What is functional analysis?

Article – October 2017 | RoyaltyRange

Kestutis Rudzika, Director

As the Organisation for Economic Co-operation and Development (OECD)’s 2017 edition of the Transfer Pricing Guidelines provides only a short explanation of what a functional analysis is, we thought we would explain it in more detail here. Our transfer pricing functional analysis description is based on our experience at RoyaltyRange and the available guidance.

The functional analysis is used for transfer pricing purposes. It analyzes the functions performed (taking into account assets used and risks assumed) by associated enterprises in a transaction. In order to determine arm’s length transfer pricing, multinational enterprises (MNEs) must identify, by means of a functional analysis, which members of the MNE group perform or exercise control over functions, provide assets and assume risks associated with the transaction. The functional analysis is a way of structuring and organizing factual information about the functions and roles of the related parties in a transaction, providing an understanding of the functional profiles of the parties to the transaction.

The functional analysis is important as it provides an overview of value creation within the supply chain in general and the related party transaction in particular. It provides an understanding of the relative contributions of the parties to the transaction and their roles in overall value creation.

The functional analysis should focus on what each of the parties actually does and the capabilities it provides. It is not the volume of functions an entity performs that is important for the analysis – it is the economic significance of those functions in terms of their frequency, nature and value to the respective parties to the transactions. The functions and their significance should be viewed in light of the value drivers of the business. Performing or exercising control over the functions that contribute most to value drivers has the biggest impact on overall value creation and, ultimately, profits from the transaction.

It is known that the functions performed and especially risks assumed can have a significant effect on the profitability of the entity that performs the functions and assumes the risks. Further, it is typically the case that the functions correlate with the risks and also impact the assets used.

A functional analysis is usually performed during a functional analysis interview meeting or call. It provides a description of the material controlled transactions and the context in which they take place. It also documents the functions performed, risks assumed and assets used with respect to these transactions.

The functional analysis provides the factual background and is used to establish the transfer pricing methodology based on the OECD’s transfer pricing guidance.

Kestutis Rudzika, Director

 

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