Page 162 - SAIT Compendium 2016 Volume2

PN 7/1999 Income Tax acT: PracTIce noTes PN 7/1999
3 Analysis of Functions of Members of the Multinational
3.1 The next step in the process would be to provide some more direct consideration to the transaction under review. Relevant information here could include:
(a) the nature and terms of the transaction;
(b) economic conditions and property involved in the transaction;
(c) the ow among the related parties of the product or service that is the subject of the controlled transaction in question; and
(d) information that might indicate whether independent rms dealing at arm’s length under comparable circumstances would have entered into a similarly structured transaction.
4 Contractual Terms
4.1 The actual contractual terms of the transaction will also be relevant. The explicit contractual terms of a transaction involving members of a multinational may provide evidence about the form in which the responsibilities, risks and bene ts have been assigned among those members.
4.2 For example, the contractual terms might include:
(a) the form of consideration charged or paid;
(b) sales or purchase volume;
(c) the scope and terms of warranties provided;
(d) rights to updates, revisions or modi cations;
(e) the duration of relevant licences, contracts or other agreements, as well as termination or renegotiation rights; (f) collateral transactions or ongoing business relationships between the buyer and the seller (including
arrangements for the provision of ancillary or subsidiary services); and (g) credit and payment terms.
4.3 The contractual terms will be relevant in determining the comparability of a controlled and uncontrolled transaction. Any differences between the contractual terms of the transactions being examined would need to be adjusted in determining an arm’s length price for the controlled transaction.
4.4 However, there may be a limit to the usefulness of the contractual terms. In dealings at arm’s length, the divergence of interests between the parties ensures that they will ordinarily seek to hold each other to the terms of the contract. The contractual terms will be ignored or modi ed after the fact, generally only if it is in the interests of both parties.
4.5 The same divergence of interests may not exist for related parties. It may, therefore, be necessary to evaluate whether or not the conduct of the parties conforms to the terms of the contract. In some cases the conduct of the parties may imply that the contractual terms are a sham, or that they have been amended or superseded by a subsequent oral agreement.
4.6 Thus, even if members of a multinational enter into explicit contractual arrangements with each other, they should still examine the actual functions performed by each member as part of their transfer pricing analyses. This requires an identi cation of the critical functions in the multinational’s operations, as well as a determination of which member (or members) is responsible for performing that function.
5 Examples of Relevant Functions
5.1 At its broadest level, a functional analysis would result in the identi cation of such general categories as: (a) research and development;
(b) product design and engineering;
(c) manufacturing, production and process engineering;
(d) product construction, extraction, and assembly;
(e) purchasing and materials management;
(f) marketing and distribution (for example selling, inventory management, warranty administration and
advertising);
(g) transport and warehousing;
(h) managerial, legal, accounting and nance, credit and collection, training and personnel management services.
5.2 Even so, dividing functions performed by a multinational into such broad category descriptions will, generally, not be suf cient. Activities within these categories may be divided between a number of members of the multinational. It is, therefore, also necessary to take into account more speci c functions performed within these general categories.
6 Relative Contribution of Various Functions
6.1
6.2 6.3
The sheer weight 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. The functions performed by a member of a multinational may be relatively few in comparison with those performed by the other members, but if they are the most signi cant functions in the multinational’s operations that member should be entitled to the major share of the pro t.
In identifying and comparing the functions performed it is, therefore, also relevant and useful to consider the assets that are employed or to be employed. This analysis should consider the type of assets used (whether they are plant and equipment, or valuable intangibles). The analysis should also consider the nature of the assets used (such as their age, market value, location and property right protections which are available).
When intangibles are identi ed, it is necessary to clearly establish their nature, before attempting to attribute to them any value or to take them into account in applying an arm’s length pricing method. Intangibles with different strengths will need to be rewarded differently. For example, a patented production process may be useful, but it may be fairly simple to design around the patented aspects in order to achieve a similar outcome. This type of intangible should not receive the same level of relative reward as a breakthrough patent that uniquely reduces production costs and improves the product so that there is greatly improved customer demand.
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SAIT CompendIum oF TAx LegISLATIon VoLume 2