Mistakes in Functional Analysis

A functional analysis is one of the most important parts of a transfer pricing study. It examines what each related company actually does, what assets it uses, and what risks it assumes.

The analysis should reflect the company’s real business activities rather than simply repeating the terms of an intercompany agreement. The IRS has emphasized that a strong functional analysis should connect the facts of the business to the transfer pricing method and explain how value is created within the group.

Common mistakes include:

• Not clearly defining the responsibilities of each related company.
• Relying on informal arrangements that are not properly documented.
• Failing to identify important functions, assets, or risks.
• Overlooking the role of valuable intangible assets in generating income.
• Failing to explain which entity develops, owns, controls, or uses important intangible property.
• Treating an entity as a limited-risk company when its actual activities and risks are more extensive.
• Using a business structure that does not match the actual activities carried out by the parties.
• Failing to update the functional analysis when the business changes.

For example, a company may describe a foreign affiliate as a limited-risk distributor, while the affiliate actually performs significant marketing, product development, or other functions. If the transfer pricing policy does not reflect those activities, the arrangement may attract scrutiny.