The Importance of Functional and Risk Analysis (FAR) in Transfer Pricing Documentation

Transfer Pricing (TP) Deep Dives

Introduction

Transfer pricing rules around the world are built on a single foundation: the arm’s-length principle. To determine whether related-party transactions comply with this principle, tax authorities rely heavily on Functional and Risk Analysis (FAR). A robust FAR analysis is the backbone of defensible TP documentation without it, even the most sophisticated benchmarking or economic analysis becomes meaningless.

This article explains what the FAR analysis is, why it matters, how it impacts method selection and profit allocation, and how multinational companies can ensure their FAR framework withstands audit scrutiny.

1. What Is FAR Analysis in Transfer Pricing?

FAR stands for:

  • Functions performed

  • Assets employed

  • Risks assumed

A FAR analysis evaluates how value is created within a multinational group and determines which entities are entitled to which level of profit.

FAR answers core TP questions:

  • Who does what?

  • Who uses which assets?

  • Who controls and bears which risks?

  • Who contributes to value creation?

  • Who should earn routine vs. residual profit?

This makes FAR the primary determinant of transfer pricing outcomes.

2. Functional Analysis: Understanding What Each Entity Does

Functional analysis identifies each entity’s contributions. Typical functions include:

Operational Functions

  • Manufacturing

  • Procurement

  • Distribution

  • Logistics

Support Functions

  • HR

  • IT

  • Finance

  • Accounting

Strategic Functions

  • R&D

  • Product development

  • IP management

  • Market strategy

Why Functions Matter

Entities performing routine functions (distribution, back-office support, contract manufacturing) are typically rewarded with routine margins, while entities performing high-value or strategic functions (IP development, product design, leadership) are entitled to higher returns.

3. Asset Analysis: Identifying the Assets Used

Assets can be:

Tangible Assets

  • Machinery

  • Buildings

  • Vehicles

  • Equipment

Intangible Assets

  • Trademarks

  • Patents

  • Software

  • Customer relationships

  • Proprietary technology

Why Assets Matter

Entities owning valuable intangibles or capital-intensive assets typically deserve higher profitability, while service-oriented entities with limited assets earn lower margins.

4. Risk Analysis: The Most Critical Part of FAR

Modern TP focuses heavily on risk control, especially after OECD BEPS Actions 8–10.

Key risks include:

  • Market risk

  • Product liability risk

  • Inventory risk

  • Credit risk

  • Foreign exchange risk

  • Operational risk

  • Strategic and decision-making risk

Why Risk Matters

Under OECD rules:

Entities that control and bear risk are entitled to higher returns.

Example:
A distributor that does not own inventory risk becomes a limited-risk distributor, earning a smaller margin.

5. How FAR Analysis Influences Transfer Pricing Method Selection

CUP vs TNMM vs Cost-Plus

  • If an entity performs high-value functions → CUP or Profit Split may be appropriate

  • If it performs routine support services → Cost-Plus

  • If it performs routine distribution/manufacturing → TNMM

The transfer pricing method must match the FAR profile.

6. FAR Analysis and Profit Allocation

Routine Returns

Entities with:

  • Limited functions

  • No valuable assets

  • Low or controlled risk

→ earn low but stable profits

Residual Returns

Entities with:

  • High-value functions

  • Strategic decision power

  • Ownership of intangibles

  • Ability to assume and control risk

→ earn high profits

This framework ensures global profit aligns with value creation.

7. FAR in OECD Audits: Why Tax Authorities Focus on It

Tax authorities rely on FAR to detect:

  • Misallocation of profits

  • Base erosion

  • Risk outsourcing

  • Shifting of functions without shifting actual control

  • Artificial arrangements or shell entities

If FAR is weak, audits become aggressive especially in:

  • MENA region

  • GCC markets

  • Africa

  • EU

A strong FAR analysis significantly reduces disputes.

8. Practical Steps to Build a Strong FAR Analysis

1. Interview Key Personnel

Document real operational behavior — not just organizational charts.

2. Map Functions, Assets, and Risks Clearly

Prepare diagrams showing how activities flow.

3. Evaluate Control Over Risk

Who makes decisions? Who approves? Who monitors?

4. Align FAR with Legal Agreements

Legal contracts must match operational reality.

5. Ensure FAR Matches Financial Outcomes

Profit levels must reflect FAR conclusions.

6. Update Annually

Business models change FAR must adapt.

9. Common Mistakes to Avoid

  • Copy-pasting FAR from prior years

  • Overstating or understating functions

  • Ignoring digital and IP-related functions

  • Misclassifying limited-risk distributors

  • Assigning risks without actual control

  • Documenting risks without financial capacity

Tax authorities challenge these immediately.

Conclusion

Functional and Risk Analysis (FAR) is the cornerstone of transfer pricing documentation. It defines value creation, determines profit allocation, and drives method selection. A strong FAR analysis protects companies during audits, ensures arm’s-length outcomes, and aligns TP policies with global regulatory expectations.

As TP enforcement intensifies across the world  especially in developing and emerging markets multinational groups must invest in accurate, detailed, and defensible FAR frameworks.

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