Functional Analysis (FAR Analysis)
In transfer pricing, FAR Analysis is the backbone of comparability. It evaluates the Functions performed, Assets used, and Risks assumed by each entity in a multinational enterprise (MNE) group. This breakdown helps determine the arm’s length nature of intercompany transactions.
Let’s break this down into clear, practical insights with frequently asked questions.
Key Takeaways
- FAR Analysis ensures that profits are aligned with the value creation of each group entity.
- It’s mandatory for determining appropriate transfer pricing methods and Profit Level Indicators (PLIs).
- Functions, assets, and risks must be carefully documented and consistently reflected across all TP reports.
What is Included in a FAR Analysis?
A comprehensive FAR Analysis consists of three elements:
Functions Performed
Functions are the day-to-day activities an entity carries out. Examples include:
- Manufacturing (e.g., assembling or producing goods)
- Procurement (e.g., sourcing materials)
- Marketing and Sales (e.g., advertising and distribution)
- R&D and IP Management (e.g., developing and owning patents)
Each function must be mapped to its contribution to the value chain. The more critical or unique the function, the more likely it is to command a higher share of the profit.
Assets Used
Assets can be:
- Tangible: machinery, equipment, buildings
- Intangible: patents, trademarks, proprietary software, customer lists
Ownership of key assets, especially intangibles, often signals greater value creation and thus justifies a larger portion of profits.
Risks Assumed
Risks influence how rewards and losses are allocated. Key categories include:
- Market Risk (e.g., customer demand volatility)
- Inventory Risk (e.g., spoilage or obsolescence)
- Credit Risk (e.g., non-payment by customers)
- Operational Risk (e.g., system failures)
Entities that bear greater risks generally expect higher returns.
Why is FAR Analysis Important in Transfer Pricing?
It underpins the choice of transfer pricing method. For example:
- Resale Price Method (RPM) is suitable for distributors with limited functions and risks.
- Transactional Net Margin Method (TNMM) is common for low-risk service providers or manufacturers.
- Profit Split Method (PSM) may apply when both parties contribute unique intangibles or bear significant risks.
Without a proper FAR analysis, it’s impossible to assess whether a transaction is arm’s length.
How is FAR Analysis Documented?
Typically, FAR analysis is structured in a matrix form, comparing each related party in terms of:
- Functions (F)
- Assets (A)
- Risks (R)
This allows tax authorities to see who does what, who owns what, and who takes on what risks—ensuring transparency and compliance.
How is a FAR Analysis Conducted in Practice?
Here's a step-by-step guide:
- Interview Key Personnel: Understand operations, responsibilities, and strategic objectives.
- Review Contracts and Agreements: Especially intercompany agreements, service contracts, IP licenses.
- Analyze Financial Statements: Identify cost structures, asset ownership, and profit margins.
- Evaluate Organizational Structure: Including legal ownership versus operational control.
- Compare With External Data: Benchmark similar companies to support your positions.
What Role Does FAR Play in Choosing a Profit Level Indicator (PLI)?
Each PLI aligns with a certain risk and function profile:
- Operating Margin: Often used for limited-risk distributors (TNMM)
- Berry Ratio: Suitable for service providers with limited cost of goods sold
- Cost Plus Mark-Up: Appropriate for contract manufacturers or routine service entities
FAR Analysis directly informs which PLI is most reliable and defensible.
Is FAR Analysis Only for Multinational Groups?
Primarily, yes. But the principles of FAR are also relevant in:
- Joint Ventures
- Cost Sharing Arrangements
- Intercompany Services
Anywhere related parties engage in cross-border dealings, FAR is crucial.
What are Common Pitfalls in FAR Analysis?
- Over-generalization: Describing all entities with similar language dilutes clarity.
- Ignoring Actual Conduct: Tax authorities place weight on actual behavior over contractual terms.
- Outdated Information: Business models evolve—so must the FAR analysis.
- Inconsistent Narrative: Descriptions in the FAR should match financial outcomes and chosen methods.
How Often Should a FAR Analysis Be Updated?
At least annually—especially if:
- There are material changes in business operations
- New functions are introduced
- Risk profiles shift (e.g., due to market entry or exit)
Stale FAR analyses are a red flag during audits.
Why FAR Analysis Matters
A functional analysis isn’t just a checkbox. It’s the anchor of every solid transfer pricing policy. It:
- Justifies profit allocation
- Supports method selection
- Helps avoid disputes with tax authorities