Overview

Functional analysis and arms length methods

Douglas Fone LLB ACA Transfer Pricing Associates

Industry analysis Functional analysis Functional classification of companies Price setting responsibility centres Review of outcomes arms length methods Review of outcomes by transaction type

Industry analysis
What is an industry analysis?
Industry analysis is undertaken to place the functional analysis in the proper context:
Economic, market and regulatory framework of industry of tested party Barriers to entry, maturity of the market Domestic and international competition Cyclical, seasonal factors Overall profitability of the industry What are the value drivers of the industry? Do these fit with competitive strengths of tested party?

Functional analysis
What is a functional analysis?
The mapping of the economically relevant facts and characteristics of the inter-company transactions with regard to their: Functions, Assets and Risks (FAR) The allocation of these FAR between those entities involved in the transaction so that each entity can be characterized appropriately An analysis of the relative importance of these FAR in the generation of business profits - what are the functions, assets and risks of the tested party?

- what is the industry norm profitability?

Functional analysis
What is a functional analysis? - Typical functions
Research and development Manufacturing Logistics Sales Marketing After-sales service Executive management Finance and administration Support services

Functional analysis
What is a functional analysis? - Typical assets
Tangible assets
Plant and machinery Buildings, office equipment

Intangible assets
Patents, formulae Copyrights, licences Trade/brand names, trade marks Technical know-how Corporate reputation High calibre staff e.g. strong sales force Distribution channels/agreements

Functional analysis
What is a functional analysis? - Typical risks
Market risk: changes in volume, product mix, price Inventory risk: obsolescence Defective products/warranty risk Credit risk Product liability risk Foreign exchange risk

Functional analysis
Why do a functional analysis?
Enables a full understanding of the economic value contributed by each entity in the value chain, leading to Selection of the tested party Identification of the tested transactions Appropriate characterization of each entity Selection of the most appropriate pricing/testing method Selection of the most comparable companies etc Prediction of the tested partys point in the range

Functional analysis
How to do a functional analysis?
Preparation, planning Gather required documentation
9 9 9 9 9 9 9

Functional analysis
How to do a functional analysis?
Financial overview Collect P&L and balance sheet for last five years Collect Schedule 25A forms for last five years Details of international related party dealings e.g. type, contracting party, amounts, for last five years Investigate and document reasons for losses, fluctuations in performance, unusual items etc Collect business plans, financial projections Collect documentation re major investment decisions e.g. Board minutes Identify gaps in information

Group structure Management organization chart Inter-company agreements Pre-existing transfer pricing documentation (inc overseas) Transfer pricing manual Product information web site, brochures Competitor information market research etc

Identify gaps in information Select appropriate interviewees

Functional analysis
How to do a functional analysis?
Fact gathering Conduct interviews with key members of staff Ascertain details of what is happening in the business Prepare detailed interview notes Interviewee reviews notes and provides any further information Ensure information gaps are filled

Functional analysis
How to do a functional analysis?
Document your findings Summarize your findings in clear, logical and unambiguous format Templates for presentation of documentation are available Conclude with identification of transactions, characterization of entity Continue to selection of most appropriate methodology

Functional analysis in practice

Functional classification distribution companies

Full Risk Marketer/ Distributor
Functional profile Entrepreneurial decision-making Marketing: strategy Marketing: execution Sales: entrepreneurial Sales: execution Management of stock Ownership of inventory Stock risk Credit risk Market risk Local intangibles Common review method High Yes Yes Yes Yes Yes Yes Yes Yes Yes Yes Yes RPM, TNMM

Taxpayers should be heavily involved in the functional analysis process

You know your business better than any consultant! Identifies commercial performance issues good business sense Capture company information before it is lost Helps to identify planning opportunities and tax/TP exposures Review it at least annually, and keep it up-to-date Leverage from overseas documentation as far as possible Be clear about who does what Be realistic - it is not a marketing exercise

Stripped Risk Buy/Sell Distributor

Medium Limited No Yes Yes Yes Yes Yes Limited Limited Limited Limited RPM, TNMM

Commissionaire

Commission/ Sales Agent

Very low No No Yes No Yes Perhaps not No No No No No CP, TNMM

Low Very limited No Yes Limited Yes Yes No No No No Very limited CP, TNMM

Functional classification distribution companies

Ball park net margin for sales entity

Functional classification manufacturing companies

Full Risk Manufacturer Contract Manufacturer
Medium Limited Yes Yes Yes Potentially limited Limited Limited CP, TNMM

Toll Manufacturer
Low No Yes Yes No No No No CP, TNMM

4%

Full risk marketer/distributor

Functional profile Entrepreneurial decision-making

High Yes Yes Yes Yes Yes Yes Yes RPS, TNMM

3%

Manufacturing know-how Management of stock Stripped risk buy/sell distributor Commissionaire Ownership of WIP, stock Stock risk Credit risk Commission/sales agent

2%

1%

Market risk Common review method

Reward belonging to Principal/Entrepreneur

Functional classification manufacturing companies

Ball park net cost plus mark-up for manufacturing entity

Price setting responsibility centres

Remunerate companies based on responsibilities:
Expense centre - eg core research, strategic marketing

12%

Full risk manufacturer

9%

actual costs (inc. variances) plus arms length mark-up standard costs x actual volumes (maybe non-controllable variances as well) plus arms length mark-up allocation of margin by way of commission on sales revenue market price x actual volumes (net margin should provide adequate return) effectively residual profit split

Contract manufacturer

Cost centre - eg contract manufacturing, support services

6%

Toll manufacturer

Revenue centre - eg limited risk sales and distribution, commissionaire

3%

Profit centre - eg full risk sales and distribution, speculative treasury operations

Investment centre - eg intellectual property owner and developer

Reward belonging to Principal/Entrepreneur

Review of outcomes arms length methods

Sales/revenue Cost of sales Gross margin SG&A Operating margin Non-operating items Interest Tax Net profit 100 (70) 30 (27) 3 2 (3) (1) 1 CUP Direct price comparison CUP Direct price comparison CPM/RPM Gross margin comparison

Review of outcomes arms length methods

Comparable Uncontrolled Price (CUP) method
Tested party Tested party Third party

PS/TNMM Net margin comparison

X Y A B

Related party

Third party

Related party

Third party

Same products/services etc, similar terms and conditions: compare price of X transaction with price of Y transaction

Same products/services etc, similar terms and conditions: compare price of A transaction with price of B transaction

Review of outcomes arms length methods

CUPs in practice
Adjustments may be required to enable reliable application
Differing volumes or currency Differing terms of trade CIF, FOB, credit terms

Review of outcomes arms length methods

Resale Price (RP) method
Related party Third party Related party Third party

Internal CUPs are usually best, but rare in practice External CUPs are possible in certain types of transaction:
Royalties (RoyaltySource database) Interest rates (Bloomberg, Dealogic) Commodity prices (London Metals Exchange prices) Crude oil prices (from relevant exchange) Factoring fees (SEC 10-K reports, American Guide to Factors) Guarantee fees (Reuters databases)
X

Tested party
Y

Tested party
A

Third party
B

Third party Similar products, limited value added by tested party distributor: compare gross margin on X with gross margin on Y

Third party

Third party

Similar products, limited value added by tested party distributor: compare gross margin on A with gross margin on B

Review of outcomes arms length methods

Resale Price (RP) method in practice
Functional comparability required
Less need for similarity in products, terms and conditions Only reliable for limited function distributors adding little value to products

Review of outcomes arms length methods

Cost Plus (CP) method
Tested party Tested party Third party

Internal RP can be reasonably reliable, but still rare in practice External RP limited by data availability and reliability
Gross margin data available from external sources in Australia since 2001 Variable treatment of certain costs eg cost of sales/ operating expenses Overseas databases, but more uncertainty re accounting treatment Possible use of RP method with TNMM as a cross-check

Related party

Third party

Related party

Third party

Similar functions, assets and risks: compare gross margin on X with gross margin on Y

Similar functions, assets and risks: compare gross margin on A with gross margin on B

Review of outcomes arms length methods

Cost Plus (CP) method in practice
Common applications:
Semi-finished goods sold between related parties (TR 97/20) Intra-group services (TR 99/1)

Review of outcomes arms length methods

Profit Split (PS) method - Residual
Contract R&D services
Investment centre Revenue centre Cost/Expense centre

Residual profit

Functional comparability required Only mark-up value-add costs i.e. non-pass through costs Data availability and reliability per RP method Need to use fully absorbed (direct and indirect) costs Benchmarking vs. external comparables sometimes done at net margin level (TNMM, as extension of the cost plus method)
Net cost plus mark-up (NCPM) = mark-up on total costs (OI/TC) Berry ratio = GP/OE

Entrepreneur
Limited risk procurement

Call centre services

Contract manufacturer
Routine returns

Limited risk sales and distribution

Review of outcomes arms length methods

Residual profit split method in practice
Identify parties carrying out routine functions => routine profit Which party is the investment centre/entrepreneur? Works well in MNC groups with centralized business model But have to benchmark the routine returns as well other methods Can be applied for parts of the group rather than group as a whole Or for individual transactions or groups of transactions Can lead to losses being grouped at investment centre level while paying tax elsewhere

Review of outcomes arms length methods

Profit Split (PS) method - Contribution Tested party $ Overall profit $$$ Related party Related party Related party
Split overall profit based on relative value contributed by each party how to assess depends on facts and circumstances

Review of outcomes arms length methods

Contribution profit split method in practice
Requires a genuine sharing of intellectual property rights Possible bases for measuring each partys contribution:
Development expenses incurred Capital invested Headcount, salaries Provision of services

Review of outcomes arms length methods

Transactional Net Margin Method (TNMM)
Related party Third party Related party Third party

Tested party
X Y

Tested party
A

Third party
B

Data intensive exercise prohibitive? Measurement of contribution can be overly subjective Examples: global trading, CCA

Third party Similar functions, assets and risks: compare net margin on X with net margin on Y

Third party

Third party

Similar functions, assets and risks: compare net margin on A with net margin on B

Review of outcomes arms length methods

TNMM in practice
Internal application more reliable but rare (per RP method) External application quite common Looks at net margins so lower level of functional comparability Generally use operating margin (i.e. EBIT/Sales ratio) Australian databases preferred (e.g. Business Whos Who) Overseas databases can also be used (e.g. OSIRIS/ORBIS) Some methods to improve reliability Degree of aggregation of transactions whole of entity? Inter-quartile range to eliminate outliers Working capital adjustments to focus more on transactions Multiple years of data (usually five years)

Review of outcomes by transaction type

Ideal method
Purchase of goods HQ/management services Contract/toll manufacturing services Royalties Interest on loans Guarantee fees Cost contribution arrangements, global trading etc
CUP CUP CUP

Common method
RPM CPM CPM

Supporting method
TNMM, applying operating margin (EBIT/Sales) TNMM, applying NCPM or Berry ratio TNMM, applying NCPM if activity driven by costs, or ROCE if activity driven by capital TNMM or other see separate paper TNMM, applying net profit before tax TNMM, applying net profit before tax Minimum IRR etc

CUP CUP CUP Contribution PS

CUP CUP CUP Contribution PS

Functional analysis and arms length methods

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