FAR and Comparability Analysis

Chapter 8
FAR and Comparability Analysis

Another key element of any TP analysis is undertaking FAR analysis of the controlled transaction vis-a-vis the transacting entities. 

To put it simply, the FAR analysis identifies the functions performed, assets employed, and risks undertaken by the respective transacting entities. The FAR analysis is the key aspect of any TP component.

FAR analysis can be said to be the first step in analyzing each transacting party’s relative contribution so as to set the foundation for determining the pricing policy. A well-conducted FAR analysis can assist in the clear understanding of the controlled transaction, the role played by each party, the determination of reward/return to each party, identifying the tested party (whose pricing/margin is to be tested vis-s-vis testing the arm’s length principle), determining the most appropriate TP methodology and basis of comparability

analysis, including identifying the right comparables (internal/external).

The importance of FAR analysis forms part of country-wise TP regulations. Further, both, the OECD TP Guidelines and the United Nations Practice Manual on TP lay specific emphasis on the same.

Comparability Analysis

As one would observe from the above, comparability analysis emerges as the most important aspect of determining/testing the ALP principle.

While undertaking the above, FAR plays a critical role as it assists in determining the tested party, identification of comparables, selection of the most appropriate TP method, and final determination of the ALP.

Having determined the tested party, TP method, etc. the next step is to undertake comparability analysis and the key typical steps of the same are as under:

• Identifying potential comparables (internal/external).
• In the case of external comparables, the process is exhaustive. It begins with a wide set of entities operating in the same/similar activity. Generally, such entities are sourced from reputed well accepted databases.
• Following the above, one would need to initiate a screening process involving qualitative and quantitative screening.?
• Qualitative screening involves identifying entities using industry/business activity codes eg. the HSN code, which will assist in excluding entities who are not engaged in similar activity/business. Also, the absence of information on the relevant period could be a criterion for elimination.
• Quantitative screening involves a more stringent process whereby entities not meeting the economic characteristics of the controlled transaction get eliminated. For eg., an entity whose turnover is just 5% of the controlled transaction value would have to be disregarded.
•  Having identified the comparables under the above step, one would now need to identify material differences between the tested party and the comparables in terms of other parameters. For eg. Differences in accounting methodology, capacity utilization, extraordinary events, etc. Once such differences are identified, the next step would be to evaluate whether such differences can be quantified so as to carry out appropriate adjustments to remove the impact of such differences. If it is not possible to quantify the differences, in which case one would not be able to carry out the adjustments and the identified comparable would have to be eliminated. In this regard, adjustments can be carried into either party’s hands.
• Having completed all of the above, the last step in the process would be to determine the ALP basis comparable entities data. Here, mostly the country-specific regulations, OECD, and UN Guidelines provide for use of multiple data ranges.

Having conducted the comparability analysis, the same would have to be documented as part of the documentation requirements. Such documentation would have to be step-wise (as stated above).