Functional analysis aims to identify the economically significant activities and responsibilities undertaken, assets used or contributed, and risks assumed by the parties involved in transactions.
Functional analysis is a critical component of transfer pricing (TP) analysis and serves as the foundation for selecting the TP method and determining the tested party. While this principle is stated in local UAE law (p. 5d, Article 34, "Arm's length principle"), no further explanation has been provided so far.
Clause 1.51 of the OECD TP Guidelines argues that functional analysis is necessary to delineate controlled transactions and establish comparability between controlled and uncontrolled transactions or entities. In transactions between two independent enterprises, compensation typically reflects the functions each enterprise performs, taking into account the assets used and risks assumed.
Functional analysis focuses on the actual activities and capabilities of the parties involved. This includes decision-making related to business strategy and risks. In this case, it is useful to understand the structure and organization of the MNE group. In particular, it is important to consider how value is generated by the group as a whole, the interdependencies of functions performed by associated enterprises within the group, and the contributions of associated enterprises to value creation. The rights and obligations of each party in performing their functions are also relevant. The economic significance of functions, in terms of frequency, nature, and value to the respective parties, is important even if one party performs more functions than the other in the transaction.
Functional analysis involves collecting and structuring information on the actual distribution of functions, risks, and assets among the transaction parties. It includes studying not only contractual arrangements but also, more importantly, examining the actual allocation of functions, assets, and risks. Functional analysis serves as a link between several stages of controlled transaction analysis, including preliminary analysis, data collection, analysing the transfer price itself, and drawing conclusions about its compliance with the arm's length (market) level. Based on the results of functional analysis, it is determined which party in the transaction performs fewer functions, assumes fewer significant risks, and owns fewer significant assets, making them the tested party for profitability analysis.
Distributor functional analysis
In this article, we focus on the analysis of resale transactions and examine different types of distributor functional profiles, ranging from the simplest ("routine") to the most complex.
On the one hand, all distributors perform similar functions: they buy products from manufacturers or wholesale distributors/procurement companies and resell them to end buyers or smaller sellers (dealers) in the market.
On the other hand, all distributors are different and may have a different set of functions and risks within their activities.
For the sake of simplicity, distributors can be divided into three types according to their functional profiles (classification as per the OECD Transfer Pricing Guidelines1):
A commissioner is a company that primarily engages in buying and selling goods. However, such activities are routine and do not involve the company owning significant assets (other than the usual office space and equipment and personnel) or incurring significant risks. Therefore, commission agents typically receive routine, often fixed, remuneration.
A distributor with a limited set of functions, risks and assets (or LRD, limited-risk distributor) is a reseller with assets such as storage facilities for goods or vehicles for transporting those goods, as well as additional functions (e.g. storage and transport of goods from producer to purchaser, promotion of goods in the local market).
These additional functions come with additional risks, such as stock impairment and loss of quality during transport and storage.
Finally, the third type of distributor is one who carries the more substantial risks and performs the key functions in the transaction. A distributor can be categorised as a full-fledged distributor if he owns significant assets, including intangible assets (brand, trademark) and performs key functions. Such functions include, for example, the following:
Such a distributor bears substantial risks in the transaction. These are not only risks related to the storage and transportation of goods, but also credit risk (risk of non-payment for delivered goods by buyers), entrepreneurial risk (non-receipt of remuneration), and market risks (including reduced demand for products from consumers in the local market, errors in sales planning, negative changes in the macroeconomic situation, etc.).
An important point to consider when conducting a functional analysis is the actual ability to control risk. For instance, the risk of reduced demand and the inability to sell all of the products purchased by the distributor can be attributed, on the one hand, to the distributor, as this company will not profit if this risk materializes. On the other hand, this risk may occur due to mistakes in the strategic sales planning of the parent company or supplier, such as supplying more products than can be sold on the market or making incorrect production and sales plans. In this case, the risk ultimately lies with the supplier since they can control it.
While a company's functions are typically determined by the contract, which outlines the terms of delivery and payment, the extent to which the company bears the risk must be inferred. Functions and risks are essentially like "communicating vessels": certain functions entail certain risks, and the party to the transaction is exposed to the risk to the extent that it bears the associated function.
Furthermore, the more functions, risks, and assets a company has, the greater the expected remuneration. For instance, a commissionaire or LRD is likely to receive minimal remuneration, often fixed or set as a percentage of revenue. It is the profitability of such a distributor that will be analysed and compared with the market level.
Whereas the profit of a distributor with a "complex" functional profile, who performs basic functions and bears substantial risks in the transaction, is likely to be more and more dependent on external factors (market situation, level of demand for the goods sold, etc.). Of course, this division of distributors into types is rather tentative and it is often not possible to classify a company strictly into one or another type of distributor. Nevertheless, in practice, a functional analysis can infer whether a distributor is a "mere" party to a transaction in relation to another party to the transaction (manufacturer or smaller reseller) and whether its profitability can be tested against the market level.
ADE Professional Solutions can provide the following support on various transfer pricing issues including:
1 OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations (2017): https://www.oecd.org/tax/transfer-pricing/oecd-transfer-pricing-guidelines-for-multinational-enterprises-and-tax-administrations-20769717.htm
