When a transfer pricing policy is to be set up, it is important first to obtain a clear picture of the enterprise and the (economic) environment in which the group conducts its activities.
The acquired information creates the framework in which the intercompany transactions take place and may provide additional pointers to the transfer prices to be employed.
In the analysis of the enterprise and its environment, the main aspects researched are the legal and organizational structure of the group to which the relevant enterprise belongs, the ownership relations within the group, the critical success factors, and the principal risks in managing the enterprise and following the strategy adopted by it.
Some (external) factors also need to be examined, including the market position of competitors, the buying and selling markets in which the group operates, and (other) industry information. All this information may provide data that is important for the determination of the appropriate transfer prices.
Finally, in the context of this analysis of the enterprise and its environment, it is important to identify the (principal) intercompany flows. They are examined at a later stage in this study of transfer pricing. If there are comparable transactions with independent third parties, they should also be described.
A functional analysis is the most important elements needed for setting up a transfer pricing policy. The purpose of a functional analysis is to establish the contribution made by a group company to the total group results, while bearing in mind the functions it performs, the risks it assumes, and the tangible and intangible assets that it employs.
A functional analysis is based on the (economic) principle that the more responsibilities a group company has in respect of the functions, risks and (in)tangible assets associated with an intercompany transaction, the greater its gross rewards should be.
A functional analysis is usually conducted by means of interviews with employees of the enterprises involved in an intercompany transaction. During the interviews, very detailed questions are often asked about the functions, risks and (in)tangible assets associated with a relevant intercompany transaction. An attempt is also made to establish the relative importance of the various elements.
After the function and risk profiles of the group companies involved in the intercompany transaction have been established, a preliminary qualitative statement may be made about the distribution of the (integral) profits made on the intercompany transaction concerned.
This qualitative distribution of the profits is compared later in this study with the results of the financial analysis (which shows the actual distribution of the profits).
The results of the functional analysis also serve as a basis for the comparable search that is to be conducted.
The design of the transfer pricing policy
The first two stages of the process provide a very detailed picture of the enterprise, the group to which it belongs, and other relevant aspects of its environment.
As a result sufficient information is often available for the purpose of selecting a transfer pricing policy. It is very important, however, that the selected transfer pricing policy, besides being justifiable for tax purposes, also adequately fits in with the group’s managerial objectives, and is in line with the nature of its activities.
It may be important, for instance, to develop formulas, rules and procedures for the transfer pricing method that has been chosen. This will make it possible to consider the group’s existing responsibilities in such areas as capacity and efficiency variance, or debtor, stock and currency risks.
Once a certain transfer pricing method has been selected, it will still need to be fleshed out. If, for example, the resale price method has been chosen for a specific intercompany transaction, the percentage of the ‘minus’ will still have to be determined. The percentage should be fixed at a level that conforms to the arm’s length principle referred to previously.
For this purpose, a survey is made of the margins achieved in the market by non-associated parties (the competition, for instance) for comparable transactions and in comparable circumstances, in so far as that is possible. This search process for margin information about non-associated parties is often conducted by means of a comparable search.