INTM466040 - Examining transfer pricing reports: Information in a report - functional analysis
As part of your general review of the company and its affiliates, you should have a good idea of what it does, to whom it sells and how it obtains what it sells. Where affiliates are involved at the other end of the transactions, you should also have an idea of what those companies do. You should also have gained knowledge of the activities of all other main group entities.
A report should explore in detail the activities of the company under review. This is known as a functional analysis. All the functions of the company should be described in detail. Remember that at arm's length, reward tends to follow a combination of the functions carried out and the risk borne, and the functions carried out tend to govern the amount of risk. The functional analysis should give you an insight into both. You will also need to understand fully how the functions carried out interact with functions carried out by affiliates. This might be as simple as a distributor making sales to third parties of products which it buys from a manufacturing affiliate, or as complex as an R & D affiliate developing goods, manufacturing them with a third party which sells to a manufacturing affiliate for assembly which sells them in turn to a distribution affiliate for first tier distribution to independent distributors or directly sells to third party end users.
To conduct a transfer pricing enquiry properly you will need to understand how each group company contributes to the overall trading affairs of the group. The transfer pricing report should tell you exactly what your company does, how other group companies are involved and allow you to consider where the relevant risk lies. The functional analysis is the most critical part of any report since without a full understanding of what your company does you will not be able to assess whether the reward it enjoys is arm's length.
A functional analysis should therefore describe what activities the company performs, and allow you to consider the relative weight and importance of those activities in earning profits for the company and the group. For example, for a generic, non-branded product which is not the result of complex R & D, the selling activity may be more important in creating profits than the simple manufacturing activity. The functional analysis should be a valuable source of evidence, which will enable you to make this kind of judgement.
Identification of the location and nature of risk is an important aspect of functional analysis. Before you can consider risk, you need to understand fully where the functions of the trade are located and carried out. Please see advice on risk assessment from INTM461230 onwards
