On 1 April 2012, after a lengthy redrafting process and much anticipation, the new South African transfer pricing rules came into operation, applying in respect of all financial years commencing on or after that date. The purpose of the redrafting was to move away from the transactional based focus, where the arm’s length price for a transaction had to be determined, to a more entity based approach, where the taxable income of an entity has to be calculated as if all transactions were concluded on an arm’s length basis.

Regardless of which rules apply though, the fundamental principle of transfer pricing, that is, the arm’s length principle, remain the same and must still be adhered to. In applying the arm’s length principle, the application of the so-called four-step approach is usually recommended by the Organisation for Economic Co-operation and Development’s Transfer Pricing Guidelines for Tax Authorities and Multinational Enterprises (“OECD Guidelines”) as well as most tax authorities, including the South African Revenue Service (“SARS”) in Practice Note No. 7 – 6 August 1999 on transfer pricing (the “Practice Note”). While the new SARS interpretation note on transfer pricing is expected to be issued by the end of May 2012, we do not expect that SARS’ approach towards the process of preparing a functional analysis will change significantly.

Accordingly, this article - the first in a series of articles discussing the abovementioned four-step approach - addresses the first step of the four-step approach, the functional analysis, based on the OECD Guidelines as well as SARS’ guidelines contained in the Practice Note.

the purpose of a functional analysis

According to the Practice Note, a functional analysis can serve two important purposes in establishing the arm’s length nature of a transfer pricing policy. Firstly, a functional analysis should provide a quick overview of the organisation for those evaluating the transfer pricing policy of a multinational group (the “Group”), to assist them in familiarising themselves with the general operations of the Group. Secondly, the functional analysis should seek to identify the functions performed by each member of the Group and assess the importance of each function to the overall operations of the Group.

Furthermore, the OECD Guidelines state that a functional analysis is necessary in determining whether or not controlled and uncontrolled transactions or entities are comparable. The functional analysis seeks to identify and compare the economically significant activities and responsibilities undertaken, assets used and risks assumed by the parties to the transactions. For this purpose, it may be helpful to understand the structure and organisation of the Group and how they influence the context in which the taxpayer operates. It will also be relevant to determine the legal rights and obligations of the taxpayer in performing its functions.

outline of operations

It is important that an overview be given of the business structure and functions being performed by the various entities forming part of the Group. Internal documentation, such as organisational charts might be useful in this regard. Furthermore, general commercial and industry conditions affecting the business and performance of functions might also be relevant,for example, technological progress and competitive conditions.

functions to be identified

The principal functions performed by the various entities in the Group should be identified in the functional analysis. At its broadest level, a functional analysis should result in the identification of such general categories of functions such as, inter alia, design, research and development, manufacturing, distribution, marketing, financing or management. Activities within these categories may be divided between various entities in the same Group and, therefore, it is also necessary to identify more specific functions performed within the abovementioned categories.

analysis of transactions between entities

Even in the context of a more profit based approach, consideration must be given to the various functions performed and transactions concluded between the various entities in the Group. In this regard it is relevant to consider the nature and terms of the transactions, the economic conditions and property involved, the flow of products and services provided, and also information that might indicate whether independent firms dealing at arm’s length under comparable circumstances would have entered into a similarly structured transaction.

The contractual terms of a specific transaction will also be relevant as it may provide evidence about the form in which responsibilities, risks and benefits have been assigned among the parties to the transaction. Such terms include, inter alia, the form of consideration that is to be paid, sales or purchase volume and credit and payment terms. The contractual terms of a contract will be specifically relevant in determining the comparability of a controlled or uncontrolled transaction.

It may also be necessary to evaluate whether or not the conduct of the parties conforms to the terms of the contract as contractual terms might be a mere sham, or they might have been amended or superseded by a subsequent oral agreement.

relative contribution of various functions

The sheer weight of functions performed by a particular member of a Group is not decisive in determining whether that member should derive the greater share of the profit. Instead, it is the relative importance of each function that is relevant. The functions performed by a member of a Group may be relatively few in comparison with those performed by the other members, but if they are the most significant functions in the Group's operations that member should be entitled to the major share of the profit.

assets used

In identifying and comparing the various functions performed, the type of assets used in performing various functions should be considered, such as, inter alia, plant and equipment, the use of valuable intangibles, financial assets, and the nature of the assets used, such as the age, market value, location and property right protections available.

Furthermore, a functional analysis should identify any intangibles and the way in which they are used. When intangibles are identified, it is necessary to clearly establish their nature, before attempting to attribute to them any value or to take them into account for transfer pricing purposes. Intangibles with different strengths will need to be rewarded differently, which means that a simple patented production process should not receive the same level of relative reward as a breakthrough patent, etc. A functional analysis should identify each party’s contribution to any manufacturing intangible or marketing intangible.

treatment of risk

A significant portion of the rate of return earned by a company reflects the fact that the company is bearing risks of various kinds. In the open market, this assumption of increased risk will be compensated by an increase in the potential expected return. An appraisal of risk is also important in determining arm's length prices. For example, controlled and uncontrolled transactions will not be comparable if there are significant differences in the risks assumed for which appropriate adjustments cannot be made. The functions carried out will, to some extent, determine the allocation of risks between the parties and, therefore, the conditions each party would expect in arm's length dealings.

Possible risks assumed that should be taken into account in the functional analysis include risks of changes in cost and price of stock, risks related to success or failure of research and development, financial risks, including risks relating to changes in foreign exchange and interest rates, credit risks, risks of manufacturing liability, and business risks related to ownership of assets and facilities.

It must also be considered whether a purported allocation of risk is consistent with the economic substance of the transaction. In this regard the parties' conduct should generally be taken as the best evidence concerning the true allocation of risk. An additional factor to consider in examining the economic substance of a purported risk allocation is the consequence of such an allocation in arm's length transactions. In arm's length dealings it generally makes commercial sense for parties to be allocated a greater share of those risks over which they have relatively more control, and from which they can insulate themselves more cheaply than the other party can.

There are many risks, such as general business cycle risks, over which normally neither party has significant control. At arm's length, these risks could be allocated to either party to a transaction. An analysis is required to determine to what extent each party bears such risks in practice.

concluding comments

A functional analysis can be performed with varying levels of detail and can serve a variety of purposes. The scope of the analysis will be determined by the nature, value and complexity of the international dealings and the nature of the taxpayer’s business activities. These include the strategies that the enterprise pursues and the features of its products or services. Also, factors such as the pricing method that is used and availability of data will affect the extent to which the analysis should be conducted.

By determining the relevant functions to be priced, the functional analysis is an important pre-requisite for the process of selection of a transfer pricing method. It can also assist in the analysis of the level of comparability present in controlled and uncontrolled dealings and in an assessment of the relative contribution of the parties when a profit-split method is used. It is important, however, not to confuse the use of a functional analysis with the determination of a transfer price. A functional analysis is not an alternative to searching for comparables. It is a means to establish what sort of comparables should be sought.