Transfer Pricing Insight
FAR Analysis &
Most Appropriate Method
CA Manas Rindani
Baroda Study Circle
May 2017
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Functions Assets & Risk Analysis
(FAR)
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Content
Why FAR?
Reference to Statute
Steps followed in preparing study report
FAR Analysis – fact finding exercise
FAR Analysis – Study of functions, assets and risks
How to get information?
Summary
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Why FAR?
• Prices charged between two independent enterprises usually reflects functions
performed, risk assumed and assets employed by each enterprise
• FAR analysis forms the basis and framework for
- Undertaking comparability study
• determining comparability between controlled and uncontrolled
transactions, comparison of functions, assets and risks necessary
- Determining the most appropriate method
- Assessment of the arm’s length price
• Reference in Statute
- Computation of arm’s length price (Section 92C)
- Most appropriate method (Rule 10C)
- Documentation requirement (Rule 10D)
• Authorities lay emphasis on FAR
- E.g. PE attribution
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Reference to the Statute
Section 92C - Computation of arm’s length price
“The arm’s length price in relation to an international transaction shall be
determined by any of the following methods, being the most appropriate
method, having regard to the nature of transaction or class of transaction or
class of associated persons or functions performed by such persons or such
other relevant factors …”
Rule 10C(2) – Most appropriate method
“In selecting the most appropriate method…..the following factors shall be
taken into account, namely:
(b) ………and the functions performed by them taking into account
assets employed or to be employed and risks assumed by such
enterprises;
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Reference to the Statute (Cont’d…)
Rule 10D - Documents to be maintained under section 92D
“(e) a description of the functions performed, risks assumed and
assets employed or to be employed by the assessee and by the
associated enterprises involved in the international transaction…”
FAR Analysis
Determination of
most appropriate
method and arm’s
length price
Maintenance of
documentation
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Steps followed in preparing Reports
Step 1
FAR
Analysis
Step 2
Economic
Analysis
(Benchmarking
Study)
Step 3
Determination
of ALP
Step 4
Conclusion
and
documenting
the process
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Understanding overall business and fact finding
• Process of finding and organizing facts about a business in terms of its FAR in
order to identify how these are divided between the parties involved in the
transaction
• Collecting basic information:
– Background information of the enterprise
 Ownership structure
– Understand business operations and activities
 Manufacturer, wholesaler, distributor, service provider
 Product profile (Single product, Multiple products, Proprietary product,
etc.)
 Marketing penetration strategies
 Manufacturing facilities; R&D centers; Warehouses
– Understand the Industry to which the enterprise belongs to
 Market segments
 Market share of an enterprise
 Specific industry regulations - Pharmaceuticals; IT/ ITES; Oil and Natural
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Gas
Understanding overall business and fact finding
•
Collecting specific information:
− Identification of associated enterprises
− Identification of international transactions
− Details of international transactions
 Product / Services
 Value
 Pricing
 Terms and conditions, etc.
• Functions generally performed; assets employed and risks assumed by each
party to the transaction for each class of the transaction
• To bear in mind that underlying aim is also to identify comparable transactions
/ comparative information
− Search for comparables can begin with review of the business operations
− Internal / external comparables
− Information on competitors
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Functions Performed
• Activities that are carried out by each of the parties to the transaction
• Transaction level analysis
• Value chain
– Functions that add more value to the transaction and fetch higher returns
• Focus should be not only to identify maximum number of functions but to
identify critical functions performed by related parties
• E.g. R&D, engineering & design work, material management, manufacturing
and assembly work, warehousing and inventory, marketing and distribution,
software development, etc.
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Functions Performed (Cont’d…)
Different functions for different business activities
Manufacturing and
Selling
Distribution
Marketing support
services
Non binding
investment
advisory
Business decisions
Budgeting
Lead / Opportunity
Data research
Budgeting
Procurement
Identify customers
Statistical analysis
Procurement
Warehousing
Industry trend
Information supply
Production
Marketing
Product survey
Investment
recommendation
Quality check
Selling
Contractual
arrangement
NAV calculation
Warehousing
Sales collection
After sales service
Fund accounting and
reconciliations
Marketing & selling
After sales service
Sales collection
After sales services
R&D, HR, Admin,
Finance, IT Support
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Asset Employed
− Assets used in the course of international transaction
− Analysis to be done considering the industry
• Capital intensive industry – Property, Plant and Equipment
• Labour intensive industry – Human resource
− Assets employed for each party and for each function need to be identified
− Significant tangible / Intangible assets
− Routine / Non routine intangibles
• Who has developed intangibles?
• Legal and Economic owner of intangibles
• Intangibles earning super profits
− Any idle capacity?
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Risk Assumed
− Risk and returns go hand-in-hand – Higher the risk, higher the return
− Identification of risks assumed in respect of each function and each party to the
transaction
− Study facilitates adjustments based on differences in risks that are undertaken
in a controlled transaction as compared to uncontrolled transactions
− Also analyze how risk is mitigated / any steps taken to reduce risk
• E.g. Foreign exchange risk – Hedging
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Risk Assumed (Cont’d…)
•
Significant risks involved in the transaction
–
–
–
–
–
–
–
–
Market / Industry risk (Competition, decline in demand, inability to market etc.)
Manufacturing risk (Losses due to errors in mfg. process etc.)
Product Liability Risk (Failure of performance)
Inventory Risk (Spoiled, stolen, obsolete inventory)
Credit Risk (Failure of payment or delay in payment)
Finance Risk (debt vs. equity, Interest subvention risk, foreign exchange risk etc.)
Contract Risk (Breach of contractual terms)
Manpower Risk (High turnover of employees, human intensive industry (service)
etc.)
– Risk of loss of data or security
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How to get information?
•
•
•
•
Annual Report
Website
Standard questionnaire
Functional interview
– Interview with Business Heads / Operational level staff
– Pre interview preparation – Domain Knowledge, Competitors
– Information that can be gathered
 Corporate background
 Group entities and holding pattern
 Geographical spread
 Product profile and end use of the products
 Industry verticals and end customers
 Business model
 International transactions
 Future projections / upcoming projects
 Factory setup, number of plants and locations
 Major suppliers
 Supply chain
 Statistical data such as proportion of domestic and export sales
 Tax holiday / any other tax benefits
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How to get information? (cont’d…)
• Inter-company agreements
• Projections
• Product brochure
• Due diligence reports
• Market strategy reports
• Internal reports (MIS)
• Prospectus
• Industry reports
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To Summarize…
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Functional & Risk Principles
–
Identifying the business
More
Functions
Less
Functions
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Functional & Risk Principles
– Manufacturing reward profile
Profit
R&D
Volume
Pricing
Quality
Raw material costs
Long term contracts
Labour costs
Down time
Fixed overhead
Manufacturing services
Toll Manufacturer
Contract Manufacturer
Risk
Full Manufacturer
Note: This graph only shows the relationship between profit and functions/risks.
It is worth noting that more functions/risks also associate with larger
potential losses.
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Functional & Risk Principles
– Distributor reward profile
Profit
Volume
Market share
Product mix
Pricing
Currency exposure
Obsolescence
Warranty
Credit risk
Marketing costs
Duties
Sales Expense
Admin & Accountancy
Commissionaire
Instant Buy/Sell
Risk
Distributor
Note: This graph only shows the relationship between profit and functions/risks.
It is worth noting that more functions/risks also associate with larger
potential losses.
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Most Appropriate Method
(MAM)
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Content
OECD & Transfer Pricing Methods
Selection of Most Appropriate Method (MAM)
Insight on each method & example
Brief on softwares for benchmarking
Summary
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Transfer Pricing Methods
TP Methods
OECD Guidelines
Indian Regulations
Comparable Uncontrolled Price
Method
Comparable Uncontrolled Price
Methods
Resale Price Method
Resale Price Method
Cost Plus Method
Cost Plus Method
Profit Split Method
Profit Split Method
Transactional Net Margin
Method
Transactional Net Margin
Method
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Selection of MAM
Reference to Statute - Sec. 92C & Rule 10C
• Indian TP Regulations do not provide any hierarchy in selection and application
of methods for benchmarking - it only prescribes selection of “MAM”
• MAM to be selected having regard to:
‒ Nature and class of the transactions
‒ The class of associated enterprises entering into the transaction and the
functions performed by them taking into account assets employed and
risks assumed by such enterprises
‒ Availability, coverage and reliability of data necessary for application of
method
‒ Degree of comparability existing between the transaction and the
uncontrolled transaction and between the enterprises entering into such
transactions
‒ The extent to which reliable and accurate adjustments can be made on
account of any differences between the transactions and the comparable
uncontrolled transaction or the enterprises entering into these transactions
‒ The nature, extent and reliability of assumptions required to be made in
application of a method.
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Selection of MAM
Nature and class of the transaction
• MAM is that method which, in the facts and circumstances of a particular
transactions, is best suited to provide a reliable measure of arm’s length.
• Nature of transaction affects selection of MAM due to inherent characteristics
of such transaction.
• Typical transactions that may require application of a particular method:
– Guarantee fees (CUP, other method?)
– Interest (CUP, other method?)
– Royalty transaction (CUP, TNMM, PSM?)
– Capital import / export (CUP, Other Method, TNMM?)
– Sale of customer contracts (Other method?)
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Selection of MAM
Data availability and reliability
• Availability and reliability of data are important elements for selection of MAM
– Limitation of data availability is a key challenge in transfer pricing analysis
• A particular method might be MAM considering class of transaction or
characterization of tested party; however, non-availability or unreliability of data
may render it inappropriate. For example
– Unavailability of third party comparable prices
– Lack of data on commission rates in the public domain
– Data on gross margins
• Indian Transfer Pricing Regulations require use of publicly available data
• Source of data to be authentic, for example
– Widely used reliable databases
– Published Annual Reports
– Valuation Reports from independent valuers
– Certified segmented accounts in case of internal TNMM, etc.
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Selection of MAM
Degree of comparability
• Transactions comparable if:
‒ no material difference in factors; or
‒ quantitative adjustments are possible to eliminate material effect of differences
• Degree of comparability and extent of reliable and accurate adjustment in case of
difference is very crucial in selection as well as application of MAM
• Different methods require different degree of comparability
• For example, application of CUP would require high level of comparability
(product level comparability) whereas under TNMM, one would look for a broader
comparability (functional comparability)
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Selection of MAM
Reliable and accurate adjustments
• Transfer pricing regulations require reliable and accurate adjustments to be made
as may be warranted
• Adjustment could be to eliminate impact of incompatibility of functions, assets or
risks. For example,
‒
‒
‒
‒
‒
‒
‒
‒
Quantitative difference like volume of sale or purchase
Qualitative differences like size, texture, purity, content ratio
Contractual terms like warranty coverage, credit terms, delivery terms, etc.
Level of the market like wholesale vs retail
Geographical difference
Risks associated like foreign currency, credit, attrition
Level of working capital
Level of risks – Captive Service Provider vs Entrepreneur
• A particular method cannot be selected as most appropriate method if it is not
possible to make accurate adjustment.
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Transfer Pricing Methods
•
In general
– CUP Method compare prices
– Resale Price Method compares gross margins
– Cost Plus Method compares profit mark-ups on costs
– Profit Split Method refers to the (total) profits from transactions and
splits them among the parties based on the level of contribution
– Transactional Net Margin Method analyses net profit in relation to an
appropriate base, such as costs, sales or assets
– Other method
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Transfer Pricing Method - CUP
•
Most direct way of determining an ALP
•
It compares the price charged in an international transaction with that
charged in comparable uncontrolled transaction.
•
Price is adjusted to account for differences, if any, which could materially
affect the price
•
Comparability
- Intended purpose of use, branding or customer perception and preference would
impact applicability
- Market comparability
- Contractual term including quantity of property sold or acquired, volume discounts,
applicable currency, marketing, advertising, after sale support, duration of contract,
terms of delivery, terms of payment etc. can not be ignored
•
Approaches
- Internal CUP
- External CUP
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Transfer Pricing Method - CUP
• Factors to Consider
–
–
–
–
–
–
–
Product/Service similarity (similar type, quality, quantity, features,
etc)
Seasonality (e.g., air conditioner, ski)
Same stage in supply chain (wholesales, retail, etc.)
Geographic market in which transaction takes place
Embedded intangibles, if any.
Contractual terms (e.g., warranty, discount policy, credit terms,
shipping liability, etc.)
Other factors that might affect comparability
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Transfer Pricing Method – CUP
Example – External CUP
The CUP method compares prices charged between related properties with those
charged between non-related parties for the same property or service.
Coal
vendor
A
Relatad Parties
Coal
Buyer
A
Coal
vendor
B
Independent Parties
Coal
Buyer
B
Requirements for CUP Implementation
− Coal of same (similar) quality, type, and quantity
− Both Producers in same (similar) markets
− Both Buyers in same (similar) markets
− Transactions occur during the same time frame
− Transactions occur during same stage of production/distribution chain
− Transactions occur under same (similar) conditions
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Transfer Pricing Method – CUP
Example
Accuracy and Possible Adjustments
Certain adjustments should be made to improve model accuracy whenever slight
differences with the tested party occur. For example:
− What if coals are of different quality?
− What if the coal buyers belong to similar, but not exact, geographic
markets?
If any of these differences have a material effect on price then adjustments are in
order.
However, if there is no information available to make these adjustments OR if the
differences are significant, then the reliability of the CUP method would be reduced
and a less direct method may be preferred.
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Transfer Pricing Method - RPM
•
The resale price method measures an arm's length price by subtracting the
appropriate gross profit from the applicable resale price for the property
involved in the controlled transaction under review.
•
The price is adjusted to take into account the functional and other
differences, including differences in accounting practices, if any, which could
materially affect the amount of gross profit margin in the open market.
•
Applicability
-
Reseller should not make any material alterations to the product traded
Comparability
•
-
Product comparability not very important, however better the product comparability
better would be the results
More functions and asset, higher risk would require higher gross margin
Accounting variations should be taken care
Other factors like geographical differences, volume, high operating cost may effect
comparison
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Transfer Pricing Method – RPM
Example
Supplier
Country A
Country B
Distributor A
Distributor B
• Non-exclusive distributor
• Only markets product
Country C
Country D
Distributor C
Subsidiary
• Non-exclusive distributor • Non-exclusive distributor • Exclusive distributor
• Only markets product
• Only markets product
• Perform technical applications
Are Gross Margins comparable?
Even if all other circumstances are identical, adjustments should be made for:
− Exclusive vs. non-exclusive selling agreement
− Value-adding services such as technical applications for customers
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Transfer Pricing Method – CPM
•
The cost plus method tests whether a profit mark-up charged in a
international transaction is at arm’s length by reference to the mark-up
charged in uncontrolled transactions.
•
Transfer pricing is calculated by adding a mark-up, earned in uncontrolled
transactions, to a direct and indirect cost of production/ services relating to
international transaction.
•
Applicability
- CPM is useful in case of long-term buy-and-supply agreements, pricing of semi-finished goods,
toll or contract manufacturing, services of purchasing agents, contract research etc.
•
Comparability
- Product comparability not very important, however better the product comparability better would
be the results
- More functions and asset, higher risk would require higher margin
- Accounting variations should be taken care
- Other factors like geographical differences, volume, high operating cost may effect comparison
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Transfer Pricing Method – CPM
Factors to Consider

Cost should include all costs associated with the process (manufacturing,
provision of services)
i) Direct Costs- materials, labor
ii) Indirect Costs – Overhead, SG&A

Mark up applied to the total cost is set or tested having regard to the third
party comparable mark ups.
(Profile of the parties involved, functions/risks/assets, accounting differences , etc.
should be considered)
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Transfer Pricing Method – CPM
Example
Contract to carry out R&D project
- Carries out contract research
Company A
Related Party Transaction
- Owns all intangibles from research
- Absorbs risk of research failure
Company B
Implementation of CPM
• Typical setup for applying the cost plus method
• All costs for the research carried out have to be compensated plus a profit
margin reflecting the complexity and innovation of the research carried out.
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Transfer Pricing Method – PSM
•
This method aims to determine what division of total profits independent
enterprise would expect in relation to the relevant transactions.
•
The profits should be split on an economically valid basis that reflects the
functions and risks of each of the parties.
•
In order to apply this method, it is necessary to identify the total profit
arising from the related party transactions and split that profit between the
parties according to their respective contributions.
•
Applicability
–
•
In certain very complex trading relationships involving very interrelated
transactions, it is sometimes genuinely difficult to evaluate those transactions on a
separate basis.
Approaches
–
–
Total profits split
Residual profit split
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Transfer Pricing Method – TNMM
•
The TNMM examines the net profit margin relative to an appropriate base
that a tax payer realizes from an international transactions vis-à-vis
comparable uncontrolled transactions.
•
Thus, the TNMM operates in a manner similar to the cost plus and resale
price methods.
•
TNMM is based on the economic theory that returns earned by an enterprise
operating under similar conditions, in the same market and industry, tend to
become more equal after some time.
•
Procedure
–
–
–
–
–
Selection of Tested Party
Data – Multiple year
Aggregation of transaction
Identification of comparable companies
Profit level indicator
• Operating Margin = OP/Sales X 100
• Net Cost Plus = OP/ Total Operating Expenses X 100
• Berry Ratio = GP/ Operating Expenses
• Return on Asset = OP/ Operating Asset X 100
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Transfer Pricing Method – Other method
•
Other method refers to “price which has been
- charged or paid, or
- would have been charged or paid”
•
Use of Other method for benchmark using prices rather than margins
•
Not fall within the meaning of property or service
•
Better benchmarking for transactions of Cost Allocation, reimbursement,
interest on loan, Share valuation, Contract valuations etc.
•
Other method could be any method – no specific method described
•
Use of Quotations
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Transfer Pricing Method
Other example – CUP vs TNMM
Supplier
Country A
Country B
Country C
Country D
Distributor A
Distributor B
Distributor C
Subsidiary
• Non-exclusive
distributor
• Perform technical
applications
• Reports service costs
in COGS (cannot be
separately identified)
• Non-exclusive
distributor
• Perform technical
applications
• Reports service costs
in COGS (cannot be
separately identified)
• Non-exclusive
distributor
• Perform technical
applications
• Reports service costs
in COGS (cannot be
separately identified)
• Exclusive distributor
• Only markets products
Method Selection
Reasons for choosing TNMM:
−
−
Significant product & market differences for a CUP
Since additional service costs cannot be independently identified, gross margins of independent
distributors must be higher, invalidating application of RPM.
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Transfer Pricing Method
Software used for benchmarking
There are various softwares used for comparable search. Some of them are -
•
•
•
•
•
Prowess – search for data relating to comparable companies (Indian
companies)
Capitaline - search for data relating to comparable companies (Indian
companies)
Royalty Stat – Search for Royalty Agreements (Global database)
KT Mine – Search for Royalty Agreements (Global database)
Loan Connecter – Search for Interest rates, guarantee commission etc.
Screen-shots from Prowess –
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To Summarize…
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Application
Analysis of transaction under TP regulation
Analyze each method of computation of arm’s
length price
Methods not applicable to be rejected with due
reasoning
Application of most appropriate method and
computation of ALP
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Questions..?
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Thank you..!
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