Meaning
Methodological examinations of the roles, assets and risks assumed by different entities in a cross-border transaction provide the basis for transfer pricing. A functional analysis identifies which company in a group performs the heavy lifting and which merely provides support services. By mapping out who does what, tax authorities can determine where the profit should logically be reported.
This process prevents multinational firms from shifting income to low tax jurisdictions where little actual work occurs.
Asset Utilization
Inventories of physical and intellectual property show which entity contributes the most value to the supply chain. During a functional analysis, investigators look at who owns the patents, the factories and the distribution networks. The entity that owns and maintains the most valuable assets is usually entitled to a higher share of the profit.
Risk Distribution
Financial exposure assumed by each participant determines the expected return on their activities. The functional analysis looks at who bears the cost of unsold inventory or the risk of currency fluctuations. Parties that take on more risk should be compensated with higher margins according to international guidelines.
Comparable Transaction
Benchmarking the internal prices against third party deals ensures that the group remains in compliance with the arm’s length principle. Results from the functional analysis help find similar companies that operate in the same market. This comparison justifies the pricing strategy to regulators.
