1. Transfer Pricing Insight FAR Analysis & Most Appropriate Method
CA Manas Rindani
Baroda Study Circle
May 2017

2. Functions Assets & Risk Analysis (FAR)

3. 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

4. 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
Price reflects FAR
Base of study
Statute
FAR determines charactaristics

5. 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;

6. 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

7. Steps followed in preparing Reports
FAR
Analysis
Economic
Analysis
(Benchmarking
Study)
Determination
of ALP
Conclusion
and
documenting
the process
How to go about recording the analysis - Practical aspect

8. 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 Gas
Ownership – gives insight on standing of the company in value chain of the whole group
Understanding – Actual operations – E.g. ITeS (low-end/High-end)
Industry – controlled or uncontrolled, how volatile, present performance of the industry etc.

9. 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
AE – Transaction structuring - deemed AE

10. 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.

11. 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
Procurement
Identify customers
Statistical analysis
Warehousing
Industry trend
Information supply
Production
Marketing
Product survey
Investment recommendation
Quality check
Selling
Contractual arrangement
NAV calculation
Sales collection
After sales service
Fund accounting and reconciliations
Marketing & selling
After sales services
R&D, HR, Admin, Finance, IT Support

12. 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?

13. 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

14. 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

15. 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

16. How to get information? (cont’d…)
Inter-company agreements
Projections
Product brochure
Due diligence reports
Market strategy reports
Internal reports (MIS)
Prospectus
Industry reports
Cost audit reports

17. To Summarize…

18. Functional & Risk Principles
Identifying the business
Full-fledged manufacturer
Licensed manufacturer
Contract manufacturer
Toll manufacturer
Stripped distributor
Commissionaire
Commission agent
Service Provider
Service Recipient
More
Functions
Less
Full-fledged Distributor
More functions – Service Provider – Full Fledged Manufacturer

19. Functional & Risk Principles
Manufacturing reward profile
Toll Manufacturer
Full Manufacturer
Risk
R & D
Volume
Pricing
Quality
Raw material costs
Long term contracts
Labour costs
Down time
Fixed overhead
Profit
Manufacturing services
Contract 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.

20. Functional & Risk Principles
Distributor reward profile
Commissionaire
Distributor
Risk
Volume
Pricing
Currency exposure
Obsolescence
Warranty
Credit risk
Marketing costs
Duties
Sales Expense
Instant Buy/Sell
Profit
Market share
Product mix
Admin & Accountancy
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.

21. Most Appropriate Method (MAM)

22. Content OECD & Transfer Pricing Methods
Selection of Most Appropriate Method (MAM)
Insight on each method & example
Brief on softwares for benchmarking
Summary

23. 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

24. Selection of MAM Reference to Statute - Sec. 92C & Rule 10C
May 15, 2018
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.

25. Selection of MAM Nature and class of the transaction
May 15, 2018
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?)

26. Selection of MAM Data availability and reliability
May 15, 2018
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.

27. Selection of MAM Degree of comparability Transactions comparable if:
May 15, 2018
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)

28. Selection of MAM Reliable and accurate adjustments
May 15, 2018
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.

29. 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

30. 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

31. 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 34

32. 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
Coal
vendor B
Relatad Parties
Independent Parties
Coal
Buyer A
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

33. 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.

34. 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

35. Transfer Pricing Method – RPM
Example
Supplier
Country A
Country B
Country C
Country D
Distributor A
Distributor B
Distributor C
Subsidiary
• Non-exclusive distributor
• Only markets product
• Non-exclusive distributor
• Only markets product
• Non-exclusive distributor
• Only markets product
• Exclusive distributor
• 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

36. 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

37. Transfer Pricing Method – CPM
Factors to Consider
Cost should include all costs associated with the process (manufacturing, provision of services)
Direct Costs- materials, labor
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) 34

38. 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.

39. 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

40. 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

41. 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

42. 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.

43. 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 –

44. To Summarize…

45. 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

46. Questions..?

47. Thank you..!