Functional analysis is one of the fundamental pillars of the transfer pricing regime and a central element for the correct application of the arm’s length principle. In the current context of intensified tax enforcement and regulatory convergence towards the standards of the Organization for Economic Cooperation and Development (OECD), this analysis takes on strategic importance for multinational groups operating in multiple jurisdictions.
Through functional analysis, tax administrations seek to understand how value is generated within a business group, identifying the functions performed, the assets used, and the risks assumed by each related entity. Its correct preparation is crucial to support transfer pricing policy and mitigate tax contingencies.
Concept and scope of functional analysis
Functional analysis is a systematic evaluation of the economic activities carried out by related parties in a controlled transaction. Its objective is to determine the actual contribution of each entity to value creation, allowing for a consistent allocation of profits in accordance with the arm’s length principle.
According to the OECD Transfer Pricing Guidelines, this analysis should not be limited to a formal description of the transactions, but should reflect the underlying economic reality and the capabilities that the parties actually contribute to the transaction. In this regard, the distinction between legal ownership of assets or risks and their effective control, as well as the financial capacity to assume them, is particularly important.
Functions: identification and economic characterization
Functions represent the activities performed by each entity within the group, such as manufacturing, distribution, research and development, marketing, logistics, or administrative services. Their analysis allows entities to be classified into specific functional profiles (limited-risk manufacturer, routine distributor, low value-added service provider, among others).
Proper identification of functions is essential for selecting the most appropriate transfer pricing method and determining the expected level of profitability. Entities that perform strategic or high value-added functions, focused on key business strategy decisions, often justify a greater share of the group’s profits. The OECD emphasizes that what is relevant is not the number of functions, but their economic importance in terms of frequency, nature, and value.
Assets: tangible, intangible, and financial
The analysis of assets considers both the tangible assets used in the operation and the relevant intangible assets, such as trademarks, patents, software, know-how, or contractual rights. The analysis must consider the nature of the assets, their age, market value, and location, as well as the existence of effective property rights.
The OECD Guidelines emphasize that mere legal ownership of an intangible asset is not sufficient to attribute the associated benefits to it. It is necessary to identify which entity develops, improves, maintains, protects, and exploits these assets, in accordance with the DEMPE approach, as well as to assess their effective economic contribution.
Risks: control, capacity, and actual assumption
The correct identification and allocation of risks is another critical component of functional analysis. For the analysis to be complete, the specific risk must be identified, how it is contractually allocated must be determined, and, fundamentally, whether the party assuming it exercises actual control must be validated.
The OECD establishes that risks must be allocated to the entity that exercises control over them and has the financial capacity to bear their consequences. Control implies having the capacity and authority to decide whether to accept or reject the risk, as well as to decide how to respond to it. It is essential to distinguish between “risk mitigation” (operational tasks that can be outsourced) and “risk control” (strategic decision-making capacity). In the absence of control or financial capacity on the part of the party that contractually assumes the risk, the associated profitability must be reallocated to the party that effectively exercises such control.
Relationship between functional analysis and the selection of the transfer pricing method
Functional analysis is decisive in selecting the most appropriate transfer pricing method. Traditional methods such as Comparable Uncontrolled Price (CUP) or Resale Price require a high degree of functional comparability, while margin-based methods, such as the Transactional Net Margin Method (TNMM), are typically applied to entities with routine functions.
Incorrect functional characterization can lead to the application of inappropriate methods, resulting in tax adjustments, fines, and disputes with tax authorities. Therefore, functional analysis must be kept up to date and aligned with the group’s operational reality.
Importance of functional analysis in audits and inspections
In practice, functional analysis is one of the first elements reviewed during a transfer pricing audit. Tax administrations use this information to assess the consistency between the taxpayer’s narrative, financial results, and profit allocation. The aim is to validate that the remuneration reflects the real options that companies would have had if they were independent under similar conditions.
A solid, consistent, and well-documented functional analysis not only facilitates technical defense in the event of an audit but also contributes to proactive tax risk management, reducing the likelihood of significant adjustments.
Conclusion
Functional analysis is an essential component for the correct application of the transfer pricing regime and for the alignment of tax results with the creation of economic value within multinational groups. Properly conducted functional analysis supports pricing policy, enables the selection of appropriate methods, and allows for effective responses to tax authority requirements, ensuring that the allocation of risks and benefits is consistent with the actual behavior of the parties in the market.
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At TPC Group, we are a company specializing in transfer pricing that assists multinational groups in the correct application of OECD guidelines, the preparation of robust functional analyses, and comprehensive tax risk management. Our team has extensive experience in technical documentation, defense in audits, and alignment of intra-group policies with economic value creation, ensuring regulatory compliance in multiple jurisdictions.
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