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Basic Problem. For the description of the functional and organizational added value, a so-called functional and risk analysis is carried out in transfer pricing practice. In addition to the analysis of the value drivers, the functional and risk analysis is the second important pillar for the determination of value contributions and arm’s length transfer prices. It serves to determine the activities and responsibilities performed at the level of the individual companies and their relative importance with regard to the transaction-related added value of the MNE.

The OECD introduced a so-called six step approach (para. 1.60 TPG), which may provide a guideline within the framework of the ALP to identify and assign risks. The core element is the so-called risk control approach, according to which an allocation of risks depends on (personnel) functions to control the risks as well as the financial capabilities to assume these risks. Control is basically defined as the ability to make decisions about taking and managing risks, and also to exercise this decision-making function (para. 1.65 TPG). Contractual arrangements are only the starting point for the analysis. The decisive factors are the actual circumstances (substance over form). It is therefore important to analyse which entities have the human resources, the actual possibility to control risks and the financial means to bear risks (para. 1.61 TPG). The prerequisite for this is that the decision-makers have the necessary experience and competencies for this and have an adequate information base (para. 1.66 TPG). It is questionable how much substance is required to underpin the transactions. If the contractual risk allocation deviates from the actual risk control and financial risk-bearing capacity, the contractual risk distribution must be adjusted for the arm’s length comparison.

Tab. 12: Six step approach

In this way, it is possible to analyse in a comprehensible manner which functions are performed by the companies under consideration and which risks are assumed. This enables the companies involved in the transaction to be characterised. Once the factual situation has been determined and the substance of the commercial and financial relationships has been identified, the actual transfer pricing should follow these conclusions.

Where can it be found. Chapter I of the TPG contains explanations of the functional and risk analysis. See also part B.2 of the TP-Manual.

Basic thoughts on the case at hand. In practical terms, the functional value creation can first be illustrated using a classic representation in three simplified value creation stages:

Fig. 6: Value Chain

Functional analysis. As part of a functional analysis, the functional contribution to added value of the individual companies in an MNE group must be determined on the basis of the activities performed and the expertise brought in. The functional analysis creates the basis for the results of the business model analysis to be further differentiated and broken down to the individual companies and their relative importance.

As central parameters of the functional contribution to value creation, the functions and responsibilities of the respective companies must be described in detail and their significance for the transaction-related value creation within the group must be determined.

In the following, a three-stage functional analysis suitable to perform such an analysis is presented:

Step 1 – Determine complexity and temporal dimension. The complexity of a function is determined in a first dimension. This is often determined by the required expertise and qualifications of the employees to perform their functions. The employee qualification is often an indicator of how difficult or easy it is to transfer a function. In addition, the temporal dimension characterizes a function on the basis of its temporal efficiency, whereby the principle is that the added value increases with increasing maturity:

Short-term operational functions relate to daily business (up to one year) and implement the tactical and strategic planning operationally.

In the medium term, tactical functions relate to a cross-period program, capacity and sales planning over a horizon of one to three years.

Long-term strategic functions relate to setting the course for the business model and have a long-term horizon of more than three years

The following figure illustrates this first step of the analysis, whereby the functional value added is higher in darker fields than in less darkly colored fields.

Fig. 7: Determine complexity and temporal dimension of functional value creation

Step 2 – Identify responsibilities. In a second step, the responsibilities with regard to the functional value creation for the respective entities has to be analysed. If several companies share the tasks and responsibilities associated with performing a function, the individual contribution to added value must be determined.

The RACI method (acronym for Responsible, Accountable, Consulted, Informed) is a possible approach to characterize responsibilities in connection with a function.

Tab. 13: RACI-Method

The following figure illustrates the second analysis step together with step 1, whereby the functional value added for darker fields is higher than for less darkly colored fields.

Fig. 8: Determination of functional value creation based on responsibilities

Step 3 – Aggregation. Finally, the results of the first two analysis steps are aggregated. Depending on the complexity of the intra-group value creation, it may make sense to present the results of the functional analysis in a higher/lower level of detail. Differentiation of the functional analysis can be performed – depending on the individual case – in the following dimensions:

transaction groups;

stages of value creation;

business areas;

product lines;

markets.

Risk analysis. The organizational dimension of value creation is based on the fact that the future is unpredictable and therefore by definition uncertain. This uncertainty creates opportunities and risks for companies, since future reality may also differ from the best planned values. The following general rules apply: the greater the uncertainty, the great­er the possible positive (opportunities) and negative (risks) deviations from the expected values. Since risks are often valued more strongly than opportunities, the expected return increases with an increasing risk structure. By taking appropriate measures, the negative consequences of risks can be partially reduced. But the positive decision to take risks without being able to actively manage them can also have an effect of positive added value. These considerations are the basis of the functional analysis of complementary risk analysis.

In the following, a three-stage risk analysis based on the risk control approach – in which the groups of people are more important for control than the contractual allocation of risks – is presented:

Step 1 – Determine risk materiality. In the first step, the materiality of individual risks is determined on the basis of the expected loss potential. The absolute risk of loss has to be assessed as the value of the negative deviation of the future outcome compared to the expected values. In principle, the larger the risk dimension is, the more material are the risks and the more profound the measures for risk management and risk prevention have to be. The probability of realizing a risk as a second parameter of risk categorization can be roughly broken down – based on expert interviews – in the following buckets:

unlikely: probability < 15 percent

rather unlikely: 15 percent ≤ probability < 50 percent

more likely: 50 percent ≤ probability < 85 percent

probable: probability ≥ 85 percent

This results in a probability-weighted risk materiality. The following figure illustrates the two dimensions and the aggregation into a probability-weighted risk materiality.

Fig. 9: Determining the risk materiality

Step 2 – Assess the risk-bearing capacity. In a second step, the risk-bearing capacity of individual entities must be assessed depending on the responsibilities for risk management and risk prevention as well as the financial capacities for taking risks. Financial capacities for assuming risks are the prerequisite for assigning risks. Market participants only trust the risk-bearing capacity if there are sufficient financial resources to actually take risks at the level of the respective entity.

The competencies for risk management and precaution are assessed on the basis of personnel resources as well as the corresponding competencies and expertise of certain individuals (groups) for risk management and precaution. The basis for risk management is the provision of the necessary information. The RACI concept presented in the functional analysis can be used to analyse the responsibilities in connection with risk management. The following figure illustrates the second step of the risk analysis, which determines the risk-bearing capacity in aggregation.

Fig. 10: Assessment of the risk-bearing capacity

Step 3 – Aggregation. Finally, the results from the first two analysis steps for each entity, alternatively in a cross-group analysis, can be aggregated in a summary overview. This results in a corresponding overview of risk allocation for each entity. Depending on the complexity of the intra-group added value, it can make sense to present the results in a higher/lower level of detail. As with the functional analysis and depending on the individual case, the risk analysis can be further differentiated in the following dimensions:

transaction groups;

stages of value creation;

business areas;

product lines;

markets.

For transfer pricing purposes, a summary of the entities’ risk profiles in relation to the individual transaction groups is usually appropriate.

Value added analysis. The distribution of the overall result from a transaction corresponds to the individual value add contributions of the entities involved, based on the arm’s length principle. In principle, the higher the functional, organizational and value driver-oriented added value of an entity, the higher its share in the multinational’s total profit or loss.

Depending on the individual case, it may be advisable to consolidate the results of the qualitative analyses of the value drivers, functions and risks (value creation factors) as part of a value creation analysis and to convert them into quantitative sizes, e. g. using scoring models. By quantifying the qualitative analysis results, the total value added can be systematically broken down to individual entities and their relative share in the total value added can be determined in clear-cut quantitative terms.

Value added contribution analysis, however, involves a certain degree of complexity, which is why it can be appropriate in simple value chains with clear differences in the value added contributions to forego an added value contribution analysis and to base the analysis on the results of the value driver analysis as well as on the function and risk analysis.

Ultimately, all analyses aim to aggregate the various dimensions of added value into broad categories such as low, moderate and high. The basic principle is that the higher the added value of a company, the higher its share in the total profit or loss of the MNE group. The following figure illustrates this relationship.

Fig. 11: Value Contributions and Profit/Loss

The considerations presented regarding the value contributions of individual group companies are also a central element for the characterisation of companies in the context of the comparability analysis (cf. Chapter 3).

With regard to the example at hand, a functional and risk analysis is carried out for the production companies in a first step. In practice, a distinction is often made between the following entity types:

Fully-fledged manufacturers plan, control, monitor the elementary functions of the value chain, have the appropriate decision-making powers and own the value drivers of the business model. By bundling competencies, fully-fledged manufacturers can operate autonomously on the market and react to changes in the economic framework.

License manufacturers have a profile comparable to that of a fully-fledged manufacturer, with the exception that the technology required for production has to be li­censed. License manufacturers can therefore operate largely autonomously on the market, but due to the technological dependency on third parties, they have limited scope to react autonomously to technological changes.

The contract manufacturers take over a limited part of the production for a principle, that provides the necessary intangibles. He procures the raw materials in his own name and on his own account. He does not maintain his own sales and marketing structure on the sales side but produces the ordered quantities exclusively for his client.

In the case of IP contract manufacturers, the peculiarity of this type of contract manufacturer is that the IP contract manufacturer is closely integrated into the value chain, but is also owner of intangibles for the production process. Despite the ownership of production intangibles, the IP contract manufacturer has only minimal influence on the business model due to the close integration.

Comparable to the contract manufacturer, the toll manufacturers take over a limited part of the production without acquiring ownership of the processed products (extended workbench). The principle procures the necessary raw materials and supplies them to the toll manufacturer.

Various production companies are active in the Zeitgaist group. These are shown schematically in the following overview. A scoring model is used to classify the individual group companies.

1.

In a first step, the following illustrations show the color coding of the value of a function, a risk or a value driver. A high value corresponds to an entrepreneurial character that tends to be represented by a gray number while a black low value represents a routine character. The following principle applies: the more gray numbers, the higher the value and at the same time the entrepreneurial character of the function, the risk and the value driver.

2.	In the second step, the different colored rectangles are filled depending on the extent of the function, risk taken over or contributions to the development, improvement, maintenance, patenting and exploitation of an intangible value. Note that it is not necessary to fill out all the rectangles.

Characterisation of the production. Innovation activities are characterised by a strong entrepreneurial character. In this respect, the numbers 2 to 5 are gray and thus show a high entrepreneurial character. The fully-fledged manufacturers carry out the innovation activities by themselves, so the respective rectangles are filled with gray. No innovation function is carried out by contract or toll manufacturers, so the gray numbers are not filled in in these two types of companies. Thus, the entrepreneurial activities are not carried out.

Fig. 12: Function-, Risk and Value Driver Analysis for Production Entities

In addition to the production companies, various sales companies are also of great importance in the Zeitgaist group. The analysis will also be worked out for the sales companies using the scoring method and the graphical representation. However, this presentation is preceded by a classic distinction between company types in the area of sales:

Fully-fledged distributors buy and sell products in their own name and on their own account. They have a high degree of freedom in performing their sales and marketing activities. Depending on the function, risk and value creation profile, however, different forms of the fully-fledged distributors are possible.

Dealers as a special form of proprietary fully-fledged distributors are involved in the sales organization and the advertising measures of the supplying company. Usually, a sales area is allocated to them with the granting of an (exclusive) distribution right. Due to the dependencies, the dealer is required to provide comprehensive reports on sales activities and customers.

Routine sales companies buy and sell products in their own name and for their own account, but these are closely integrated into the sales organization of the supplying company. The demarcation from a dealer is fluid, whereas routine companies tend to carry fewer risks.

Sales representatives mediate transactions between customers and sellers on behalf of others. The core of the work is the acquisition and mediation of customers and sales. The business activity of commission agents are comparable, although they act formally in their own name and only on the account of the principal.

The following overview shows the characterisation for the case at hand.

Fig. 13: Function-, Risk and Value Driver Analysis for Distribution Entities

Conclusion. The foregoing analysis has provided an overview of how to gain a good and substantiated understanding of the functional and risk profile. This understanding should be obtained at the beginning of any transfer pricing analysis. The models and methods listed are one possible way. Neither the OECD nor the UN have made a clear statement about the applicable models and methods.

What else to consider. In transfer pricing tax audits, it is advisable to develop a common understanding of the respective function and risk profiles together with the tax administration right from the beginning. The overviews shown are schematic and can be adapted to the respective circumstances. Functional and risk profiles are the core element of every transfer price analysis. Accordingly, no solution can be found in principle if one already has a different view.