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Functional characterization and expense structure

Published in Transfer pricing news

In transfer pricing projects, both for the preparation of annual documentation and for the definition of a transfer pricing policy or specific valuation criteria, one of the aspects that is most cryptic for clients is the so-called functional analysis or distribution of the functions exercised, assets employed and risks assumed by each of the group companies (related parties) involved in the transactions.

No wonder. For companies, a group’s business is perceived as an organisational unit, and divisions between legal entities often go unnoticed beyond the legal or tax departments.

However, the principles governing the corporate taxation require the tax burden to be calculated by legal (or fiscal) entity and hence the need for transfer pricing and the arm’s length principle: transactions between related parties should be taxed as if they were carried out between independent parties.

In the application of the arm’s length principle, the functional analysis of the related parties involved in the transactions is crucial. It consists of analysing the economic structure of the operations -the value chain of the business- in order to define the “role” played by each legal entity. As if it were a classic comedy, functional analysis seeks to define the role of each of the actors: the liar, the charlatan, the braggart, the rogue, the lover…

The conclusions of the functional analysis will result in the assignment of this economic “role” in the structure of the controlled transactions to each related party, which conditions the search for comparable independent transactions or companies and, therefore, the resulting valuation of the related party transactions.

And as in a play, spectators expect actors to stick to their assigned role in the comedy in their performance. What would happen if the rogue shows in a scene the innocence of the lover? Total disconcert. Booing? Maybe.

That’s exactly what the Spanish National Court (“Audiencia Nacional”) found in its ruling of 29 March 2019. An actor who does not follow his role.

Judgment of the Spanish National Court of 29 March 2019

The taxpayer is part of a multinational group that operates in the consumer electronics industry, and is assigned commercial tasks in the Spanish territory through a Limited Risk Distribution Agreement with its Principal, the master distributor for the markets of the EMEA area (Europe, Middle East & Africa).

By performing its functions as a limited risk distributor (LRD), the taxpayer perceives an arm’s length distribution margin, validated through the appropriate transfer pricing study.

The controversy

Contrary to what might be expected, the transfer pricing controversy does not arise from the valuation of products purchased by the LRD from its Principal. The operating margin of the entity is not challenged.

The controversy concerns the financial expenses for factoring operations carried out by the taxpayer with independent financial entities and their deductibility for tax purposes in Spain.

Inconsistency between financial expenses and functional characterization

In the audited tax years, the taxpayer had to incur higher financial expenses to finance its activity. The Tax Administration considers that this increase in financial expenses is due to circumstances contrary to the role assigned to the taxpayer -LRD- and therefore its deductibility should not be allowed for Spanish tax purposes.

Specifically, the following causes of the increase in financial expenses are identified:

  1. A change in the group’s marketing strategy, which prioritizes the retail channel, in which the collection periods are higher, without there having been a change in the payment period to the master distributor;
  2. Changes in the logistics of the master distributor, which increases the weight of maritime versus air shipments, with the Spanish LRD bearing the cost of financing during this period;
  3. Cancellations of orders by customers do not automatically cancel the order to the master distributor, being the LRD responsible for financing the inventory until it manages to sell it to other customers.

After analysing the contractual clauses of the Limited Risk Distributor Agreement, the Court concludes that the higher financial costs borne by the Spanish LRD are not consistent with the distribution of functions and risks contained in that contract.

Consequently, although the financial expenses are real, have been incurred by the taxpayer with independent third parties and necessary for the activity, the Court considers that they are not deductible because they do not correspond to the distribution of functions, assets and risks assigned to the taxpayer in the structure of related-party transactions and in the group’s transfer pricing policy.

Moral

Every classic comedy has its moral. We can also draw some useful conclusions from the analysed court ruling.

First of all, the importance of carrying out the functional analysis correctly. The functional analysis is not only a formality required by the Corporate Income Tax Regulation to be included in the documentation. It constitutes the economic base that must guide the correct definition of the transfer pricing policy.

Secondly, the annual documentation of related-party transactions is not a mere formality. It should serve as an exercise to verify that the hypotheses and assumptions that led to the adoption of the transfer pricing policy are met. And that verification exercise should include a review of the factual circumstances of the functional analysis and its conclusions.

Because no one likes an actor to spoil a good comedy for us.