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Summary TP - functional analysis (EXAM SCHEMES)
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TRANSFER PRICINGA. The Arm’s length principle:
Transfer Pricing is the consequence of enterprises creating value chains which cover several
jurisdictions, therefore giving several authorities the right to levy taxes on the income attributable to
their respective jurisdiction.
Given that MNCs can enter into transactions with associated parties, these may not reflect the
attribution of income that would take place between independent parties. This is because by setting
the price in favourable ways, they would be able to shift income to low-tax jurisdictions.
o In order to strike a balance between the interests on MNC and tax administrations with regard
to the setting of TP the Arm’s length principle is applied.
This guarantees that the prices charged between related parties reflect the prices that
would have been charged between independent parties in a comparable transaction in
comparable circumstances
The ALP is based on the theory of market forces, which dictates that supply and demand determine the
prices for good/services between independent parties.
o Setting intercompany prices at arm’s length implies relying on the pricing that would be
adopted by independent companies1 in comparable situations2.
o In order to compare transactions that are actually comparable:
1. The heart of TP consists in applying the 5 comparability factors (in particular the functional
analysis)
2. Then, based on the outcome of the step above, transfer prices are determined as part of a
comparability analysis (ie benchmarking process).
Accordingly, the arm’s length price is determined by relying on objective factors (ie the conditions
identified through the comparability factors) that would be relevant between independent parties to
establish the appropriate price.
o Hence, the ALP is based on 3 fundamental principles:
1. The separate entity approach3;
- Each party is deemed to be acting in their own interest by trying to maximise
profits
2. The relevance of contractual arrangements;
3. The comparability analysis4
By ensuring that the ALP is respected, this ensures that the parties’ income, and eventually the
corporate taxes paid on their profits, is acceptable in the various states involved.
1
After Step 1 is done (ie identification + delineation), it is possible to undertake Step 2 -> benchmarking process
2
The 5 comparability factors -> identify and delinate the controlled transaction. This is vital to then find a comparable
independent transaction (ie benchmarking).
3
The associated enterprises should be treated as separate legal entities pursuing their own interests.
4
The assessment of the ALP should be performed by ‘comparison’ of ‘conditions made or imposed’ between
associated enterprises and independent ones in a comparable situation.
, B. The comparability process
The comparability process includes 2 Phases divided in 9 Steps.
C. The tested party
Choice of the tested party amongst the parties to the transaction (Para. 3.18 & 3.19 OECD TPGs (2017)).
Tested party = least complex functions/routine functions
Distinguish key from routine on the basis of functional analysis and risk analysis
D. The application of the ALP in practice:
The process leading to the application of the ALP should comply with these fundamental steps:
Step 1: the identification of the commercial or financial relations Phase 1
Step 2: the recognition of the accurately delineated transaction undertaken
Step 3: the selection of the most appropriate TP method Phase 2
Step 4: the application of the most appropriate TP method (Benchmarking)
E. Step 1: the identification of the commercial or financial relations
In order to get the accurate delineation of the actual transaction it is important to start with the
identification of the commercial or financial relations between the associated companies. In order to do
so:
(i) First, understand the industry sector in which the MNC operates
- In particular, identify the various factors that influence the performance of the sector as
a whole
(ii) Second, perform an analysis of the MNC Group itself
- In particular, the ownership structure, the role and relations of the related entity
- The TPG provide 5 comparability factors to identify the commercial and financial
relations between the associated parties:
1. Contractual terms
2. Functional analysis
3. Characteristic of property or services
4. Economic circumstances
5. Business strategies
1. Contractual terms
Analysis of the contractual relations is the starting point of a comparability analysis
Hence, the written terms defining the functions, risks ecc must be analysed
2. Functional analysis
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