A higher-margin comparable can look attractive on paper. Until you realise it earns those margins by doing a completely different business.
This matters in transfer pricing, particularly for Indian IT exporters providing software development or IT services to overseas group entities.
A company that develops and owns valuable intellectual property may earn very different margins from one that provides routine services on a cost-plus basis.
Yet both may appear in the same broad industry search.
That is where FAR analysis – Functions, Assets and Risks – becomes critical.
Before accepting a comparable, the analysis needs to establish:
- Functions: Does it provide routine IT services or develop and commercialise products?
- Assets: Does it own valuable intellectual property or other significant intangibles?
- Risks: Does it bear market, product and credit risks, or operate with limited risk exposure?
These differences can affect profitability and the reliability of the arm’s-length benchmark.
A comparable-company search is only the starting point. The real work lies in examining whether the selected companies are economically comparable, assessing available segmental information and documenting why inclusions or exclusions are justified.
The objective isn’t to find companies with lower margins.
It is to defend a benchmark that reflects the business being tested.When was your comparable set last reviewed beyond industry classification and financial ratios?
