What is Functional Analysis? Why does it matter?
Under Malaysia’s transfer pricing regulations, functional analysis is a central component of transfer pricing compliance stipulated in the Transfer Pricing Guidelines 2024 (MTPG 2024) which is largely aligned with the OECD’s transfer pricing guidance. During an IRBM (Inland Revenue Board of Malaysia) audit, companies must demonstrate how functions, assets, and risks are allocated between related entities and whether these allocations justify the reported profit levels. Given IRBM’s heightened tax audits, a robust FAR analysis” (functions, assets and risk) is not just a compliance formality—it serves as the key evidence to substantiate your arm’s length price.
The functional analysis in transfer pricing analyses the functions performed, assets used and risks assumed by associated enterprises in a controlled transaction. Functional analysis plays an important role in the quest to determine the arm’s length transfer pricing. Associated enterprises within a multinational enterprises (MNEs) group or within the small and medium enterprise (SME) sector must identify which entity of the group performs and exercises control over functions, provides assets and assumes risks associated with the transaction. Functional analysis structures and organizes information about the economic roles of the associated enterprises involved in a transaction, thus providing an understanding of the functional profiles of the related parties to the transaction. It offers specifically how value is created within the overall supply chain of the related party transaction in particular.
A well-prepared FAR provides clarity on value creation within the supply chain, supports benchmarking analyses, and significantly reduces the risk of adjustments, surcharges, or penalties during an IRBM audit. It entails conducting a rigorous analysis of the functions performed, assets contributed, and risks taken by both parties. Essentially, it is a dissection of each entity’s operations and allocation of risks within the specific controlled transaction.
Typically, entities of controlled transactions should conduct functional analysis before commencement of any transaction. Functional analysis provides the factual background to help you choose the most appropriate transfer pricing methodology to justify its pricing policies. The functional analysis forms an important part of the contemporaneous transfer pricing documentation (CTPD) which must be completed before the annual corporate tax filing deadline and furnished within 14 days upon IRBM’s request.
Transfer pricing compliance is far more complex and risk sensitive than ever before. It requires thorough analysis, detailed calculations and careful adjustments in the search for suitable comparables to substantiate that each transaction has been priced at arm’s length. Functional analysis is the key to transfer pricing compliance—and the backbone of your required determination of arm’s length price to be documented in a transfer pricing documentation.
Breaking down Functional Analysis through “FAR Analysis”
For all its complexity, there is a clear method to the functional analysis. It focuses on the big picture- analysing the company through the functions performed, assets used and risk undertaken. It entails understanding the enterprise’s business model and operational structure including its significant economic activities, its processes, the responsibilities performed, their tangible and intangible assets used, as well as who’s bearing what kind of risk in relation to the controlled transactions. Simply put, functional analysis answers three questions: who does what (functions performed), who owns and uses what (assets used) and who bears which risks (risks undertaken).
The next move being drilling down by segmenting the functions and the specific activities carried out by the transacted entities into digestible components—for example, R&D, product development, strategic procurement, manufacturing, assembly, distribution, marketing, as well as support functions such as back-office which includes procurement, accounting, HR, IT system and routine administration.
In some groups, the parent company takes the lead in performing the major functions, while the subsidiaries focus on limited supporting functions. In other business models, the subsidiaries undertake key economic functions supported by the parent company through intercompany financing. There is no right or wrong structure and what matters is the allocation of functions aligns with the group business strategy for generating profits.
The next element in the FAR analysis would entail determining what assets were being employed in the transaction. Assets can be tangible such as fixed assets: plant, office space, equipment, human resources. Tangibles are listed on the company’s balance sheet, which can simplify the task of analysing the relative value of the relationship between the assets and its contribution to the profit.
On the other hand, intellectual properties are intangible assets such as patents, trademarks, proprietary technology, know-how, marketing contacts, software and processes. The elements within DEMPE framework (Development, Enhancement, Maintenance, Protection, and Exploitation) help evaluate the value and contribution of intangibles in the controlled transaction.
The final element of a functional analysis is the risk assumed, which focuses on identifying which entity has the capacity to control and mitigate risk and has the financial capacity to bear the financial consequences in the event the risk materialises. Some examples of risks are financial risk, regulatory risk, credit risk, foreign exchange risk, market risk, inventory risk and technology risk. It is crucial to document how these risks influence the decision-making of each entity so that a fair arm’s length price or profit margin is appropriately determined.
Understanding why functional analysis is a key aspect of transfer pricing and corporate tax is important for best results.
Why does Functional Analysis matter?
Functional analysis matters and there are several key factors that explain why:
1. Compliance with Arm’s Length Principle
Functional analysis assists to demonstrate that the price set by the related-party transactions, align with prices that would have been agreed upon by independent parties under comparable economic conditions. Given IRBM’s increased audit scrutiny, Malaysian taxpayers must be able to show clearly how functions performed, assets deployed, and risks assumed align with fair market value. The rationale behind carrying out functional analysis is to ensure that intercompany transactions are priced according to the arm’s length principle. This arm’s length principle mandates that transactions between related entities should be priced as if they were conducted between independent, unrelated parties. A robust functional analysis helps demonstrate that the pricing accurately reflects the functions performed, assets used, and risks assumed by each entity involved.
2. Strengthen Defensibility During TP Tax Audits
Functional Analysis provides a structured understanding of how economic value is being created in an accurately delineated controlled transaction. By clearly identifying each entity’s economic contributions and responsibilities, the taxpayer is able to substantiate the basis for a defensible profit allocation. A transfer pricing policy which is based on a robust FAR backed by data and commercial reasoning is much easier to defend. Without a robust functionality analysis, the transfer pricing price runs the risk of being misaligned with the actual economic reality of the group’s operation, potentially leading to adjustments and penalties by IRBM.
3. Selection of Transfer Pricing Methodology
Functional Analysis provides the critical evidence needed to defend the selection of the transfer pricing method to IRBM. This is particularly important in Malaysia, where IRBM prefers
local comparables than foreign comparables. The most suitable transfer pricing methodology to be used in any given case is determined by the information gathered through functional analysis. The transfer pricing methodology selected varies, depending on the nature of the controlled transaction, the tested party, information derived from functional analysis and the availability of reliable comparable data. When an entity functions as a manufacturer, the appropriate transfer pricing method would be the cost-plus method as compared to a reseller the most appropriate transfer pricing method would be the resale price method. However, in both situations the TNMM may also be the most appropriate method. The selection of the TP method heavily relies on the findings from functional analysis.
4. Documentation Requirements
Under Malaysia’s Contemporaneous Transfer Pricing Documentation (CTPD) framework, taxpayers must have documentation ready before filing their tax returns and submit it within 14 days upon IRBM’s request. Transfer Pricing policies, under the Malaysian tax jurisdiction requires taxpayers to maintain thorough and extensive documentation. For this documentation mandate to be complied with, it is imperative that the functional analysis is documented accurately and align with the actual conduct of the parties of the transactions. The end objective of this exercise is to provide a clear and comprehensive description of the functions, assets, and risks associated with each entity involved in a particular transfer pricing transaction to substantiate the arm’s length price.
5. Reflects the True Economic Contribution
The IRBM typically seeks to identify potential profit shifting between entities across different domestic tax tiers or between entities in Malaysia towards low-tax jurisdictions. A well-prepared functional analysis helps demonstrate the actual value contributed by each entity involved in the controlled transactions. By clearly outlining the functions performed, assets employed, and risks assumed, it provides a strong basis to justify the remuneration allocated to each entity in line with its economic contribution.
Conclusion – Strengthening Transfer Pricing Compliance in Malaysia
As Malaysia continues to strengthen its regulatory framework through the Transfer Pricing Rules 2023 and MTPG 2024, the importance of preparing a robust Functional Analysis and maintaining thorough transfer pricing documentation cannot be overstated. This is a strong step towards meeting compliance requirements by protecting profitability, demonstrating transparency, and mitigating the risk of costly disputes with the IRBM.
A well-prepared functional analysis highlights how a Malaysian entity contributes to value creation within the wider multinational group, ensures that risk allocations are defensible, and provides the foundation for selecting the most appropriate transfer pricing methodology. More importantly, it helps prepare for impending transfer pricing audits and cross-border tax scrutiny.
At Treasure Advisory, we specialise in guiding businesses through the complexities of transfer pricing compliance in Malaysia. From preparing Contemporaneous Transfer Pricing Documentation (CTPD) to conducting benchmarking analysis, risk assessments, and intercompany agreement reviews, our team offers practical, hands-on support tailored to your business operations.
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Disclaimer: This article is written for general informational purposes only. The content should not be construed as professional tax, legal, or transfer pricing advice. Readers are encouraged to seek tailored guidance from qualified professionals before making any business or compliance decisions.