agent,” “limited-risk distributor,” or “full-fledged distributor.” Manufacturing activities might be characterized as “full-fledged manufacturer,” “contract manufacturer,” or “toll manufacturer.”
How you characterize entities will drive your comparability search—if your tested party is a limited-risk distributor, then guess what you’ll be looking for in your benchmarking analysis? Right–other limited-risk distributors. 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.
Want to learn more about constructing a functional analysis? Listen to The Fiona Show: How to Rock a Transfer Pricing Functional Analysis.