Functional Analysis (FAR): Functions, Assets and Risks

Every decision in a transfer pricing study is a conclusion drawn from one factual document: the functional analysis of the parties — their functions, assets and risks. The tested party is selected from it, the method follows from it, the PLI is chosen from it, and the comparable pool is screened against it. A study built on a wrong FAR is wrong in a way the data will not show you, because the data is the input and the FAR is the lens — and the Transfer Pricing Officer’s examination starts by re-deriving that lens from the same sources you used.

The three elements

Functions — what the party actually does, at the level of decision-making authority, not job titles. “Manages the business” is not a function; “negotiates and sets prices for a defined customer set” is. The working categories:

Function type	What to record
Production / manufacturing	What is made, to whose specification, on whose assets, with what capacity decisions
Distribution / sales	Who owns the customers, who sets the price, who bears the receivable, who takes the returns
Services	The scope, the specification, the service-level terms — execution against a contract, or direction of the work
Financing	Who arranges the funds, who sets the rate, who carries the credit
R&D / development	Who directs the work, who owns the output, who funds the failure
Headquarters / coordination	The specific coordination activities — and what is not included (a holding company that does nothing is a holding company that does nothing)

Assets — what the party contributes, and the distinction that decides most intangibles cases: using an intangible and owning it are different asset positions. The tangible base (property, plant, equipment, inventory), the intangibles owned (patents, brands, know-how, customer relationships, data), and the intangibles merely used under licence — each recorded with the ownership position stated.

Risks — what the party bears, and, decisively, what it controls. Bearing a risk and controlling a risk are different positions, and the control is what marks the entrepreneurial party:

Risk	Bearing it (routine)	Controlling it (entrepreneurial)
Price	Accepts the price set by the contract	Negotiates and sets it, and can reprice
Demand	Absorbs the volume under a specified scope	Holds the customer relationships and the volume decisions
Inventory / obsolescence	Stock for a specified order	Buys for the market, takes the write-down
Input cost	Passes through per the contract’s terms	Bids, hedges, sources — and takes the difference
Regulatory	Complies within the scope	Holds the licences, bears the licensing outcome

The FAR is complete when each party’s row is filled: what it does, what it contributes, what it bears — and, for each risk, whether it controls it.

Drawing the profile: from the facts, not the study

The sources, in order of weight:

1. The intercompany agreements — the written terms: scope, pricing mechanics, risk allocation, term and termination.
2. The actual organisation — who approves what: the price-approval matrix, the budget decisions, the customer-negotiation records. The contract says what the parties agreed; the organisation shows what the parties do.
3. The asset positions — the registers, the licences, the ownership records for each intangible the parties touch.
4. The commercial reality — what happens in practice when volumes move, inputs reprice, a product fails: who decides, who absorbs.

The profile itself is a per-party summary — one paragraph per party: the functions at decision-authority level, the asset position (owned / used), the risks (borne / controlled). Two paragraphs for a two-party transaction, three for a three-party one. If the FAR only makes sense when read with the study’s intended conclusion already in mind, it is a conclusion wearing a lens — draw it again.

The interview questions — the set that draws the profile from the business people (and that the TPO will effectively re-ask):

1. Who sets the price for the intercompany transaction — and who can change it mid-year?
2. If demand falls below the plan, who absorbs the shortfall?
3. Who owns the intangibles the transaction uses or produces — and who decided that?
4. Who funds the working capital, and who makes the investment decisions?
5. What happens on termination — what does each party keep, and what does it lose?
6. Who employs the people who do the work — and who directs them?

How the FAR drives the downstream decisions

The four decisions of the study, each a function of the FAR:

Decision	What the FAR supplies	Where
Tested party	Which party is the least complex, routine one — the one whose result a pool can measure	Tested party selection
Method	Whether a one-sided test can capture the result, or both parties are non-routine and a two-sided approach is needed	How to choose a method
PLI	What the routine function earns for — the return indicator that isolates it	Profit level indicator
Comparables	The profile the pool must match — product, function, risk, scale	Comparable companies

And where the transaction is an intangibles one, the FAR’s risk-control column is the input to the DEMPE allocation — who developed, enhanced, maintained, protected and exploited the value, and who controlled it. See DEMPE.

The FAR in the file — and in the audit

The FAR is Rule 10D block 3 of the Local File: the functions performed, risks assumed and assets employed by each enterprise in the transaction. Three properties make it the block the examination turns on:

• It frames everything after it. The method block answers “given this FAR, why this comparison” — a FAR that understates a function (a hidden pricing role, a shared risk) makes the method block look like convenience.
• It must agree across the documents. The Master File’s intangibles and group structure are the group-level statement of the same facts; a Local File FAR that says “this entity owns no valuable intangibles” while the Master File assigns the core IP to it is the finding before the pricing is reached. See the documentation pillar guide.
• It is re-derived against the same sources. The TPO does not accept the taxpayer’s FAR as given; the officer reads the same agreements and asks the same questions. The file’s FAR is defensible to the extent it matches what those sources actually show.

FAQ

Who prepares the functional analysis — management, the advisors, or the auditor? The taxpayer (or its advisors), from the primary sources: the agreements, the decision records, the asset registers. Management supplies the facts; the advisors structure them. The TPO then tests the result against those same sources — which is why the preparation is a fact-gathering exercise with a structure, not a drafting exercise with a conclusion.

Is the FAR static across years? It is a description of the year’s actuals, prepared for the year. A reorganisation, a new product line, a changed risk allocation or a changed pricing authority changes the FAR — and with it the tested party, the method, the PLI and the pool. That is why a structural change voids a study (re-scope it) rather than updating it (roll it forward).

What if the contract says one thing and the organisation does another? The substance governs — the arm’s length standard is applied to what the parties actually do, and the file should say so. The contract is the strongest evidence of the arrangement; where the actual practice diverges from it, the FAR records the practice, and the divergence itself is a documentation point (the agreement should be conformed, or the file should explain the gap).