Main aspects of Functional Analysis and Comparability Analysis
RoyaltyRange
Functional Analysis and Comparability Analysis are integral components of Transfer Pricing, providing a framework for assessing the arm’s length nature of related-party transactions.
Let‘s explore the main aspects of Functional Analysis and Comparability Analysis, highlighting their importance in Transfer Pricing practice and their role in promoting fair and transparent taxation in an increasingly globalized economy.
Comparability analysis
According to the OECD, Comparability Analysis includes comparing a transaction between related parties with a similar transaction between unrelated parties. Transactions are considered comparable when any differences between them would not significantly impact the aspect being examined, such as price or profit margin. Alternatively, if there are differences, adjustments can be made to eliminate their effects, ensuring a fair and accurate comparison.
Elements, that possibly may affect price or profit should be included in Comparability Analysis. There are five factors, that are mentioned in the regulations:
- Functional Analysis
- Contractual term
- Risk
- Economic condition
- Property or service
Aspects of Functional analysis will be discussed in more detail later in the text.
The OECD identified nine steps of Comparability Analysis performance. These steps are not mandatory, but they provide perfect technical guidance:
- Step 1 – Determination of years to be covered
- Step 2 – Broad-based analysis of the taxpayer’s circumstances
- Step 3 – Understanding the Controlled Transaction(s)
- Step 4 – Review of Existing Internal Comparables, if any
- Step 5 – Review information on external comparable
- Step 6 – Selection of the most appropriate Transfer Pricing method
- Step 7 – Identification of Potential Comparables
- Step 8 – Make comparability adjustments if necessary
- Step 9 – Interpretation and usage of data that has been collected, and determination of arm’s length aspects
Step No. 9 is taken to calculate an arm’s length price or profit level indicator using a reliable comparable. Note, that most times, this process is not a linear one. A consistent Transfer Pricing analysis seeks to achieve a strong level of comparability between related-party transactions and transactions conducted between independent parties. To assess the level of comparability accurately and make necessary adjustments, it is essential to establish parameters for comparing factors that could affect the similarity between the analyzed transactions and independent transactions.
Functional Analysis
The Functional Analysis provides a foundation for applying Transfer Pricing methods and determining arm’s length prices for related-party transactions. By understanding the economic substance of the transaction and allocating functions, assets, and risks appropriately, Functional Analysis helps ensure that transfer prices accurately reflect market conditions and prevent tax avoidance practices.
So, in most cases, Functional analysis, also known as FAR analysis, entails identifying the functions executed, assets utilized, and risks undertaken regarding an enterprise’s internationally controlled transactions. It aims to highlight and compare the economically impactful activities and duties carried out by both independent and associated enterprises. An economically significant activity is one that substantially influences the price set in a transaction and/or the resulting profits.
Functional Analysis involves the process of gathering and structuring information regarding a transaction, focusing on the functions, risks, and assets to discern their allocation among the involved parties. By examining these elements, the analysis aims to ascertain the types of functions carried out, the extent of risks assumed, and the nature of assets utilized by each party. This examination aids in selecting the appropriate tested party/parties, determining the most suitable Transfer Pricing method, identifying comparables, and ultimately assessing whether the profits (or losses) earned align with the functions performed, assets employed, and risks undertaken.
The importance of Functional Analysis is that the anticipated return of entities engaged in a transaction depends on the significance of the functions executed, the nature and extent of risks undertaken, and the nature and value of assets utilized. Typically, the party that performs more valuable functions, employs more assets and assumes greater risks stands to gain a higher expected return (or face a greater potential loss). Consequently, thoroughly outlining the functions performed, assets employed, and risks assumed by all associated enterprises concerning the investigated controlled transaction is very important.
Functional Analysis and Comparability Analysis are critical for applying Transfer Pricing methods effectively, ensuring compliance with the arm’s length principle, and mitigating tax risks associated with related-party transactions.
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Sources:
https://www.un.org/esa/ffd/wp-content/uploads/2014/09/8STM_PPT_Chapter5.pdf
https://tpguidelines.com/b-2-comparability-analysis/
https://www.linkedin.com/pulse/transfer-pricing-comparability-analysis-functional-sakhare-k01bf/
https://portal.finiz.singidunum.ac.rs/Media/files/2018/99-106.pdf