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Functional analysis and arm’s length methods Douglas Fone LLB ACA Transfer Pricing Associates
Functional analysis and arm’s length
methods
Douglas Fone LLB ACA
Transfer Pricing Associates

Industry analysis

Industry analysis

What is an industry analysis?

 

Industry analysis is undertaken to place the functional analysis in the proper context:

 

Economic, market and regulatory framework of industry of tested party Barriers to entry, maturity of the market Domestic and international competition Cyclical, seasonal factors Overall profitability of the industry What are the value drivers of the industry? Do these fit with competitive strengths of tested party?

- what is the “industry norm” profitability?

Functional analysis

Functional analysis

What is a functional analysis? - Typical functions

Research and development

Manufacturing

Logistics

Sales

Marketing

After-sales service

Executive management

Finance and administration

Support services

Overview

Overview

Industry analysis

Functional analysis

Functional classification of companies

Price setting – responsibility centres

Review of outcomes – arm’s length methods

Review of outcomes – by transaction type

Functional analysis

Functional analysis

What is a functional analysis?

The mapping of the economically relevant facts and characteristics of the inter-company transactions with regard to their:

Functions, Assets and Risks (FAR)

The allocation of these FAR between those entities involved in the transaction so that each entity can be characterized appropriately

An analysis of the relative importance of these FAR in the generation of business profits

- what are the functions, assets and risks of the tested party?

Functional analysis

Functional analysis

What is a functional analysis? - Typical assets

Tangible assets

 

Plant and machinery Buildings, office equipment

Intangible assets

Patents, formulae Copyrights, licences Trade/brand names, trade marks Technical know-how Corporate reputation High calibre staff e.g. strong sales force Distribution channels/agreements

Functional analysis

Functional analysis

What is a functional analysis? - Typical risks

 

Market risk: changes in volume, product mix, price

Inventory risk: obsolescence

Defective products/warranty risk

Credit risk

Product liability risk

Foreign exchange risk

Functional analysis

Functional analysis

How to do a functional analysis?

 

Preparation, planning – Gather required documentation

Group structure Management organization chart Inter-company agreements Pre-existing transfer pricing documentation (inc overseas) Transfer pricing manual Product information – web site, brochures Competitor information – market research etc

Identify gaps in information Select appropriate interviewees

Functional analysis

Functional analysis

How to do a functional analysis?

 

Fact gathering – Conduct interviews with key members of staff Ascertain details of what is happening in the business Prepare detailed interview notes Interviewee reviews notes and provides any further information Ensure information gaps are filled

Functional analysis

Functional analysis

Why do a functional analysis?

Enables a full understanding of the economic value contributed by each entity in the value chain, leading to – Selection of the “tested party” Identification of the “tested transactions” Appropriate characterization of each entity Selection of the most appropriate pricing/testing method Selection of the most comparable companies etc Prediction of the tested party’s point in the range

Functional analysis

Functional analysis

How to do a functional analysis?

Financial overview – Collect P&L and balance sheet for last five years Collect Schedule 25A forms for last five years Details of international related party dealings e.g. type, contracting party, amounts, for last five years Investigate and document reasons for losses, fluctuations in performance, unusual items etc Collect business plans, financial projections Collect documentation re major investment decisions e.g. Board minutes Identify gaps in information

Functional analysis

Functional analysis

How to do a functional analysis?

Document your findings – Summarize your findings in clear, logical and unambiguous format Templates for presentation of documentation are available Conclude with identification of transactions, characterization of entity Continue to selection of most appropriate methodology

Functional analysis – in practice • Taxpayers should be heavily involved in the functional analysis

Functional analysis – in practice

Taxpayers should be heavily involved in the functional analysis process

You know your business better than any consultant! Identifies commercial performance issues – good business sense Capture company information before it is lost Helps to identify planning opportunities and tax/TP exposures Review it at least annually, and keep it up-to-date Leverage from overseas documentation as far as possible Be clear about who does what Be realistic - it is not a marketing exercise

Functional classification – distribution companies Ball park net margin for sales • Full risk
Functional classification –
distribution companies
Ball park
net margin
for sales
• Full risk marketer/distributor
entity
4%
3%
• Stripped risk buy/sell distributor
Commissionaire
2%
• Commission/sales agent
1%
Reward belonging to Principal/Entrepreneur
Functional classification – manufacturing companies Ball park net cost plus mark-up for manufacturing entity 12%
Functional classification –
manufacturing companies
Ball park net
cost plus
mark-up for
manufacturing
entity
12%
• Full risk manufacturer
9%
• Contract manufacturer
6%
Toll manufacturer
3%
Reward belonging to Principal/Entrepreneur

Functional classification – distribution companies

Functional classification – distribution companies
 

Full Risk

Stripped Risk

Commissionaire

Commission/

Marketer/

Buy/Sell

Sales Agent

Distributor

Distributor

Functional profile

High

Medium

Low

Very low

Entrepreneurial decision-making

Yes

Limited

Very limited

No

Marketing: strategy

Yes

No

No

No

Marketing: execution

Yes

Yes

Yes

Yes

Sales: entrepreneurial

Yes

Yes

Limited

No

Sales: execution

Yes

Yes

Yes

Yes

Management of stock

Yes

Yes

Yes

Perhaps not

Ownership of inventory

Yes

Yes

No

No

Stock risk

Yes

Limited

No

No

Credit risk

Yes

Limited

No

No

Market risk

Yes

Limited

No

No

Local intangibles

Yes

Limited

Very limited

No

Common review method

RPM, TNMM

RPM, TNMM

CP, TNMM

CP, TNMM

Functional classification – manufacturing companies

Functional classification – manufacturing companies
 

Full Risk

Contract

Toll

Manufacturer

Manufacturer

Manufacturer

Functional profile

High

Medium

Low

Entrepreneurial decision-making

Yes

Limited

No

Manufacturing know-how

Yes

Yes

Yes

Management of stock

Yes

Yes

Yes

Ownership of WIP, stock

Yes

Yes

No

Stock risk

Yes

Potentially limited

No

Credit risk

Yes

Limited

No

Market risk

Yes

Limited

No

Common review method

RPS, TNMM

CP, TNMM

CP, TNMM

Price setting – responsibility centres

Price setting – responsibility centres

Remunerate companies based on responsibilities:

• Expense centre - eg core research, strategic marketing

 

actual costs (inc. variances) plus arm’s length mark-up

• Cost centre - eg contract manufacturing, support services

 

standard costs x actual volumes (maybe non-controllable variances as well) plus arm’s length mark-up

• Revenue centre - eg limited risk sales and distribution, commissionaire

allocation of margin by way of commission on sales revenue

• Profit centre - eg full risk sales and distribution, speculative treasury operations

market price x actual volumes (net margin should provide adequate return)

• Investment centre - eg intellectual property owner and developer

effectively residual profit split

Review of outcomes – arm’s length methods

Review of outcomes – arm’s length methods

Sales/revenue Cost of sales Gross margin

100

CUP – Direct price comparison

(70)

CUP – Direct price comparison

30

CPM/RPM – Gross margin comparison

SG&A

(27)

Operating margin

3

PS/TNMM – Net margin comparison

Non-operating items

2

Interest

(3)

Tax

(1)

Net profit

1

Review of outcomes – arm’s length methods

Review of outcomes – arm’s length methods

CUPs in practice

Adjustments may be required to enable reliable application

Differing volumes or currency Differing terms of trade – CIF, FOB, credit terms

Internal CUPs are usually best, but rare in practice

External CUPs are possible in certain types of transaction:

Royalties (RoyaltySource database) Interest rates (Bloomberg, Dealogic) Commodity prices (London Metals Exchange prices) Crude oil prices (from relevant exchange) Factoring fees (SEC 10-K reports, American Guide to Factors) Guarantee fees (Reuters databases)

Review of outcomes – arm’s length methods

Review of outcomes – arm’s length methods

Resale Price (RP) method in practice

Functional comparability required

Less need for similarity in products, terms and conditions Only reliable for limited function distributors adding little value to products

Internal RP can be reasonably reliable, but still rare in practice

External RP – limited by data availability and reliability

Gross margin data available from external sources in Australia since 2001 Variable treatment of certain costs eg cost of sales/ operating expenses Overseas databases, but more uncertainty re accounting treatment Possible use of RP method with TNMM as a cross-check

Review of outcomes – arm’s length methods

Review of outcomes – arm’s length methods

Comparable Uncontrolled Price (CUP) method

 
Tested party X Y Related party
Tested party
X
Y
Related party
Third party
Third party
Tested party A Related party
Tested party
A
Related party
Third party B Third party
Third party
B
Third party

Same products/services etc, similar terms and conditions: compare price of X transaction with price of Y transaction

Same products/services etc, similar terms and conditions: compare price of A transaction with price of B transaction

Review of outcomes – arm’s length methods

Review of outcomes – arm’s length methods

Resale Price (RP) method

 
Related party
Related party
Third party
Third party
Tested party X Y Third party
Tested party
X
Y
Third party
Related party Tested party A Third party
Related party
Tested party
A
Third party
Third party Third party B Third party
Third party
Third party
B
Third party

Similar products, limited value added by tested party distributor: compare gross margin on X with gross margin on Y

Similar products, limited value added by tested party distributor: compare gross margin on A with gross margin on B

Review of outcomes – arm’s length methods

Review of outcomes – arm’s length methods

Cost Plus (CP) method

Tested party X Y Related party
Tested party
X
Y
Related party
Third party
Third party
Tested party A Related party
Tested party
A
Related party
Third party B Third party
Third party
B
Third party

Similar functions, assets and risks:

Similar functions, assets and risks:

compare gross margin on X with gross margin on Y

compare gross margin on A with gross margin on B

Review of outcomes – arm’s length methods

Review of outcomes – arm’s length methods

Cost Plus (CP) method in practice

Common applications:

Semi-finished goods sold between related parties (TR 97/20) Intra-group services (TR 99/1)

Functional comparability required

Only mark-up value-add costs i.e. “non-pass through” costs

Data availability and reliability – per RP method

Need to use fully absorbed (direct and indirect) costs

Benchmarking vs. external comparables sometimes done at net margin level (TNMM, as extension of the cost plus method)

Net cost plus mark-up (NCPM) = mark-up on total costs (OI/TC) Berry ratio = GP/OE

Review of outcomes – arm’s length methods

Review of outcomes – arm’s length methods

Residual profit split method in practice

Identify parties carrying out routine functions => routine profit

Which party is the investment centre/entrepreneur?

Works well in MNC groups with centralized business model

But have to benchmark the routine returns as well – other methods

Can be applied for parts of the group rather than group as a whole

Or for individual transactions or groups of transactions

Can lead to losses being grouped at investment centre level while paying tax elsewhere

Review of outcomes – arm’s length methods

Review of outcomes – arm’s length methods

Contribution profit split method in practice

Requires a genuine sharing of intellectual property rights

Possible bases for measuring each party’s contribution:

Development expenses incurred Capital invested Headcount, salaries Provision of services

Data intensive exercise – prohibitive?

Measurement of contribution can be overly subjective

Examples: global trading, CCA

Review of outcomes – arm’s length methods Profit Split (PS) method - Residual Investment centre
Review of outcomes –
arm’s length methods
Profit Split (PS) method - Residual
Investment centre
Revenue centre
Residual profit
Contract R&D
Cost/Expense centre
services
Call centre
Entrepreneur
services
Limited risk
procurement
Contract
manufacturer
Limited risk
sales and distribution
Routine returns

Review of outcomes – arm’s length methods

returns Review of outcomes – arm’s length methods Profit Split (PS) method - Contribution Overall profit

Profit Split (PS) method - Contribution

Overall

profit

$$$

Tested party

Related party

Related party

Related party

$
$

Split overall profit based on relative value contributed by each party – how to assess depends on facts and circumstances

Review of outcomes – arm’s length methods

Review of outcomes – arm’s length methods

Transactional Net Margin Method (TNMM)

 
Related party
Related party
Third party
Third party
Tested party X Y Third party
Tested party
X
Y
Third party
Related party Tested party A Third party
Related party
Tested party
A
Third party
Third party Third party B Third party
Third party
Third party
B
Third party

Similar functions, assets and risks:

Similar functions, assets and risks:

compare net margin on X with net margin on Y

compare net margin on A with net margin on B

Review of outcomes – arm’s length methods

Review of outcomes – arm’s length methods

TNMM in practice

Internal application more reliable but rare (per RP method)

External application quite common

Looks at net margins – so lower level of functional comparability

Generally use operating margin (i.e. EBIT/Sales ratio)

Australian databases preferred (e.g. Business Who’s Who)

Overseas databases can also be used (e.g. OSIRIS/ORBIS)

Some methods to improve reliability Degree of aggregation of transactions – whole of entity? Inter-quartile range to eliminate outliers Working capital adjustments to focus more on transactions Multiple years of data (usually five years)

Functional analysis and arm’s length methods

Functional analysis and arm’s length methods

Question time

Review of outcomes – by transaction type

Review of outcomes – by transaction type
 

Ideal method

Common

Supporting method

method

Purchase of goods

CUP

RPM

TNMM, applying operating margin (EBIT/Sales)

HQ/management services

CUP

CPM

TNMM, applying NCPM or Berry ratio

Contract/toll manufacturing

CUP

CPM

TNMM, applying NCPM if activity driven by costs, or ROCE if activity driven by capital

services

Royalties

CUP

CUP

TNMM or other – see separate paper

Interest on loans

CUP

CUP

TNMM, applying net profit before tax

Guarantee fees

CUP

CUP

TNMM, applying net profit before tax

Cost contribution arrangements, global trading etc

Contribution PS

Contribution PS

Minimum IRR etc