Coined by Michael Porter in 1985, value chain analysis (VCA) is a strategic tool that breaks down a firm's activities into primary activities (i.e., logistics, operations, manufacturing and distribution, marketing and sales, and service) and support activities (i.e., infrastructure, human resources, technology, procurement, etc.). In a multinational enterprise (MNE), these business functions are often geographically dispersed across related entities. VCA therefore helps identify the activities through which a business creates value and sources of its competitive advantage. A value creation process encompasses activities through which a company transforms raw materials, knowledge, or services into a product or service with a higher value.
For transfer pricing (TP) purposes, VCA provides an important foundation for understanding value creation across an MNE group, supporting functional analysis, and the pricing of intercompany transactions from an arm’s-length standpoint.
Interplay between VCA and TP
The diagram below illustrates how VCA connects business activities to TP outcomes.
By mapping activities and identifying key value drivers across the MNE group, VCA provides context for functional analysis. The functions performed, assets deployed, and risks borne (i.e., FAR analysis) by each entity guide the selection of the appropriate TP method and arm’s-length outcome.
The central question underlying both VCA and TP is deceptively simple: where is value created, and how should the entities contributing to that value be appropriately rewarded? VCA approaches this question from a business and strategic perspective by identifying activities with unique capabilities that contribute to value creation and competitive advantage. TP approaches it from an arm’s-length perspective, examining functions performed, assets utilised, and risks assumed by related parties to determine an appropriate allocation of returns among them.
The two intersect where an understanding of an MNE’s business model and value chain informs the functional analysis of its intercompany transactions. In this sense, VCA provides the broader business context, while TP translates that understanding into an arm’s-length remuneration.
The above can be understood from the outcome of a famous case, M/s L’Oreal India Private Limited v Deputy Commissioner of Income Tax (2017), where the Mumbai Income Tax Appellate Tribunal emphasised the importance of following the “value created”, rather than simply following the “spend”. The Indian entity incurred substantial advertising, marketing, and promotional (AMP) expenditure to promote its products and increase sales in the local market. The TP officer, however, viewed the excessive AMP expenditure as evidence that the entity was performing certain DEMPE (development, enhancement, maintenance, protection, and exploitation) functions and enhancing the value of the French parent’s brands. On this basis, the TP officer also questioned the royalty paid to the parent for the use of its trademarks.
The arm’s-length price of the royalty was determined at ‘nil’ on the premise that the entity was already enhancing the parent’s brand through its AMP activities. The court, however, observed that the AMP activities were undertaken for the entity’s own business, with any benefit to the parent’s brands being incidental. The court observed that the VCA helped show that the AMP expenditure was directed towards creating value for the Indian entity’s own sales, while the enhancement of the parent’s brand was only an incidental benefit. This supports the court’s view that the AMP spend was not a service to the French parent and did not, on its own, mean that the trademark royalty should be nil.
BEPS and the role of VCA
The OECD in its BEPS project addresses tax avoidance strategies that exploit gaps and mismatches in international tax rules. In the TP context, BEPS strengthened the focus on aligning TP outcomes with the economic activities and value creation taking place within MNE groups.
Actions 8 to 10 of the BEPS programme sought to align TP outcomes with value creation by examining the FAR analysis among the related affiliates. This placed greater emphasis on understanding how value is created across an MNE’s business activity, providing a basis for applying VCA in the TP context. Action 13 further strengthened this focus by introducing a three-tiered TP documentation framework, increasing transparency around MNEs’ value creation and TP policies.
Importantly, VCA serves as a practical framework for mapping activities, functions, and value drivers across an MNE group, supporting functional analysis and documentation. Thus, while VCA itself is not a mandatory requirement under the OECD framework, its underlying analysis helps demonstrate how value is created and distributed across an MNE group.
The key considerations are as follows:
Start with the business model, not the tax outcome – a robust VCA should begin by understanding the purpose and operating model of the business. A centralised model may concentrate activities within a central entity, while a decentralised model requires clarity on which activities are decentralised and why. The VCA and FAR analysis should reflect commercial reality rather than a predetermined TP outcome. In short, the business should lead, and tax should follow.
Look beyond labels to identify genuine value creation – activities should not automatically be classified as routine based on their functional label. For instance, procurement may be routine where an entity simply purchases on instructions, but if its capabilities generate economic benefits for the group, its contribution may warrant a different analysis. A comprehensive FAR analysis and review of contractual arrangements is therefore essential.
Benchmark the value chain against the industry – a robust VCA should be tested against competitors and industry practices, across products and business models to assess whether the identified value-adding activities reflect broader commercial realities. As technology, supply chains, and customer expectations evolve, the VCA should also be reviewed periodically.
The outlook
A robust VCA reflects the business model, identifies value drivers, and supports the FAR analysis underlying TP outcomes. Businesses should look beyond functional labels, as routine activities may generate significant value depending on their economic contribution. VCA should remain dynamic, with value chains periodically reviewed against industry practices and business changes.
Ultimately, effective TP governance requires collaboration between tax, finance, and shared service or group functions. Rather than treating TP as a year-end compliance exercise, businesses should adopt a continuous cycle of strategy, implementation, monitoring, and review.
