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
- 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.
- 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.
- 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:
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 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.
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
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.
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.?
- Swasta does not assume credit risk
- Swasta does not assume foreign currency risk
- Swasta does not assume market risk
- Swasta does not assume technology risk
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.
- 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