The Functional Fallacy

This article provides a critical examination of the reliance on functional activity or conduct in the transfer pricing exercise. The changes made in the BEPS Project significantly boosted the focus on functional activity in assessing related-party transactions. This new approach is largely delivered in the “accurate delineation” process which is at the heart of the BEPS changes to the OECD Transfer Pricing Guidelines. Under the new approach, the rights and obligations expressed in intercompany contracts are no more than the “starting point” in determining the transactional relationship between the parties, and those terms are subject to verification based on the actual conduct of the parties. The idea that legal/contractual arrangements can be modified – or constructed – based on the conduct of the parties is not new, and it is seen by many as a relatively uncontroversial idea. However, the conceptual, technical and practical challenges it poses have never been subject to any serious examination in the course of framing the relevant OECD guidance, contributing to an uncertain landscape in which the core principles being applied have become contested, and in which the standards to which taxpayers and tax authorities should expect to be held are difficult to discern. This article explores these themes, taking into account the historical development of the reliance on conduct, the current requirements and the experience of applying the conduct-based approach in practice.