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How to Rock a Transfer Pricing Functional Analysis

At the heart of the transfer pricing benchmarking process is the functional analysis. And as CrossBorder Solutions’ Chief Economist Mimi Song explains on the ‘Fiona Show’ podcast: Once you get a handle on functions, assets, and risks, the rest of your transfer pricing report falls into place. But assessing the functions of different multinational entities is not as straight-forward as it seems.

Mary Lynn Mitcham Strom: So let’s start with the very basics. What is a transfer pricing functional analysis?

Mimi Song: So the functional analysis of any transfer pricing study is really the heart of the analysis. What it is, is it provides a description of the various functions being performed, the risks being assumed, and the assets that are employed with respect to the intercompany transaction. It’s really important that the functional analysis is reflective of the facts and circumstances so that the economist performing this study can appropriately apply the right methods.

Mary Lynn Mitcham Strom: So basically you’re looking at the function of each entity and the assets and the economic risks that each one is assuming. Now, why would you need to know that? Why is that so important to somebody who’s doing a transfer pricing analysis?

Mimi Song:  So a transfer pricing analysis essentially is based on the facts and circumstances. In order to do the analysis appropriately, and in order to apply the various methods from a transfer pricing perspective, then you need to understand what it is that the business is doing, right? It’s critically important to understand what the business is doing and who is bearing what levels of risks in order to apply the methods correctly.

So we can talk about the application of a Comparable Profits Method where you have to select a certain tested party. And so if you are trying to analyze the arm’s length nature of that intercompany transaction and you select one entity as the tested party, then essentially what you’re going to do is identify companies that are performing similar functions, that are bearing similar levels of risk, and holding similar levels of assets in order to make a apples-to-apples comparison to the extent that we can.

You know, we can’t control for everything, right?

Mary Lynn Mitcham Strom: Right. So this really helps you in your comparison. And this reminds me of when Andrei was on here, he said that question he often gets is, “Why aren’t my competitors my comparables?”

Mimi Song: Because a functional analysis is very specific to the actual intercompany transaction. It doesn’t necessarily mean a functional analysis for the whole entity. And so you have to look at it specifically on what it is that the transaction that’s being analyzed. Because in a certain situation, this company could be a major pharmaceutical manufacturing company. But the transaction you might be looking at is a services transaction where the U.S. headquarter company is providing certain services to a subsidiary. And in that case, your functional analysis is focused on those services that are being performed, not necessarily all of the different activities being performed by the manufacturer or the pharmaceutical company.

Mary Lynn Mitcham Strom: Well, let’s just bring in the big guns for a second and let’s ask Fiona what she thinks. Fiona, what does a functional analysis impact in transfer pricing?

Fiona: Just about everything, Mary Lynn. It indicates which entity should be your tested party. It can impact the comparables in the profit level indicators you use. The functional analysis can also have impact restructuring or penalties and adjustments.

Mary Lynn Mitcham Strom: One thing we touched upon with Fiona is that it determines how an entity is characterized. Can you talk a little bit about that?

Mimi Song: So why, why do you even need to characterize an entity? Well, I mean the idea of characterizing them is just so that at least from an economic perspective or an analysis perspective, you’re trying to find like companies. I mean, that’s all it is, right? You’re just saying, “Okay, now that I’ve, now I understand the functional profile of this company and it’s like a distributor.” And so essentially that means I can do a benchmark analysis for distributors of other companies that are comparable. Right?

Mary Lynn Mitcham Strom: So if you are going to understand an entities, functions, assets and risks, you kind of need to understand the company as a whole. So what kinds of things do you want to consider? What kinds of things do you want to know?

Mimi Song: Lots of different things. Things you want to know: how many people there and their company, you want to know where that company resides, what are the people actually doing within that company? What are the different departments? What are the different departmental roles? What might be that company’s go to market strategy? What might be that company’s reason for being in that your particular jurisdiction?

So those are all the different types of elements that you want to see. Because when you’re doing a transfer pricing analysis and you’re doing a functional analysis, you just need to understand what that company does and even if you’re looking at it on a segmented basis.

So going back to my pharmaceutical example, if you’re trying to isolate management services, that’s called segmenting the entity. You’re doing a segmented sort of intercompany transaction analysis. Even in that case, you do want to go down to that level of detail to understand what exactly is happening and being performed by each of the different employees of that company so that you can really understand the rationalization from a business perspective of why they’re doing this.

Mary Lynn Mitcham Strom: You get a really unique look at a company this way, by breaking it down like this.

Mimi Song: Absolutely. It’s interesting because, I’m sure consumers typically look at a company and we’ll say, “Oh, that company is a company that performs A, B, C,” right? So you might take a company like Pepsi and say, “Oh, Pepsi manufacturers soda products, and lots of different types of beverages.”

Now from a transfer pricing perspective, what’s really interesting and fascinating is that a company like Pepsi is more than just a soda manufacturer. In fact, they’re brand developers. They’re sort of leaders in this lifestyle brand development and consumer experience beyond that. And in certain situations, Pepsi’s actually a really good example because they also have a bottling operation. And so that impacts the entire supply chain.

So the bottling operation at one point used to be part of Pepsi. They used to be a related subsidiary, part of their entire supply chain, and they were a vertically integrated organization.

And then there were certain business decisions that they made where they actually spun it off, and the bottling company was a completely different third party, unrelated entity. Then that bottling company, bottled products for other companies. And then – different business descriptions, economic situations impacted these business decisions – they decided to spin it back, bring it back internally, and re-vertically integrate. So it’s fascinating because people don’t really know that, that like Pepsi may or may not have at any given point in time bottled their own products. And that’s a function.

Mary Lynn Mitcham Strom: So let’s just ask Fiona for a minute. Fiona, what other types of functions might be used in a functional analysis?

Fiona: That can mean any function that an entity provides in a transaction. There are so many functions. Manufacturing is an obvious one. Distribution is another, but there are plenty more design, purchasing, marketing and so on.

Mimi Song: Well, along the lines of my previous two examples: management services, administrative functions, back office functions, don’t forget the tax function, right? In addition you have bottling, you have assembly, you have design and development, market development, business development… I mean, those are all very important functions to any organization.

Mary Lynn Mitcham Strom: So typically, entities or organizations have more than one function. How do you show this on a transfer pricing report? How do you show the functions? Is there a chart that you mark off with different types of things that an entity might do?

Mimi Song: Yup, and we not only have a functional analysis chart, but we also describe that function in more detail. Because it’s one thing to say, “Oh, this company has an R&D function.” But what does that mean? What is, what is R&D relative to that particular company? So then we have a chart that says, “Yes, this entity performs that function.” And then we have a description that says, “R&D functions include development of pharmaceutical products, which includes researching underlying active formulas…” and all that fun chemical chemistry stuff.

But I did not pass Chemistry 101, which is why I’m in tax.

Mary Lynn Mitcham Strom: That’s okay! We’re happy to have you here in tax. So if you’re preparing a functional analysis, what questions do you need the company to answer?

Mimi Song: The basic question you start off with is “Tell me what your company does.” And that’s just the basic question you start with because once they start talking about it, then you go into more specifics… “Okay. That, that’s great. Tell me more about that particular aspect of your business. Why do you have that particular type of sales strategy? How does this support your particular business model? Do you do anything different in this country versus this country?”

Mary Lynn Mitcham Strom: That’s a good one. How does breaking down the functions then help in terms of your analysis?

Mimi Song: So we always have to sort of break down what a company does into these components so as, because we’re trying to control for them that’s really what it is. And in order to control for as many factors as you can, you want to look at it in sort of digestible pieces. And in theory from a transfer pricing perspective, you want to analyze everything on a transactional basis.

So let’s go back to our example where we have a big pharmaceutical company that provides management services to its subsidiaries. One of the services could be a tax service, one of it could be IT support services. But if we know that those are two different types of services being performed, well we might want to do two different benchmarks because a third party company that performs provides IT services may not in fact also provide finance or tax services. So you want to break it down into these digestible components where you think you will be able to actually identify third party companies that are performing similar activities or comparable activities.

Mary Lynn Mitcham Strom: So you’re really putting things under the microscope.

Mimi Song: Right.

Mary Lynn Mitcham Strom: So let’s look at assets employed for a minute. What are assets when we talk about our transfer pricing transaction?

Mimi Song: So assets can be both tangible assets, fixed assets, and they can also be intangible assets. And tangible assets are easy to identify because it’s on your balance sheet. It relates to the PP&E – plant, property, and equipment – that you might hold. A manufacturing facility has huge machinery and so, if they have a significant level of machinery and they manufacture goods, that’s an important aspect of understanding how they operate as an organization. Logistics is actually a really good example of that.

So in some logistics services, they own the ships or the modes of transportation where they get things from point A to point B. In other cases, they don’t own the assets. And in both business models, they’re both logistic services, but they are in very different returns. To be honest, Uber is technically a logistics service – and they don’t own any of the cars. Versus Hertz is a car rental company. They own all the cars and still, it’s providing a somewhat of a logistics service.

Mary Lynn Mitcham Strom: So they wouldn’t be comparable.

Mimi Song: They wouldn’t be comparable. Like FedEx owns, I think, the courier airplanes that actually take the products from point A to point B versus other logistics companies that don’t own their own carriers and that makes a huge impact. To the margins that they are earning and also how much they’re contributing to the transaction. So well, the aspect of assets that we haven’t really talked about yet would be intangible assets. And that’s a whole ‘nother ball of wax when it comes to assets, right? And something that is not as controllable because by definition an intangible… is not tangible. And therefore, how do you quantify it? How do you know what it’s actually worth? And it’s worth different things to different companies.

DMPE relates to intangible assets, right? So the idea of DMPE functions, it’s development enhancement, maintenance, protection and exploitation. That’s what that acronym stands for. And there’s a lot of focus there because in certain business situations, they’ve established a framework where all the IP or the intangibles are owned by a jurisdiction that actually didn’t develop the IP. And then it’s owned by a jurisdiction that’s not actually the one exploiting the IP, or enhancing the IP. And so there’s a lot of focus on “What constitutes IP ownership?” “What is a sufficient level of activities or functions to be performed to constitute IP ownership?” But both legally and economically, like there’s a lot of debate around that.

Mary Lynn Mitcham Strom: So to list that IP as an asset that you’re contributing to this transaction.

Mimi Song: Well you wouldn’t really, a lot of times you would never say that I’m contributing IP to this transaction per se. So you might analyze a transaction where one party licenses the rights to exploit IP. That’s a, that’s a particular type of transaction. And usually when we look at IP transactions, we look at them in isolation too. Because as transfer pricing economists, you want to try to, analyze things at the lowest level possible. That’s always dependent on the availability of data – and both internal and market data. So it’s important to take that into consideration before you actually do the analysis.

Mary Lynn Mitcham Strom: So moving on to risks, what are you referring to? This one is always confusing to me. What are you referring to when you talk about risks?

Mimi Song:  So different businesses have different types of risk. I mean, I think the easiest type of risk to talk about at least between a related party versus third parties is foreign exchange risk because – if I were to buy something in euros versus U S dollars – if  the exchange rate fluctuates, I could be made worse off or better off.

So for an exchange rate, risk does have an impact to the intercompany pricing. I think it’s important to take that into consideration. It’s one thing that you can at least try to control for when you look for comparable companies. There’s lots of different risk — there’s market risk, operational risk, credit risk –just the typical types of risks that you would be looking at in any business context. And why that’s important is in a related party context, you can actually indemnify all the related parties of lots of different types of risks.

So if you’re actually stripping out the risk, then ultimately they should earn a profit margin that is in line with that level of risk that they bear because the basic tenant of economics is risk equals reward.

Mary Lynn Mitcham Strom: So once you’ve identified each entity’s functions, the risks they’re assuming and the assets they’re contributing, what is the next step?

Mimi Song: Based on your understanding of the functions, assets and risks then we have to evaluate how we can best analyze the intercompany transactions. So you look at both sides. If we’re applying a profit based economic analysis, you’d look at which entity is bearing less risk and performing less functions because that’s easier to control for.

This is all about how are you going to perform an empirical exercise on controllable functions, and that’s really what it boils down to. You’re going to look at all of the different activities being performed in order to understand which side of the transaction you want to benchmark from a profit-based analysis perspective. If you are going to apply a different type of method, then you’re going to make sure to look for potential CUPs with the same characteristics that you identified as a result of the functional analysis.

Mary Lynn Mitcham Strom: And what might some of those characteristics be?

Mimi Song: So you might be looking at, once again, are they holding inventory risk? Are they actually buying the good from the related party as a distributor? Or are they purely drop shipping the goods to the customer as purely a sales operation? And if they are holding it in their warehouse for exampl, and varying that level of inventory risk, that has a direct impact to the type of companies you want to examine.

Mary Lynn Mitcham Strom: Okay. And so what do those characterizations tell you? What do they indicate for you? Do they indicate, I mean obviously you mentioned they indicate, which comparables you’re going to look at. Do they also tell you anything about profit level indicators?

Mimi Song: Actually, yeah, if we want to tie this into private level indicators: absolutely. Because I think the functional analysis and the understanding of the control transaction also has an impact to what type of private level indicator you might want to apply. Because you want a profit level indicator to actually reflect the facts and circumstances, to actually reflect the functional profile. So if you’re looking at a distributor, evaluating a return on sales is an appropriate level to measure profitability.

So as opposed to services usually looking at services as a return on their costs is an appropriate profit level indicator to understand what a service provider should earn. Because the majority of the service provider’s overhead is people costs.

Mary Lynn Mitcham Strom: So I bet when you look at a company, you see things that other people do not see.

Mimi Song: Well, I try. But yeah, I think transfer pricing is fascinating because you get to learn so many facets of a business and you get to understand the entire value chain and the supply chain and it’s not a lot of people learn that or see the inner workings of an organization. You get all the details – all the details. And what it seems like to me is if you take your time and do like put a real effort into the functional analysis, then the rest of your transfer pricing report becomes a lot easier to fall into place.