Why accurate functional analysis is critical to have right transfer pricing

Why do we pay the prices we pay for things we buy? Naturally, we always want to be sure we are not paying too much. This is something the sellers are always aware of. And business must be sensitive to its pricing. Set the prices too high and you won’t have buyers; set them too low and you won’t lack customers, but your business will not be around for too long.

But how much is too much? There is no scientific answer to this question. It all depends on the quality of the service you receive or product you buy.

In other words, you gauge the price of what you are buying by your estimate of how much expertise and raw material has gone into producing what you are buying.

Sometimes, you just care about the brand, you know that certain recognizable brands will guarantee some level of quality.

In other words, it is not the absolute price of the product that matters. It is the nature of the service you are receiving that justifies its price.

The same principle applies to transfer pricing. When related companies trade among each other, they ought to show that those prices reflect the reasonable compensation commensurate with the nature of the products or services they offer each other. In transfer pricing terms, we use the terms ‘functions performed, risks assumed and assets employed’ to provide the product or service / product.

Functions relate to what companies actually do to provide the inter-company transactions. In order to provide a service or product the provider of the service will perform some activities or functions.

If a manufacturer, they will employ a production facility, purchase raw materials and process the raw material to arrive at the final product. On the other hand, a mere distributor will simply purchase the goods and sell these to the final customers. Functions may vary from a fully-fledged manufacturer, a contract manufacturer to a toll manufacturer. Needless to say, the higher the levels of functions, the higher the remuneration the service provider will entitled to.

Functions are intertwined with another element to a functional analysis; risk. Every transaction has some inherent risks.

If an airline company sells you a plane ticket, it carries the risk of not being able to get you where it promises in time - in particular, in the event of delay, you may be entitled to a refund.

Other financial risks for an airline include adverse movements in fuel prices, and market risks that might impact load factors on particular routes.

These are examples of risks that an airline has to carry. For transfer pricing purposes, the issue becomes what are the key risks in a related party transaction.

Often, with cross-border transactions, risks may include foreign exchange risks, logistical risks such as transport and foreign exchange risks. Other broader risks may entail market risks and credit risks. One needs to not only identify the important risks, but also demonstrate that the party bearing the risk on paper actually has the ability to absorb the risk. In other words, the substance of the transaction has to reflect what is documented in the contract between related parties.

The other component of a functional analysis is assets that are used. For transfer pricing purposes, assets are broadly categorised as tangible and intangible.

Tangible assets may include your plant and equipment, machinery, motor vehicles and buildings, to name a few.

Increasingly however, it is the intangible assets that play a bigger role in modern commerce. Components to intangible assets include technical know-how, trademarks and patents. Intangible assets also include brands that may have significant impact in the success of a business. In other words, if a service being provided involves the use of high-value technological know-how or proprietary knowledge, you would expect the payment for that service to command a premium.

Any transfer pricing analysis must begin with a thorough functional analysis. It is correct understanding of the functional analysis that lays the foundation for an accurate benchmarking study. As scrutiny over transfer pricing increases for both taxpayers and tax authorities, greater levels of thoroughness are to be expected. It will no longer be sufficient to have well drafted intercompany agreements. The actual functions, assets and risks borne by related parties must align with the contractual agreements.