Page 147 - SAIT Compendium 2016 Volume2

PN 7/1999 Income Tax acT: PracTIce noTes PN 7/1999
is only acting as a contract manufacturer, the subsidiary should be entitled to a relatively smaller portion of the
pro t (representing a fair return on the functions it performs).
8.3.3 Most of the recommended transfer pricing methods (Cost Plus, Resale Price, Transactional Net Margin and
Pro t Split methods) focus on functions performed, risks assumed and assets utilised rather than on the goods or services being transferred. When applying one of these methods in a transfer pricing analysis, the comparability of functions performed by the member of the multinational and the independent entity or entities to which it is compared is very important. In contrast thereto the CUP method is based on a direct comparison of the price charged for goods or services and the characteristics of the goods or services are therefore signi cant.
8.3.4 A practical way of evaluating functional comparability is to prepare a functional analysis. A functional analysis is a method of nding and organising facts about a business’s functions, assets (including intangible property) and risks. It aims to determine how these are divided between the parties involved in the transaction under review.
8.3.5 Functional analysis serves, therefore, to identify the economically signi cant activities (functions performed, assets employed and risks assumed) that are undertaken by the member of a multinational, and for which it should expect to be rewarded. This identi es the nature and characteristics of the connected party dealings that have to be priced.
8.3.6 Functional analysis also serves to help appraise the validity of an independent rm, as a benchmark for appraising the behaviour of a member of a multinational. Consider, for example, an independent rm and a member of a multinational that both sell toasters. The independent rm sells at the retail level with a liability for claims under warranty. By contrast, the member of the multinational sells at the wholesale level with no liability for defects. In this case, the independent rm’s functions are quite different from those of the member of the multinational and would not ordinarily be used as a comparable. The member of the multinational should, instead, attempt to locate a comparable independent rm operating at the same level of the market, performing similar functions and assuming similar risks.
8.3.7 A functional analysis will help to highlight where such signi cant functional differences may exist. However, it must be noted that functional analysis is not a pricing method in its own right. Rather, it is a tool assisting in the selection of a transfer pricing method and the proper determination of an arm’s length price.
8.3.8 Functional analysis is discussed in detail in Annexure A. The extent to which functional analysis should be performed depends on the transactions at issue. For more involved transactions a functional analysis should address all of the following:
(a) An overview of the organisation, the overall structure and nature of the business undertaken by a member of
a multinational.
(b) General commercial and industry conditions affecting the member of the multinational, an explanation of
the current business environment and its predicted changes.
(c) Direct consideration of the transaction under review, the nature and terms of the transaction, economic
conditions and property involved in the transaction, how the product or service that is the subject of the
controlled transaction in question ows between the connected parties.
(d) Actual contractual terms of the transaction, because this may provide evidence about the form in which the
responsibilities, risks and bene ts have been assigned among those members.
(e) The functions undertaken by the relevant members of the multinational.
(f) The relative contributions of various functions: The number of functions performed by a particular member
of a multinational is not decisive in determining whether that member should derive the greater share of the
pro t. It is the relative importance of each function that is relevant.
(g) An appraisal of risk. In the open market, this assumption of increased risk will be compensated for by an
increase in the expected return. The risks assumed should therefore be taken into account in the functional
analysis.
(h) 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. The functions undertaken by an entity will, to some extent, determine the allocation of risks.
8.4 Economic circumstances
8.4.1 Arm’s length prices may vary across different markets, even for transactions involving the same product or service. To achieve comparability, it is important to ensure that the markets in which the parties operate are comparable. Any differences must either not have a material effect on price, or be differences for which appropriate adjustments can be made.
8.4.2 The OECD Guidelines at paragraph 1.30, identify a number of factors relevant for comparing markets, including: (a) geographic location of the market;
(b) size of markets;
(c) extent of competition in the markets;
(d) availability of substitute goods and services; (e) transport costs;
(f) the level of the market (retail or wholesale).
8.4.3 These factors may have particular relevance in the South African situation. Because South Africa is a small country, it may be dif cult to obtain comparables from the South African market. Refer to paragraph 11.2 for a discussion of this problem.
8.5 Business strategies
8.5.1 Business strategies are also relevant in determining comparability for transfer pricing purposes. Business strategies are a legitimate aspect of arm’s length operations. The arm’s length principle, therefore, acknowledges those strategies. Business strategies would take into account many aspects of an enterprise, such as innovation
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