Harvey & Associates managing partner Harvindar Singh
THE transfer pricing (TP) narrative focuses on the need to validate that related-party transactions are being carried out in an arm’s-length manner.
A related party is one over whom the relevant person has control (for example, where 20% or more shares are held in a company).
While independent enterprises are concerned with maximising individual profits by aiming for the lowest costs and highest returns, a multinational group might be concerned with overall group profits and tax management which may result in an unequal distribution of profits within the group.
A Malaysian subsidiary might sell the manufactured goods at an unreasonably low price to its Singapore holding company, resulting in low profits in Malaysia.
The Singapore holding company then sells the products to its customers at the market price thus capturing the lion’s share of the profits.
This is termed “shifting the profits” from Malaysia to Singapore to pay lower taxes overall as the corporate tax rate in Malaysia is 24% and 17% in Singapore.
An arm’s-length price is defined in the TP guidelines as the price which would have been determined if the transactions were between independent entities under the same or similar circumstances.
Unlike third-party transactions, for related-party transactions, bargaining strength and the issue of market forces rarely comes into play.
Let’s use an example to illustrate the above point. Assuming A Sdn Bhd buys a piece of land from a third party (an unrelated individual or company) for RM5mil when the market value of the land is, say RM8mil.
The third party tried unsuccessfully to sell the land at the market price but was forced to sell at a subdued price due to an urgent need for funds.
The third party’s bargaining strength is therefore low, especially if A Sdn Bhd is aware of its predicament and tries to lower the transaction price as much as possible.
A Sdn Bhd, in a back-to-back arrangement, then sells the piece of land to its subsidiary (which will carry out development activities on the piece of land) for RM5mil on the basis that this is the price transacted with the third party, claiming therefore that it is an arm’s-length price.
This results in neither a gain nor a loss for A Sdn Bhd from the back-to-back buying and selling transaction.
In this case, although the price at which the land was purchased from a third party was used, the similarity ends there as the issue of bargaining strength, market forces etc are not in play for the transaction between the two related companies (same or similar circumstances do not exist).
If A Sdn Bhd had sold the land to a third party, it would have tried to maximise its profit from the sale and therein lies the difference.
There is a deferment of the taxes by the group as the taxes are shifted to the subsidiary company, which will pay taxes at a later date when it has sold the units developed and sold.
The Inland Revenue Board (IRB) is empowered to disregard the above sales value of RM5mil and replace it with the market value of RM8mil on the basis that the transaction between A Sdn Bhd and its subsidiary was not carried out in an arm’s-length manner.
The Ministry of Finance Malaysia issued the Income Tax (Transfer Pricing) Rules 2023 on 29 May 2023. These rules are effective from the year of assessment (YA) 2023 and subsequent YAs.
The Income Tax (Transfer Pricing) Rules 2012 will continue to apply for prior YAs.
Statistically speaking, about two thirds of world trade takes place between related parties. As such, the transfer pricing rules and guidelines would affect many businesses and entities.
Taxpayers are required by law to prepare transfer pricing documentation (TPD) with relevant data and analysis to validate that their transactions with related parties are carried out in an arm’s-length manner.
With the new rules, there is a lot more data to be included in the TPD document and the IRB is given greater powers to do TP adjustments. Taxpayers are required to have contemporaneous TPD ready by the due date for filing their tax returns.
The TPD is to be submitted to the IRB within 14 days of being requested to do so, otherwise a penalty ranging from RM20,000 to RM100,000 could be imposed.
Further, the failure to prepare proper TPD can result in adjustments which attract surcharges of up to 5%. Taxpayers are also now required to include the date on which the TPD is completed.
Prior to the TP Rules 2023, no definition was given on the arm’s length range.
In practice, the key principles under the TP Guidelines issued by the Organisation for Economic Co-operation and Development (OECD) were used to determine the arm’s length range (where the comparability results give the lower and upper quartiles or ranges).
To enhance the reliability of the arm’s length range, the interquartile range from 25 percentile to 75 percentile was often used.
With the new rules, the arm’s length range is now defined as a range of figures or a single figure falling between the value of 37.5 percentile to 62.5 percentile of the benchmarking data set.
The above probably sounds like Greek to most readers. What is meant by the arm’s-length range?
Basically, in order for a taxpayer to validate that its transactions with its related parties are arm’s-length in nature, the taxpayer would need to compare its financial results (for example, its gross profit margin of 4.5%) with other players in the taxpayer’s industry (the comparables).
The search for suitable comparables might yield a number of competitors whose gross profit margins range from say, 2% to 10%.
Looking at it simplistically, let’s assume the upper quartile is 10%, the lower quartile 2%, and the median 6%.
Based on the OECD Guidelines (at 25%-75% of the data range), the acceptable range of gross profit margin would be between 4% and 8%. Therefore, the gross margins of 4.5% earned by the taxpayer are within the acceptable range of 4% to 8%.
However, with the new TP rules 2023, with the acceptable range being set at 37.5% to 62.5% of the benchmarking data set, the acceptable range of gross profit is now between 5% and 7%.
Unfortunately, the taxpayer’s gross margin of 4.5% now falls below the arm’s-length range.
In such as situation, the new TP rules empower the IRB to adjust the margin to the median point i.e. 6%. Therefore, the taxpayer would face a TP adjustment of 1.5% (6%-4.5%).
The TP adjustment of 1.5% will be applied to the sales revenue to determine the omitted income.
Further, even if the price or margin is within the arm’s length range, the new rules increase the ambit of the IRB’s power whereby the TP adjustment to the median or any other point above median arm’s length range can still be imposed if the IRB has a reason to believe that the comparables that used are not suitable.
To carry out a TP analysis, there are five methodologies that are accepted and used:
> The Uncontrolled Price Method (comparing the price for transactions between related parties with prices in third-party transactions – as in the example involving A Sdn Bhd explained at the beginning of the article)
> The Cost Plus or Resale Price Method (to compare the gross margins of the taxpayer with the margins earned by others)
> The Profit Split Method (the proper allocation of profits based on the level of functions carried out and risks assumed – if the Singapore holding company mentioned in the article is merely a marketing company and the Malaysian subsidiary is the manufacturing arm, most of the functions and risks would reside with the Malaysian subsidiary – therefore it’s only fair that most of the profits should belong to the Malaysian subsidiary)
> The Net Margin Method (where the net margins are compared instead of the gross margins).
With the new TP rules, the IRB can replace any TP method selected by the taxpayer with the other most appropriate method if there is reason to believe that the taxpayer’s selected method is not the most appropriate method in determining the arm’s length price.
TP is a very technical area of taxation and the need to justify and validate that related parties carry out their transactions in an arm’s-length manner is becoming more and more important and compulsory.
Harvindar Singh is managing partner at Harvey & Associates. The views expressed here are the writer’s own.
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