Page 164 - SAIT Compendium 2016 Volume2

PN 7/1999 Income Tax acT: PracTIce noTes PN 7/1999
8.3
8.4 8.5
1
1.1
1.2 1.3 1.4
1.5 1.6
1.7
2
2.1
2.2
2.3
By determining the relevant functions to be priced, the functional analysis can assist in the selection of a transfer pricing method. It can also assist in the analysis of the level of comparability present in controlled and uncontrolled dealings and in an assessment of the relative contribution of the parties when a pro t-split method is used.
It is important, however, not to confuse the use of functional analysis with the determination of a transfer price. Functional analysis is not an alternative to searching for comparables. It is a means to establish what sort of comparables should be sought.
Annexure B sets out a four-step practical approach for determining transfer prices. The discussion in that annexure further considers functional analysis in a practical context.
ANNEXURE B
THE FOUR-STEP APPROACH
Step 1: Understand the cross-border dealings between connected parties in the context of the business
The taxpayer and the Commissioner will have to understand the nature and extent of the dealings between the taxpayer and connected parties in the context of the taxpayer’s business. It is important for a taxpayer to be able to explain:
1.1.1 how the international connected-party dealings of the enterprise are undertaken;
1.1.2 the purpose or object of the dealings;
1.1.3 what the taxpayer obtains from its participation in the dealings (for example products, services or strategic
relationships);
1.1.4 the signi cance of the dealings to the taxpayer’s overall business activities and to those of the
multinational.
At this stage of the process the taxpayer should, therefore, prepare some documentation that outlines these considerations. The insight developed in this process will assist in determining the extent of any functional analysis that might be necessary for an analysis of comparability in applying the arm’s length principle.
The taxpayer should also develop a preliminary functional analysis to consider the broad functions performed by the relevant members of the multinational. This will assist in determining an appropriate pricing method in step 2 of the process.
The functional analysis should not be comprehensive at this stage. As will be discussed in step 3 of the process, the detail included in a functional analysis is affected by a taxpayer’s choice of pricing method. At this stage, the aim of the functional analysis should be to determine which method (or methods) is/are likely to be appropriate to the taxpayer’s circumstances. The nature of the information that will be required to apply that method should also be determined. Location of comparables: A taxpayer should also, at this stage, begin to assess potential sources of information on which to base its analysis. These comparables may be identi ed internally within the group (if a member of the multinational transacts with an independent external party), or by reference to transactions between independent external parties.
If internal comparables can be located, it is likely that they will be more reliable than external comparables. This is because:
1.6.1 they are more likely to ‘ t’ the af liated transaction as they occur within the context of the group’s business;
1.6.2 more information about the comparable situation should be readily available;
1.6.3 one representative internal comparable may be suf cient to support a defence of the transaction under
review, whereas a wider base of support may be required if external comparables are used.
It should be noted, however, that internal transactions may not provide reliable comparables for determining an arm’s length price if they do not occur on normal arm’s length terms. For example, internal transactions are unlikely to provide reliable comparables for determining an arm’s length price if:
1.7.1 they are not made in the ordinary course of business; or
1.7.2 one of the principle purposes of the uncontrolled transaction is to establish an arm’s length price to be used
as a comparable for the controlled transaction.
Step 2: Select the pricing method or methods
In terms of the OECD Guidelines, the choice and resultant application of a method or methods for calculating an arm’s length price should be made and documented, having regard to:
2.1.1 the degree of comparability between the uncontrolled transactions used for comparison and the controlled transactions of the taxpayer;
2.1.2 the completeness and accuracy of the data relied on;
2.1.3 the reliability of all assumptions;
2.1.4 the sensitivity of any results to possible de ciencies in the data and assumptions.
The application of these criteria will depend on the quality of the information available to the taxpayer. Thus, at this stage of the process, the taxpayer will need to make an assessment of the quality of the data it has available. This assessment should be made for the purpose of determining which pricing method (or methods) is likely to provide the greatest consistency with the factors mentioned above and result in the most reliable measure of the arm’s length price required under section 31.
To this end, the information obtained in step 1 can assist with the:
2.3.1 2.3.2
determination of comparability, when traditional transaction methods are appropriate; and/or determination of comparability between enterprises, when pricing methods using pro t comparisons are appropriate; and/or
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SAIT CompendIum oF TAx LegISLATIon VoLume 2