Transitioning from FAR to FARM analysis

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India & many developing countries have traditionally been strong advocates of source based taxation. In the context of transfer pricing, the spirit of OECD's guidelines in terms of "Functions Assets and Risk" (FAR) Analysis have been practiced and reliance thereon is also upheld by the Indian Courts in many rulings. 

Developing countries like China or India have been advocating expanding the scope of profit attribution in source jurisdiction, based on not just FAR analysis but also considering the 'market' analysis, also referred to as FARM analysis. A renewed focus on 'value creation' post BEPS is accompanied by even stronger consideration of demand side factors in the TP analysis in some of the developing jurisdictions.  This is also accompanied by the debate on whether ‘OECD Authorized Approach (AoA)’ using just FAR is adequate, especially in the context of digital economy taxation. While this debate is immediately relevant in the context of digital economy, the fundamental principles relating to FAR versus FARM analysis and AoA approach are also relevant in the context of transfer pricing. 

Do you believe that market jurisdictions which create ‘value’ should be remunerated in addition to the outcome of FAR analysis? Will ‘profit attribution’ considering demand side factors be an appropriate solution for digital as well as traditional economy business models? Are these approaches in line with OECD's work on BEPS Action 8-10?

T.P. Ostwal
Partner, T.P. Ostwal & Associates

In my opinion, FAR analysis does not give importance to market place which is one of the major weaknesses of the FAR analysis. The theory of creation of value by use of intangibles is merely a one-sided approach which has been developed by OECD (developed countries mainly) ignoring the views of developing countries (like G20) and is therefore going to be a sore issue of dispute in future. 

In today’s world, manufacturing and services have shifted from developed to developing counties like China, Brazil, India, Indonesia, Philippines etc. which means that the revenue generating ability of developed countries has shifted to developing countries. Therefore, developed countries have created this new theory of value creation giving sole importance to intangibles, which is the major component of manufacturing cost. That is how developed countries intend to shift the attribution of profits to intangibles. In the process, developed countries consider manufacturing & services as low value addition items which need to be rewarded on cost plus 5% markup basis, this approach being quite ridiculous. Once goods are manufactured in these developing countries, the developed world accesses the markets of these developing countries and makes huge profit. In my opinion, when...

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Rahul Mitra
Partner and National Head, Transfer Pricing & BEPS, KPMG India

“Functions, assets & risk (FAR) analysis is a key to the characterizations of parties to a transaction or in a supply chain, vis-à-vis allocation of profits amongst them, from the perspective of arm’s length principle under transfer pricing (TP). Uniqueness of a market per se is not a unique/ non-routine attribute or intangible, which may be ascribed to any one entity, for it to receive a share of profit more what is arrived by applying the arm’s length principles, since such uniqueness of the market or location specific advantages (LSAs), would be available to all & sundry operating in the said market; and thus, subsumed within the results of local comparable companies, which reflect the arm’s length price. This is why selection of local comparables is extremely critical for arriving at the arm’s length price under TP. 

If either of the two parties to a transaction carries unique or non-routine intangibles, being distinct from what the market in which it operates, provides to all its players, namely inter alia the local comparable companies, in that case carrying out a “one sided testing” for such party with reference to such local comparable companies, may not provide the ideal...

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Vijay Iyer
National Leader, Transfer Pricing, EY India

FAR analysis is the standard process of understanding and analysing the functions performed, assets owned and risks undertaken by the (related) parties involved in a transaction. In transfer pricing, the profit attribution for routine and non-routine functions are essentially determined by FAR analysis. 

Tax authorities of India and China have raised a concern in international forums, such as the OECD that FAR based attribution does not adequately compensate the local entity. Their view points are mainly twofold: 

  1. Excess demand in these markets warrant additional profit attribution than what is “arm’s length” by FAR analysis. These markets create additional “value” to the supply chain of a company and should be remunerated as such. 
  1. There are certain “location savings” enjoyed by companies operating in these markets and the entities in these locations should be remunerated properly. 

This argument is made especially in the context of enterprises in the digital economy. While is widely accepted that profits must flow where value is created the FARM concept seems to be heading in a different direction. Value contributed by a market is identical for the local affiliate and the comparable entities in the same jurisdiction. The use of...

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Vishweshwar Mudigonda
Partner, Deloitte Haskins & Sells LLP

It is not uncommon for MNCs to take advantage of the unique market conditions to earn additional profits. Developing countries like India and China, which together represent nearly 1/3 of the world population, offer large market with customers having growing spending capacity for goods and services (digital or otherwise) of the developed countries. Given the ambitious economic growth of India and China, it is not surprising that tax administrations of these countries insist on getting a larger share of the overall profits of the MNEs, either through increased profit or savings in costs, due to unique market characteristics, colloquially known as locational advantages. 

Indian Transfer Pricing regulations do not have any specific provision on treatment of location advantages/ savings. They have also reversed their earlier position on the subject in the India chapter of the latest UN TP Manual (the ‘Manual’).  , Both the latest UN Manual as well as the OECD TP Guidelines considers locational advantage as only a key comparability criterion for performing a benchmarking analysis, recognising thereby the earlier competitive disadvantage that large number of comparables bring and whittles down any locational advantage. 

In performing such comparability analysis, emphasis is on identification and...

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Kunj Vaidya
Partner and Leader, Transfer Pricing PwC India

The notion that a market jurisdiction either due to its size or the purchasing power of its consumers deserves an additional remuneration beyond the value created in its jurisdiction pulls at the fundamental consensus reached through the BEPs AP 8-10, which involved many developing countries in reaching that consensus. 

BEPS AP 8-10 rightly focuses on value creation, i.e., profit should be taxed where value is created and requires that the FAR (Functions performed, Assets used and Risk assumed) analysis focus on ‘significant people functions’, ‘economic substance’ and ‘intangibles’ in arriving at the appropriate share of profits to be taxed in that market jurisdiction. For example, when it comes to intangibles, the consensus is that returns to intangibles should be allocated by reference to the location of personnel who perform or control the DEMPE (development, enhancement, maintenance, protection and exploitation) of the intangible. To conclude, value creation happens in the country which houses the supply side (ie significant people functions, DEMPE functions for intangibles) rather than the country that houses the demand side (ie consumers). 

Let’s take the example of India's IT industry which has created tremendous value for its clients and local stakeholders (employees, shareholders, Government,...

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Munjal Almoula
Partner Grant Thornton India LLP

There has been significant debate on the adequacy of the present taxation system for dealing with transactions within the digital economy.  In several instances, due to the way the businesses are structured, especially in e-commerce related dealings, there is little or no tax attributed vis-à-vis the business in the country of origin (of the entrepreneur) and in the “market” country where the products are sold. 

Amongst the various aspects that are being debated to modify the existing tax approaches to deal with the changing business environment, one such aspect relates to the expansion of scope for profit attribution.  The debate revolves around moving from the traditional FAR based analysis to a FARM based analysis to cover market / demand related factors.   The debate to replace the existing FAR analysis with the FARM based analysis extends beyond digital economy extending the principles even to traditional businesses. 

At this stage, replacing the existing FAR based analysis by the FARM  based analysis would be pre-mature and create significant challenges especially in cases where a business may not have significant functions, assets and risks prevalent in the market jurisdiction.  Shifting of profits from a jurisdiction where valuable IP is owned and / or where significant business...

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Maulik Doshi
Partner and Senior Executive Director Transfer Pricing & Transaction Advisory Services SKP Business Consulting LLP

In the new era of transfer pricing post BEPS project, there is a lot of discussion around aligning transfer pricing with the value creation and an important factor which is attracting limelight, especially in India and China, is the advantages/ values derived by MNCs from the market attributes in these countries, such as access to large local markets and consequential huge demand potential in the region, reasonably priced skilled and knowledgeable workforce, rental space, etc. 

The market attributes discussed above are definitely advantageous in any MNCs business scenario.  That is the reason India, China and similar growth oriented countries are the favorite investment and business destination for MNCs from across the globe.  However, from transfer pricing standpoint, simply claiming that the sheer size of the Indian/ Chinese market and the opportunities to sell products locally here, i.e. market premium, and the vast array of workers and production opportunities would necessitate more profits to be allocated to the local enterprise may not hold good taste in the transfer pricing analysis. 

The question whether these market attributes deserve additional remuneration / profit attribution or not requires a close analysis of the specific business model of the MNC, nature...

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Rakesh Nangia
Managing Partner, Nangia & Co LLP

1) Do you believe that market jurisdiction in addition which create ‘value’ should be remunerated in addition to the outcome of FAR analysis?

The evolution of transfer pricing in developing countries, has helped coin these new terms – location savings and market premium. It has been seen that certain issues such as location savings and market premium arise are advocated by developing economies like China and India, rather than in established and developed economies (which form the bulk of OECD members). 

According to OECD, market size/ premium is not an intangible because it is “not capable of being owned, controlled or transferred by a single enterprise”. OECD Transfer Pricing Guidelines (‘OECD TPG’) gives importance to functions performed, assets employed and risks assumed (FAR analysis). Hence, the FAR analysis forms the backbone of any TP analysis, with location savings and market premium like concepts not being given any separate importance in OECD TPG other than being subsumed as part of FAR analysis. The UN Manual, however recognizes market as bargaining power. 

In our view, FAR analysis still remains the backbone of TP and market being an integral part of it. However, both, industry analysis and quantitative...

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