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HMRC internal manual

International Manual

Transfer pricing: operational guidance: examining transfer pricing reports: information in a report: functional analysis

What is a functional analysis?

As part of the general review of the company and its affiliates, case teams should have a good understanding of what the company does, to whom it sells and how it obtains what it sells. Where affiliates are involved at the other end of the transactions, teams should also understand what those companies do, as well as a broad understanding of the activities of all other main group entities. In most cases this will have been reviewed during the risk assessment process (see INTM482000 onwards).

A transfer pricing report should explore in detail the activities of the company under review and of the affiliate(s) with which it transacts. This is known as a functional analysis, the importance of which is emphasised by the OECD Transfer Pricing Guidelines at paragraphs 1.42 to 1.51.

At arm’s length, reward tends to follow a combination of the functions carried out, the assets employed and the risk borne. The functions carried out and assets employed tend to govern the amount of risk. The functional analysis should provide an insight into all three. Case teams will also need to understand fully how the functions carried out interact with functions carried out by affiliates.

Role of functional analysis

Conducting an effective transfer pricing enquiry requires an understanding of how each group company contributes to the overall trading activities of the group. The transfer pricing report should explain exactly what the company does and how other group companies are involved, which should assist case teams 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 a company does it’s impossible to make a valid assessment of whether it receives an arm’s length reward. It should have been prepared with substantial input from the people in the business who have day to day experience of operating the relevant functions.

A functional analysis should therefore describe what activities the company performs, where those activities take place, who bears what risks and who gets what reward. It should assist with considering 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. An effective functional analysis will be a valuable source of evidence. Its credibility may depend on several factors, including the extent of work conducted by the authors of the report; how detailed an examination of functions and risk in the business has been performed; the quality of evidence obtained from interviews with key personnel, and so on.

Identification of the location and nature of risk is an important aspect of functional analysis. Before risk can be considered, case teams need to understand fully where the functions of the trade are located and carried out. For detailed guidance on risk assessment, see INTM482010 onwards.

Need for critical examination

Unfortunately not all transfer pricing reports contain a good functional analysis.

  • The analysis may lack detail about the UK business or the transactions being scrutinised.
  • The analysis may have been carried out at a high level rather than being built up from questioning the operational employees of the UK business.
  • Assumptions may not have been checked and facts may be incorrect.
  • Some intra-group transactions may have been omitted.
  • Exceptionally the transfer pricing report may not include a functional analysis at all!

Critical examination of a functional analysis is very important, because where it is inadequate, the value of the remainder of the report is doubtful.