FAR Analysis – Transfer Pricing

  • Functional, asset and risk analysis is often referred to as FAR analysis.
  • When transactions between the AEs are examined for the purpose of determining the ALP, one has to analyse the three components closely, namely
FAR Analysis

Functions performed

  • Functions performed by different parties are examined to ascertain which party performs the most significant activities and which one performs the routine activities.
  • Suppose A Inc (US Company) is a manufacturer of a product and B Ltd (Indian Company) is a distributor while A Inc identifies undertakes the manufacturing process, employs intangibles, conducts quality checks etc. and B Ltd is engaged in identifying the end customer and distributing it, functions of A Inc is significant and not B Ltd. Enterprise which performs key or significant activities has to earn higher return out of the total return.
  • Some of the significant functions are
  • Manufacturing, production or assembly work
  • Purchase and material management
  • Logistic support
  • Business process management
  • Administration functions
  • Finance/ budgeting / Treasury
  • Warehouse / inventory management
  • Quality control
  • Comparing the activities performed in a controlled transaction with that of uncontrolled transaction is a good metric to ascertain the economic value of the activity performed.

Assets Employed

  • In order to perform the requisite functions, each party should deploy assets.
  • The assets employed therefore corroborate with the functions in a transaction.
  • Further, ownership of the intangible assets also plays a key role in the profits attributable to each entity.
  • If one entity has the legal ownership of significant intangible asset and other entity uses the same to perform its functions, then the first entity would be recognised as employing significant assets.

Risks assumed

  • In any business transaction or operation, there are risks involved. Often higher the risk, higher the expected returns.
  • So the party which assumes high risk is expected to remunerate the other party with lower or marginal return.
  • For example, a contract manufacturer who does not assume any product risk will not be remunerated same as the entrepreneur manufacturer.

Common risks that are assumed in a business operations are:

Credit risk

Normally, an enterprise offers some credit period to the customers and if the customer does not pay then such loss has to be borne by the person assuming credit risk

Market risk

Market risk arises due to competition, pricing pressure, etc.

Foreign exchange risk

Enterprises often transact in foreign currency which is different from reporting currency. Any fluctuation in the foreign currency would affect the profit.

Obsolescence risk

The product or services which an enterprise offers may become obsolete over time and the enterprise may have to invent new products / services to stay in business

Technology risk

There is a rapid change in technology and this may result in products become outdated or there may be higher costs for updating the technology.

Capacity utilization risk

Capacity utilization risk relating to loss of profit due to unutilized capacity. Lack of demand for a product or a lock out may result in lower capacity utilization.

Question

Swasta India Ltd manufactures cars by procuring raw materials both from AEs abroad and also locally which are coordinated by the parent company. It has an agreement by which the parent company has to provide necessary intangible and also controls the quality of manufacture, quality of raw material, manufacturing process automation etc. They export all the cars to its unrelated distributors abroad and also sell them in India to unrelated retailers.?

  1. Swasta does not assume credit risk
  2. Swasta does not assume foreign currency risk
  3. Swasta does not assume market risk
  4. Swasta does not assume technology risk

Answer d.

Swasta India has a agreement with its parent company for provision of intangibles, control the manufacturing process etc., We can assume that there are clauses in the agreement which would indemnify Swasta for any deficiency in the raw material, quality or technology. Though it will bear the risk to its ultimate customer the same would be indemnified by the parent company. 

Sourcing information

  • Official publication, reports, studies etc.,
  • Market research studies
  • Price publications including stock exchange and commodity market operations
  • Agreements with AEs and with other unrelated enterprises for similar transactions
  • Letters, communication or other correspondences
  • Accounting policies followed

Introduction to Transfer Pricing

Introduction to Transfer Pricing Transfer Price “Transfer Price” is the price at which an enterprise charges for its transaction within its group entitiesInternational transaction involves more than one tax jurisdiction, and due to disparity in tax rates and method of computing income, the parties may try to adjust the transfer pricesSince the …
Read More

Limitation of interest deductions – transfer pricing

Limitation of interest deductions – transfer pricing Introduction Popularly known as ‘Thin Capitalization Rules’, this provision intends to cap the interest that can be paid to the AEs in case of borrowings.Generally, debt is a preferred instrument to provide funds to the subsidiary or group company rather than equity due to the …
Read More

Income from transaction with Non-Residents – Transfer Pricing

Income from transaction with Non-Residents – Transfer Pricing Applicability Section 92 is the charging section for Chapter X of the Act. Sec 92 provides that any income arising from an ‘International transaction’ shall be computed having regard to ALP.For this purpose, the allowance for any expense or interest shall be determined on …
Read More

Secondary Adjustment – transfer pricing

Secondary Adjustment – transfer pricing Introduction As per the OECD’s TP guidelines for Multinational Enterprises and Tax Administrations (OECD TP Guidelines), secondary adjustment may take the form of constructive dividends, constructive equity, or constructive loans.The provisions of secondary adjustment are internationally recognized and are already part of the TP rules of many …
Read More

International Transaction [Section 92B] – Transfer Pricing

International Transaction [Section 92B] – Transfer Pricing Transfer pricing provisions are applicable to determine the arm’s length price of international transaction and specified domestic transaction. Though, specified domestic transactions are also part of the transfer pricing provisions, it predominantly deals with international transaction. Therefore, it is essential to understand the term …
Read More

Specified Domestic Transactions – Transfer Pricing

Specified Domestic Transactions – Transfer Pricing Introduction The concept of Specified Domestic Transactions (SDT) was introduced in Finance Act 2012. Prior to that the AO were empowered to disallow payments made to related parties which were unreasonable or excessive under section 40A(2)(b) of the Act. Further, TPPs were applicable only for international …
Read More
Scroll to Top