Is a given uncontrolled transaction comparable to the controlled transaction being examined?
The "functional analysis" process is essential to determining whether a given uncontrolled transaction is relevant for comparison purposes to the related-party transaction being examined. Functional analysis examines the specific economic activities that are inherent in the transactions being compared. In this manner, functional analysis acts as a filter for eliminating uncontrolled transactions that are not comparable from a transfer pricing analysis.
The official definition of functional analysis as it applies under United States transfer pricing rules can be found in Section 482-1 (d)(3)(i) of the transfer pricing regulations:
(i) Functional analysis. Determining the degree of comparability between controlled and uncontrolled transactions requires a comparison of the functions performed, and associated resources employed, by the taxpayers in each transaction. This comparison is based on a functional analysis that identifies and compares the economically significant activities undertaken, or to be undertaken, by the taxpayers in both controlled and uncontrolled transactions. A functional analysis should also include consideration of the resources that are employed, or to be employed, in conjunction with the activities undertaken, including consideration of the type of assets used, such as plant and equipment, or the use of valuable intangibles. A functional analysis is not a pricing method and does not itself determine the arm’s length result for the controlled transaction under review. Functions that may need to be accounted for in determining the comparability of two transactions include—
(A) Research and development;
(B) Product design and engineering;
(C) Manufacturing, production and process engineering;
(D) Product fabrication, extraction, and assembly;
(E) Purchasing and materials management;
(F) Marketing and distribution functions, including inventory management, warranty administration, and advertising activities;
(G) Transportation and warehousing; and
(H) Managerial, legal, accounting and finance, credit and collection, training, and personnel management services.
Here is a pdf of the complete regulations: 26 CFR 1.482.
Here is an article that discuss the functional analysis process: