International Taxation – FAR Analysis

International Taxation – FAR Analysis

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FAR Analysis

Functions, Assets and Risk (‘FAR’) analysis is an analysis of the functions performed, taking into account assets used and risks assumed by associated enterprises (AEs) in controlled transactions.

A method of finding and organizing facts about a business in terms of the functions performed, assets used (including intangible property) and risks assumed by such business to:

  • Identify how they are divided among the AEs; and Ø
  • Assess the importance of each function in the overall value chain.

FAR analysis is the starting point in determining the arm’s length price of an international transaction.

Importance/Need of FAR Analysis:

Let us take an example. Can we compare a manufacturer with a logistic service provider? The answer is “No”. Both of them will perform different functions, employ different kind of assets and undertake different type of risks.

So, How would one determine whether the entity is a manufacturer or a logistic service provider? Simply, by undertaking  FAR  Analysis.

Components of FAR:

  1. Functions Performed:

Functions performed are the activities that are carried out by each of the parties to the transaction. In performing functional analysis, important and significant functions are considered.

Such functions add more value to the transactions and therefore, are expected to fetch higher returns for the entity performing such functions. Thus, the focus should not only be on identifying the maximum number of functions but on identification of critical functions performed by the related parties. While functions performed depends on the facts of the case, some of the important functions that are generally observed and examined in a transaction are:

  • Research and development
  • Budgeting
  • Purchasing and materials management
  • Manufacturing, production or assembly work
  • Warehousing and inventory
  • Marketing and distribution
  • Business process management/ administrative functions
  • Scheduling
  • Supervision

The above list is only for illustrative purpose. The functions may differ on the basis of different types of businesses.

  1. Assets employed:

It’s obvious that as functions are compared, similarly assets employed in the business are also required to be compared.

Now, when it comes to the comparison of the assets, it is obvious that both tangible and intangible assets are required to comparison.

The existence of intangible assets in the form of technical knowhow, trademarks, patents, etc. contribute to the super normal growth in profits of an enterprise.

However, an entity which owns only tangible assets which are used in normal course of operations such as computers, furniture & fixture, plant and machinery, etc. is expected to earn routine/normal profits as earned by other companies engaged in similar business.

  1. Risks assumed:

Every enterprise undergoes various risk factors in order to successfully run and earn from the business.

Risk study involves identification of various risks that are assumed by each of the parties to the transaction. It is commonly understood that risk and return go hand in hand.

In the open market, more the risks assumed by an enterprise, higher the returns that it expects. Conversely, in case where the risks undertaken by the enterprise in a transaction are minimal, the returns expected to be generated from such transactions should also normally be lower.

Types of Risks:

  • Market risk: Risk relating to increased competition and relative pricing pressures, change in demand patterns and needs of customers, inability to develop/penetrate in a market, etc.
  • Inventory risk: Risk associated with management of inventory in case of overstocking or slow/non-moving inventory. As a result, the enterprise may be forced to bear a loss of margin on the inventory, or incur additional costs to dispose-of the same.
  • Credit risk: Risk relating to default in receivables by customers.
  • Product liability risk: Risk associated with product failures including nonperformance to generally accepted or regulatory standards. This could result in product recalls and possible injuries to end-users.
  • Foreign exchange risk: Risk relating to the potential impact on profits that may arise because of changes in foreign exchange rates.
  • R&D risk: Risk associated with loss incurred due to unsuccessful R&D expenditure.
  • Capacity Utilization risk: Risk associated with loss of profits due to unutilized capacity
  • Attrition risk: Risk associated with losing trained personnel which contribute to the success of the enterprise

Risk factor plays a vital role in FAR analysis of the enterprise. While comparing risks, it is very important to identify the right type of risk on the basis of businesses as it would help in determine the true characterization of each of the parties to the transaction.

For instance, a distributor solely engaged in purchasing goods for the purpose of resale without performing any value addition may be characterized as a low risk distributor whereas a distributor who performs significant value addition in terms of packing goods, holding inventory, incurring advertisement and promotional expenditure, undertaking market risk, etc. may be characterized as a ‘full-fledged distributor’.

So, you can see one cannot compare the risks associated with the distributor with that of retailer.

Conclusion:

In practice, one cannot compare all the functions, risks and assets employed. Hence, a crucial step in the comparability analysis is the comparison of the “economically significant” functions performed, risks assumed and assets employed (i.e. such functions, assets and risks that are likely to have an impact on cost/expenses, prices, profits arising in a transaction) by the associated enterprises with those by the independent parties which have been selected as potentially comparable for benchmarking the arm’s length price of the controlled transactions.

So, here I am ending this part.

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