Functional Analysis in Transfer Pricing

Defining a Functional Analysis

A functional analysis is an analysis aimed at identifying the economically significant functions undertaken, assets used or contributed, and risks assumed by related parties or connected persons in a controlled transaction.

The functional analysis offers a foundational step in evaluating each party’s contribution to profit and determining appropriate pricing for intra-group transactions.

The Importance of a Functional Analysis

All UAE taxpayers having transactions with related parties and connected persons whose pricing must reflect the arm's length price (ALP) must perform a functional analysis in order to delineate the transaction and determine comparability between the controlled transaction and uncontrolled transactions.

Understanding the functions performed, assets used, and risks assumed (FAR) by the entities involved in a controlled transaction through a functional analysis assists in understanding the contribution of the entities to the value chain and, therefore, in arriving at the appropriate compensation for their activities.

Furthermore, a functional analysis provides the foundation for accurately characterizing entities, assessing comparability, and selecting the most appropriate transfer pricing method.

Article 34 of the UAE Corporate Tax Law emphasizes performing a functional analysis as one of the steps in determining the ALP of related party transactions. Functional analysis plays a vital role in TP policy development for several reasons:

• Functions correlate with the risks assumed and assets developed or maintained.
• The FAR associated with a related party’s operations significantly influences profitability.
•  The functional analysis provides insights into intercompany transactions and helps identify comparable uncontrolled transactions.

The Performance of a Functional Analysis

A robust functional analysis involves gathering information from various sources to ensure accuracy and completeness. Key inputs include:

• Interviews with management and operational teams
• Business processes, policies, standard operating procedures (SOPs), organizational matrix, and key employee details
• Transaction terms and entities involved
• Intercompany agreements
• Industry details, value drivers, and competitor analysis
• Existing Master File and Country-by-Country Reporting (CBCR), if applicable
• Public domain information (e.g., company websites, social media, press releases)
• Financial data for both the local entity and the group.

Key Takeaways

The FAR analysis plays a pivotal role in several aspects of transfer pricing as detailed below:

• Understanding business, transaction, and value drivers.
• Entity characterization and selection of tested party.
• Selection of the most appropriate transfer pricing method.
• Conducting economic analysis.

By analysing the functions, risks, and assets associated with related party transactions, businesses can ensure that they adhere to the arm's length principle, minimize tax disputes, and optimize their transfer pricing strategies. A functional analysis is not only a critical step in aligning transactions with market conditions but also in understanding the core business operations that drive value across a corporate group.