Transfer Pricing Starts with the Facts – The Power of a Functional Analysis Questionnaire
So what is the purpose of transfer study to begin with?
A business might need a transfer price study when that have related companies that do business with one another, especially if the business are across borders. For example, a U.S. company pays a foreign affiliate for services. Or maybe a foreign parent charges a U.S. subsidiary management fees. Or even related entities that buy or sell products from one another. A transfer price study is very much neeed because the IRS could come knocking on the door asking, ”Is the company’s pricing reasonable?” Would an un-related party agree to the price if the transaction was between completely unrelated parties? A well-documented transfer price study will answer these questions and protect exposure from transfer pricing penalties if the tax authorities come knocking. A taxpayer needs to show that it reasonably selected and applied an appropriate method to determine intercompany pricing and that such pricing matches reality given the specific industry. This article will elaborate on such documentation requirements.
Documentation Requirements
The first thing that will be needed for a transfer price study is a questionnaire, specifically it is called a “Functional Analysis Questionnaire”. What is a functional analysis questionnaire? What can a business owner do to prepare their answers and to ensure that I have the best possible and well-supportable transfer price? This is the most important tool because it will capture the facts and ultimately drive the analysis like a racecar.
A functional analysis questionnaire in transfer pricing is a tool that helps to gather the facts and evaluate the components and functions that a business performs. It is a tool used to help evaluate the assets used and the risks assumed by each party involved in the intercompany transactions. The questionnaire is used to determine a level of comparability to determine how other businesses might price out their products to support the required arms-length standard. Here is what a functional analysis questionnaire covers:
- Characteristics of the operations, products, and services involved in the controlled transaction
- Functions or activities performed by each party, including the assets used and risks assumed
- Contract terms or conditions governing the transactions
- Economic circumstances, financial information, and an evaluation of the environment in which the economic group operates, including market conditions.
- Business strategies, such as those related to market penetration, permanence, and expansion
- Identification and analysis of comparable transaction prices, both internally and externally
- Allocation of relevant functions, risks, and assets between the parties, as required by documentation standards in various jurisdictions and under OECD (Organization for Economic Cooperation and Development).
- Justification for the transfer pricing method selected and the key financial indicators used.
In practice, the purpose of the functional analysis questionnaire is used to get the facts and to apply the appropriate transfer pricing method. It is important to get the facts straight from the onset because Treasury Reg. Section 1.6662-6(d)(2)(ii) indicates the importance that a taxpayer maintain sufficient documentation in order to establish that it reasonably concluded that the transfer pricing method it selected and applied provides the most accurate measure of an arms-length result.
So, mention that sufficient documentation is a must. What are the documentation requirements exactly? Well, here is a good table from Bloomberg Law, Section 482 in the Tax Practice Series. The principal documents that set forth the transfer pricing analysis are described at Reg. Section 1.6662-6(d)(2)(iii)(B).
Below is a breakdown of the required documentation types and the potentially responsive material associated with each category:
Type of Documentation:
An overview of the client’s business, including an analysis of the economic and legal factors that affect the pricing of its property or services:
Potentially Responsive Material:
10K, annual reports, other pertinent U.S. and foreign government filings (for example, customs reports or SEC filings), timely articles written about the client or its industry, investment analyses, releases from the client’s public relations department, releases by the client’s shareholders’ relations department, and other information released by the client to the public or local, state, or federal regulatory bodies.
Type of Documentation:
Description of the client’s organizational structure (including an organizational chart) covering all related parties engaged in transactions potentially relevant under 482, including foreign affiliates whose transactions directly or indirectly affect the pricing of property or services in the United States.
Potentially Responsive Material:
Management charts, organizational charts, annual reports, portions of the 10K, Forms 5471 and 5472, internal documents outlining: controlled transactions; worldwide organizational structure; ownership; capitalization; financial arrangements; principal businesses and the place or places where such businesses are conducted; and major transaction flows.
Type of Documentation:
Documentation explicitly required by the regulations under 482.
Potentially Responsive Material:
Needed in special situations, e.g., market penetration strategy, blocked foreign income, or cost sharing agreement.
Type of Documentation:
Description of the transfer pricing method selected and an explanation of why that method was selected.
Potentially Responsive Material:
Invoices, accounting entries in books and records, tax department documentation, intercompany agreements, third party agreements. (Consider providing subsequently prepared analysis.)
Type of Documentation:
Description of the alternative methods that were considered and an explanation of why they were not selected.
Potentially Responsive Material:
If no information available, state no other methods were considered as the current method is considered by the client to be the best method. (Consider providing subsequently prepared analysis.)
Type of Documentation:
Description of the controlled transactions (including the terms of sale) and any internal data used to analyze those transactions.
Potentially Responsive Material:
Intercompany agreements and memos, existing pricing, distribution, or licensing agreements, marketing and financial studies, business segment reports, budgets, projections, business plans, and worldwide product line or business segment profitability reports, tax department documentation, Forms 5471 and 5472.
Type of Documentation:
Description of the comparables that were used, how comparability was evaluated, and what (if any) adjustments were made.
Potentially Responsive Material:
Consider providing subsequently prepared analysis.
Type of Documentation:
Explanation of the economic analysis and projections relied upon in developing the method.
Potentially Responsive Material:
Consider providing client internal analyses such as marketing plans, sales projections, projected financials, and budgets. (Consider providing subsequently prepared analysis.)
Type of Documentation:
Description or summary of any relevant data that the client obtains after the end of the tax year and before filing a tax return, which would help determine if a client selected and applied a specified method in a reasonable manner.
Potentially Responsive Material:
If not applicable, so state.
Type of Documentation:
A general index of the principal and background documents.
Potentially Responsive Material:
Provide index of materials as they are assembled. This index does not have to exist at the time of the filing of the return.