The importance of FAR Analysis in Distribution industry
RoyaltyRange
Distribution plays a crucial role in commerce, however, beyond the basic function of moving goods, distributors operate in diverse and distinct ways shaped by the specific products, markets, storage needs, security concerns, logistical challenges, and legal obligations involved in the transactions. These differences are important for Transfer Pricing compliance because they affect how value is generated, who owns the assets, and who bears the risks in intercompany transactions.
When related companies engage in business with one another, the essential point is determining the contribution of each entity to ownership, value creation, and associated risks. These factors lie at the core of Transfer Pricing complexity, making compliance a significant challenge. As a result, detailed documentation becomes particularly important, especially when it comes to the functional analysis and the selection of the appropriate Transfer Pricing methodology. Tax authorities often look at these aspects thoroughly, highlighting the need for careful and precise analysis.
Example scenario
To understand the importance of functional analysis, let‘s consider a simple scenario. The manufacturer produces the goods, packs them, and ships them to the warehouse using different transportation (trucks, railway, ships, etc.). The products are stored there until an order is received. A warehouse worker then decides whether to ship the entire pallet or break it down to fulfil the order before delivering it to the final customer.
This example represents a basic outline of a distributor’s role. However, even in this seemingly simple scenario, complexity arises quickly when you think about the specifics – what is being shipped and under what conditions. Is the product perishable? Is it a controlled substance, a rare metal? What are the implications if something is damaged or stolen during transit? These factors directly relate to the Transfer Pricing.
The FAR analysis
The example scenario above highlights the importance of functional analysis, or “FAR analysis” (focusing on functions, assets, and risks). It thoroughly examines the elements of value creation, identifying who handles each function, who owns the assets, and who assumes the risks. It is a critical component of Transfer Pricing compliance, laying the groundwork for identifying comparable transactions, selecting the appropriate Transfer Pricing methods, allocating profits, and establishing arm’s length pricing.
Although FAR analysis is not a Transfer Pricing method, it plays a significant role in shaping the key elements of your economic analysis. By determining the role of each entity involved in a transaction, functional analysis helps you identify comparable entities and choose the most suitable Transfer Pricing method. Additionally, it provides evidence to support that profits are being taxed in the locations where value is created.
No matter the distribution model, investing time in a thorough functional analysis greatly increases the chances that your entire Transfer Pricing report will come together smoothly and effectively. This also includes the understanding of the multinational enterprise and mapping out organizational charts that detail the location of each entity and its role within the overall operations.
After mapping out the charts, focus on the entities directly involved in the transaction. Identify which specific functions each entity contributes to in your transaction. Those typically involve manufacturing, invoicing, distribution, marketing, advertising, purchasing, etc. Then, provide a summary of how each function operates within the company: Who is responsible for each task? Where are these functions conducted? Who oversees the process? Additionally, address any questions related to these functions. This should result in a detailed description of specific functions performed by the entities in question.
With a clear understanding of each entity’s role, the next step is to identify which entity contributes the most assets to the transaction. Tangible assets can range from manufacturing equipment and office space to computers, while intangible assets, like manufacturing processes, designs, or trademarks, are more complex in terms of ownership. For these, you need to determine which entity is responsible for the development, enhancement, maintenance, protection, and exploitation—commonly referred to as the DEMPE functions.
For an accurate comparability analysis, it’s also crucial to identify which entity takes on the most risk. Risks can be divided into several forms, including credit risk, where losses occur if customers can’t pay; foreign-exchange risk, where exchange rate changes negatively affect the company’s finances; and market risk, where selling products or making a profit in a specific market becomes difficult. Inventory risk is also important—if inventory becomes obsolete or expires, it’s vital to determine who is responsible for those losses.
Characterizing Distributors
Once the FAR analysis is complete, the next step is to characterize the business in a manner that is clear and relevant to tax authorities. This characterization is particularly important as it connects your comparability analysis directly to the prices or returns documented in your Transfer Pricing report. For Transfer Pricing purposes, distributors are generally classified into two main categories:
- Limited-risk distributors. In short, they buy goods from related companies and resell them, focusing on essential tasks like receiving, storing, and shipping. Under close supervision from the parent company, they face fewer risks and earn a steady but modest profit, without the need to develop significant marketing intangibles.
- Full-fledged distributors. They handle the entire distribution and sales process, buying goods from both related and independent suppliers and selling them to end customers. They manage inventory, customer relationships, and strategic marketing, which helps build local brand value. Due to their broader responsibilities and risks—like supply chain issues, inventory, credit, compliance, and market fluctuations—they are expected to earn higher returns.
Both limited-risk and full-fledged distributors must gather detailed documentation to show that their transfer prices meet the arm’s length standard, with FAR analysis as the foundation. However, the depth and complexity of the documentation will differ based on their operational roles and risk levels.
No matter which distributor model you use, the documentation backing your functional analysis uncovers the intricate details of your business. This thorough examination provides valuable insights that can enhance your internal operations, identify areas for cost savings and operational improvements, and guide strategic adjustments—all of which could potentially increase your profitability.
If you require any help with finding the right comparables or choosing the appropriate method for your Transfer Pricing analysis, you can review the solutions offered by RoyaltyRange here.
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