In addition to carrying out interviews, analysts should examine documents and other information from the entities. This information includes: organisation charts; existing inter-company pricing policy statements; inter-company agreements such as licences and agreements covering distribution, R&D, cost-sharing, management services, etc.; and product and marketing information. Examples of product and marketing information include product brochures and literature, stock analyst reports, trade press articles, in-house news publications, reports on competitors, advertising literature and information regarding customers. This information aids in understanding the information gathered at interview and the economics of the markets in question.
Note that the company itself is not the only source of information to the person conducting the functional analysis. The analyst should also gather information on trade associations, competitors, academics, etc., to learn as much as possible about the company, its industry, its products and the markets it serves. These days, it is also likely that information of relevance is publicly available on the internet (as the internet is accessible worldwide, tax authorities are also making use of the available data in the conduct of their transfer pricing investigations).
405. Functions
Functions are defined as the activities that each of the entities engaged in a particular transaction performs as a normal part of its operations. Table 4.1 provides a list of some typical business functions. In general, the more functions that a particular entity performs, the higher the remuneration it should earn, and its prices should reflect this.
It is not enough simply to determine which entity has responsibility for a particular function, risk or intangible. The proper development of a transfer pricing policy requires that the transfer pricing analyst also determines the relative importance of each function in that transaction, industry and market. For instance, it is common in many industries for a foreign distribution subsidiary to be responsible for marketing and advertising, as well as distributing the parent’s product. However, marketing and advertising activities may be far more important in the consumer goods market, where products may be differentiated by image and brand name recognition, than in the
chemical industry, where the company’s name may be of limited importance compared with the specific chemical properties of the product.
Several functions are particularly important in the context of a manufacturing company. The first is the materials purchasing function. For instance, does the parent corporation purchase raw materials on behalf of its manufacturing subsidiary and then consign those materials to its subsidiary, or does the subsidiary purchase its own raw materials? The selection of materials will naturally have a significant impact on the price and quality of the finished goods, the reliability of supply and other areas of the business process.
Another major function in manufacturing is production scheduling. Does the parent corporation tell its manufacturing subsidiary what to produce, how much to produce and when to produce it, or does the subsidiary plan its own production schedule?
Quality control is also an important area. The analyst must determine which legal entity is responsible for establishing quality control policies, the implementation of those policies and the monitoring of their differences. Does the manufacturing subsidiary have limited control over the policies that it uses, or does it develop and implement its own quality control procedures?
Table 4.1 Typical business functions Product research, design and development Purchasing materials, supplies and equipment Controlling stocks of raw materials and finished goods Developing and administering budgets
Quality control
Production of finished goods Packaging and labelling of products Sales
Marketing
Shipping of products to customer Facilities engineering
Personnel
Manufacturing engineering
Maintenance: building, grounds and equipment Electronic data processing
Public relations
Production planning and scheduling Industrial engineering
Management and supervision of offshore operations Manufacturing site selection
Administrative services Government affairs Finance and control Accounting services
Arranging product liability insurance
Table 4.1 Typical business functions Establishing and controlling pricing policy Technical service
406. Risks
A significant portion of the rate of return (ROR) earned by any company reflects the fact that the business is bearing risks of various kinds. Table 4.2 provides a list of some potential business risks.
Market risk relates to the potential loss that may be associated with selling in an uncertain marketplace. If a parent company has made arrangements to protect its manufacturing subsidiary so that it does not incur operating losses if it encounters adverse market conditions, then the subsidiary should sell to affiliates at considerably lower prices (and earn lower levels of profit) than if it bears the full risk of market fluctuations. In such a case, the plan will probably have been for the marketing subsidiary to carry the risk of the market. It is particularly important to document this fully and to ensure that the marketing company has sufficient capital resources to support the risk it is taking. This should assist in fending off a tax authority attack on losses contained in the marketing company (tax authorities often tend to assume that such companies do not carry the risk of the market and therefore seek to disallow losses accruing in this way).
Table 4.2 Typical business risks Market risk
Inventory risks: raw materials, work in progress and finished goods Defective products and warranty
Credit risk Product liability risk Foreign exchange risk Environmental risk
There are various ways to judge whether market risk exists. One way is to determine the time in the product development cycle at which manufacturing responsibility for the product was transferred to the subsidiary by the parent company. For example, if the product is first manufactured by the subsidiary immediately after it leaves the group’s pilot manufacturing plant, then the manufacturing subsidiary has considerably more market risk than if the product had been manufactured first by the parent and was firmly established in the marketplace at that time.
The extent of market risk depends also on the degree of competition and economic structure in the market. For instance, where the parent has limited competition in a particular industry, the manufacturing subsidiary may face considerably less market risk than if it faced stiff competition from several companies that produce close substitutes for its product.
The existence of limited competition within a particular industry or product sector can arise from a number of factors. Barriers to entry by new firms, such as government regulation or the need for an extremely large initial investment (the development
and commercialisation of new drugs in the ethical pharmaceutical market is a good example). Even if there is more than one firm in the industry in question, a company can establish a competitive advantage by developing a patent or proprietary know-how that essentially bars or inhibits competition in a particular product or market. If such barriers exist, they can have a material impact on the degree of market risk faced by a particular firm.
Market risk can also vary with the sensitivity of the industry to general economic conditions. The performance of some industries, such as the automotive industry, varies dramatically over the business cycle. When the economy is in recession, these industries are in recession, and when the economy is booming, so too are they. Other industries, such as pharmaceutical and medical supplies, may be more immune to the impact of fluctuations in the national or world economy. People fall ill and suffer injury during good and bad times alike. As a consequence, the protection that a parent may provide for its subsidiary against market risk can be significantly more valuable in some industries than in others. It depends on the market structure and the underlying demand profile for the product.
Inventory risk is another factor that should be investigated in every transfer pricing study. Both raw materials and finished products inventory risk are particularly
important, but work in progress may also be material (for instance, the value of work in progress for a whisky distiller, which needs to age the stock for many years before it can be sold as premium aged Scotch).
If a company wishes to maximise profits in a manufacturing subsidiary, it must be prepared to take all write-offs associated with inventory in that subsidiary. This responsibility reduces profits in the year of the write-off; however, that experience can be used to demonstrate to a tax authority that inventory risk lies within the subsidiary.
Some manufacturers rarely own any raw materials or finished goods; their inventory risk is minimal or nonexistent. On the other hand, some manufacturers do face inventory risk since they typically purchase raw materials, schedule production and hold a stock of finished goods. In short, inventory risk is a critical component of the risk assumed by parties engaged in an inter-company manufacturing transaction.
Other important risks include defective product, warranty and environmental risks.
If a product is returned as defective by the final customer, for instance, who bears the cost of that return? Is it the company that distributed the product or the foreign manufacturer? Who bears the warranty costs? If an environmental accident occurred at the manufacturing subsidiary, which party would bear the cost of the clean-up?
With increased attention being paid worldwide to environmental problems in virtually every industry, it is becoming increasingly important to develop a clear understanding of which party assumes this risk and how these risks vary across countries.
It is also important to consider how contract law might be used to deal with the location of risk in this area. For instance, it might be that a manufacturing operation is obliged by local law to be responsible for all environmental risks associated with its activities. However, its parent company might be able to establish indemnity arrangements to cover this risk, effectively shifting the local, legally imposed risk to another jurisdiction.
It is important to recognise that risks can vary markedly across industries and geographic markets. In some businesses, there is no credit risk because customers are
required to pay before delivery is made. The retail trade is often operated in this way.
By comparison, in other industries it is standard practice to request payment within three to nine months of delivery. Differences in judicial systems across countries can mean that, within a given industry, underlying product liability risk is a much more significant factor in one geographic market than another.
407. Intangibles
Table 4.3 provides a list of typical intangible assets.
Table 4.3 Typical intangible assets Patents
Unpatented technical know-how Formulae
Trademarks and brand names Trade names
Licences Copyrights Technical data
Ability to provide after-sales service Customer list
High-calibre personnel, such as a strong sales force
Intangibles are ordinarily divided into two categories: manufacturing and marketing.
Manufacturing intangibles are characterised as one of two types – patents or nonpatented technical know-how – and arise out of either R&D activity or the production engineering activities of the manufacturing plant.
Marketing intangibles include trademarks, corporate reputation, the distribution network and the ability to provide services to customers before and/or after the sale.
This category of intangibles is very broad indeed, and regard must be had to the question of ownership of such assets as well as to their maintenance and development.
It is not necessary that the asset appears on the balance sheet for it to have significant value for transfer pricing purposes. The accounting practices that apply to particular categories of asset vary enormously from one country to another and any apparent balance-sheet value may therefore be of little relevance. For instance, goodwill arising on the acquisition of a highly successful business might be written off immediately or carried forward and depreciated over 40 years, depending on the accounting practice adopted in the acquiring country. In both cases, the goodwill might, in reality, be an appreciating asset.
It must be determined which intangible assets play a role in the transaction under consideration, as well as their relative values. Specifically, the transfer pricing analyst must determine which type of intangible – manufacturing, marketing, or both – accounts for the success of a particular product. Does the product’s design explain its success? Or is it the company’s ability to deliver the product when promised? Or is it the company’s trade name? In this connection it must be borne in mind that all marketing intangibles are not created equal. A trade name that is well-known and
thus valuable in one market may be completely unknown and of no initial value in another market.
The return earned by the various entities should vary directly with the importance of the functions performed, the degree of risks undertaken and the value of intangibles provided. Looking at the production intangibles, is it a proprietary manufacturing process that enables the company to produce goods at 20% below the cost of its nearest competitor? Or is it a combination of this and other intangible assets?
Companies that have developed valuable proprietary manufacturing know-how may decide not to patent the technology for fear of making the process known to competitors. This know-how can range from design changes made on a standard machine to a more efficient plant layout, to an innovative production process. A particularly pertinent question to ask when visiting a plant is whether there is anything in the plant that the company would not show to a competitor. If the answer is yes, the analyst may have found a valuable manufacturing intangible, though further investigation would be necessary to establish who developed the know-how, its value to the company, etc.