In dealing between two independent enterprises, the price charged, usually reflects the functions that each enterprise performs ( taking into account assets used and risks assumed). Therefore, in determining whether controlled and uncontrolled transactions are comparable, comparison of the functions performed, assets used and risks assumed by the parties is necessary. This comparison is based on a FAR Study. Functional study thus forms the basis, and provides a framework for comparability study and subsequent determination of the most appropriate method. It assists in proper assessment of comparability for the purpose of arm’s length study.
How to conduct and document functional analysis :
The steps involved in performing functional study can be broadly classified into
- Fact finding process ;
- study of functions, assets and risks; and
- Industry study.
These steps are discussed as under:
Fact finding process
Functional Analysis is, as such, a process of finding and organizing facts about a business in terms of its functions, risks and assets in order to identify how these are divided between the parties involved in the transaction. The functions, risks and assets are analyzed to determine the nature of functions performed, degree of risks undertaken and the kind of the assets used. This study helps to determine whether the profits (or losses) earned by the entities are appropriate to the functions performed, assets used and risks assumed.
Gathering basic information :
To conduct a Functional Analysis, it is necessary to gather information from different sources ( internal as well as external). The process of Functional Analysis is generally carried out in stages / steps. Before initiating this process, as a precursor to functional study, it is necessary to gather background information about the enterprise to understand its business operations and activities. For this purpose, the enterprise’s Annual Report, Product brochures, management letters, internal reports ( for example, due diligence reports, market strategy report, product and technology report et.) Could act as a good starting point. A study of these documents will provide an idea of the industry to which enterprise belongs, nature of its business activities ( i.e. Manufacturer, wholesaler, distributor etc.), its market segment, market share, market penetration strategies, type of products/services dealt etc. This exercise not only helps in understanding the business environment of the enterprise but also facilitates the process of documenting the following information required by the regulations:
- Description of the ownership structure of the enterprise ;
- Profile of multinational group of which the enterprise is a part ;
- Broad description of the business of the enterprise ;
- Broad description of the industry to which the enterprise belongs.
Gathering specific information:
Having gathered the general information about the enterprise’s business activities and operations, one needs to gather specific information which is as under:
- Identification of associated enterprises ;
- Identification of international transactions ; and,
- Details about international transactions ( nature of products / services transferred, value thereof, terms and conditions etc.
In the process, following information needs to be gathered with respect to each class of international transaction:
- Functions generally performed by each party.
- Assets generally employed in a transaction.
- Risks generally assumed by each party to the transaction.
- Identification of comparables.
Besides, the contractual terms that have effect on transfer prices are also to be examined. For understanding the terms of a transaction, one may need to go through the correspondence / communication between the parties in addition to written contracts.
Gathering relevant documents:
In addition to the above information, one may need to collect the following important documents:
- Agreements, common group policy, written pricing policies etc., between the associated enterprises, etc.
- Product brochures, marketing materials etc.
- Documents providing information such as marketing strategies, pricing strategies etc.
- Information about major competitors, customers, market, etc.
Identifying comparables :
During data / information gathering process, it is crucial to bear in mind that underlying aim is also to identify comparable transactions / comparative information. The availability of comparable transactions varies from case to case. The search for comparable can begin with a review of the enterprise’s business operations. During the fact finding discussions, one would have to go into the existence of any internal and to some extent of the external comparables. The most important source of information on external comparables can be the operating personnel, who know their industry and characteristics of competitors and can frequently provide valuable sources of information about competitors and potential comparables.
Functional study is not an alternative to searching for comparables but it is a way to establish what sort of comparables need to be sought.
Analysis of functions, assets and risks undertaken:
In conducting functional study, one basic rule followed is that the return earned by the entities involved in a transaction varies directly with the importance of the functions performed, the degree of risks undertaken and the value of assets deployed:
Functions performed are the activities that are carried out by each of the parties to the transaction. In performing functional analysis, important and significant functions are considered. Such functions add more value to the transactions and therefore, are expected to fetch higher returns for the entity performing such functions. Thus, the focus should be not only on identifying the maximum number of functions but on identification of critical functions performed by the related parties.
Some of the important functions that are generally observed and examined in a transaction are:
- Research and Development ;
- Process engineering and designing work ;
- Purchasing and materials management ;
- Manufacturing, production or assembly work ;
- Warehousing and inventory ;
- Marketing and distribution ;
- Development of software services;
- Business Process Management;
- Outsourcing nature of wok etc.
Having identified the principal functions performed by the parties in a controlled transaction, as next step of comparability study, the same are compared with the functions performed in uncontrolled transactions.
Risks assumed :
Risk study involves identification of various risks that are assumed by each of the parties to the transaction. It is commonly understood that risk and return go hand-in-hand. In the open market, more the risks assumed by an enterprise, higher the returns that it expects. Conversely, in case where the risks undertaken by the enterprise in a transaction are minimal, the returns expected to be generated from such transactions should also be normally lower. Some of the significant risks present in transactions are tabulated below :
|Nature of Risks
- Method of funding
- Funding of losses
- Foreign exchange risk.
- Design and development of product
- Upgradation / obsolescence of product
- After sales service
- Risks associated with R and D
- Product liability risk
- Intellectual property risk, if any.
- Development of market including advertisement and product promotion, etc.
- Fluctuation in demand and prices.
- Business cycle risk.
- Risk of loss associated with capital investment.
Risk study is an important exercise as it facilitates adjustments based on differences in risks that are undertaken in a controlled transaction as compared to uncontrolled transactions.
As regards assets employed, one needs to identify the assets ( tangible as well as intangible) used in the course of international transaction. One also needs to study the role of various departments in performing the desired functions and utilization of all kinds of assets.
The study should involve identification of the type of capital assets used, as well as the capital assets left idle and the nature of assets used, such as the age, market value, location, property right protections available etc., and quantify the same, whenever possible.
In case of capital intensive industries, the employment of a capital asset such as property, plant and equipment etc. Is costly and has to be financed either internally or externally. However, there can also be cases where entities involved are doing pure assembly work for which the assets employed may not require huge capital investment.
It is also essential to know which entity developed the intangibles, which has the legal ownership of the intangibles, and which receives the benefit of the intangibles.
A check-list for gathering information with illustration covering transaction of export of finished goods is provided below:
Checklist for information gathering with illustration:
Compliance to TP Regulations should be preceded by a thorough study of the assessee’s business and various aspects attributed to it. The same can be assimilated from various sources viz., Internet website of the assessee, company annual reports, various business journals, etc.
The aim of the above said exercise is to understand the business operations of the assessee so as to properly identify, analyze and categorize the assessee, and also comparables and arrive at an objective ALP.
Information to be obtained, in case of manufacturing companies would include product profile, product strategy and design, share of different products in the sales turnover of the company, production capacity, research and development activities undertaken by the company etc. Whereas, in case of service providers, requisite details would comprise of nature of services rendered / availed of, pricing of such services in the relevant industry etc.