What is Transfer Pricing?
Transfer pricing generally refers to inter-company pricing arrangements for the transfer of goods, services and intangibles between ‘associated persons’. Transfer pricing laws and guidelines ensure fairness of the transactions by enforcing the arm’s length transaction. Based on the arm’s length principle, transactions between parties should be conducted at a price as if such transactions were done between independent entities.
Every taxpayer who has entered into “controlled transactions” with associated persons is required to prepare transfer pricing documentation (more details below), though the compliance requirements may differ depending on factors such as gross income of the business, amount of related party transactions, as well as financial assistance provided. A taxpayer may run a higher risk of being scrutinized for transfer pricing compliance if the company repeatedly reported low margins, has a large number of transactions with its associated companies or subsidiaries, has high-value cross-border transactions, reports profits that are lower than the industry’s average, or repeatedly makes losses.
The scope of Transfer Pricing in Malaysia
Under the Income Tax Act 1967 (“ITA”), a person who enters into a transaction with an associated person for the acquisition or supply of property or services, must determine and apply the arm’s length price for the acquisition or supply. In other words, the law requires taxpayers to determine and apply the arm’s length price on controlled transactions, failing which, the Director-General of Inland Revenue (DGIR) is empowered to make adjustments to the transaction to reflect the arm’s length price, by substituting the transaction price with an arm’s length price.
Meaning of “Control”
The ITA refers to “control” as both direct and indirect control. For example, a person shall be taken to have control of a company if he is able to exercise or is entitled to acquire control (whether direct or indirect) over the company’s affairs, or if he possesses the greater part of the issued share capital of the company.
However, pursuant to Finance Act 2018, with effect from 1 January 2019, the meaning of “control” under the ITA has been expanded to include the situations where the share capital held by a person is 20% or more, along with the satisfaction of either of the following situations:
- the business operations of that person depending on the proprietary rights (eg. patents, non-patented technological know-how, trademarks, or copyrights, provided by the other person or a third person;
- the business activities, such as purchases, sales, receipt of services, provision of services, of that person are specified by the other person, and the prices and other conditions relating to the supply are influenced by such other person or a third person; or
- where one or more of the directors or members of the board of directors of a person are appointed by the other person or a third person.
The above factors reflect the different dimensions of ‘control’ in different commercial relationships, and captures not just parent-subsidiary relationships, but could potentially also capture joint ventures, licensor-licensee and even investor-investee relationships.
Determination of Arm’s Length Principle
The governing standard for the ‘arm’s length principle’ in Malaysia is largely modelled after the OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations 2010.
Based on the Transfer Pricing Guidelines 2012 issued by the IRB (“Guidelines”), the determination of an arm’s length price involves multiple steps; from analysis of transactions and functions, characterization of business, identification of comparable transactions, determination of a tested party (one which a transfer pricing method can be applied in the most reliable manner and for which the most reliable comparable can be found), selection and application of transfer pricing methodologies.
There are multiple methodologies that can be used in arriving at the arm’s length price, such as comparable uncontrolled price method, resale price method, cost plus method, profit split method, and transactional net margin method.
In essence, this involves a transfer pricing study by the professional advisors, for the implementation of the appropriate transfer pricing policy. As a rule of thumb, in setting inter-company pricing, a taxpayer should ensure that the services rendered are compatible with the economic benefits received. It is also important to have the relevant agreements in place to record the terms of the inter-company transactions. For example, an inter-company loan agreement should contain terms like tenure of the loan, currency of the loan, interest rate, payment terms, etc. For recurring transactions, be sure to regularly invoice, with clear descriptions on the invoices.
Obligations of taxpayer
For transfer pricing purposes, a taxpayer who has entered into a controlled transaction is required to prepare and keep contemporaneous documentation. Controlled transactions may involve sales or purchases of raw materials, stock in trade or other tangible assets, royalties, license fees, management fees, research and development, rents, interests or guarantee fees.
This obligation extends to taxpayers who are involved in domestic controlled transactions (ie, even between Malaysian companies) where at least one party enjoys tax incentives or suffers from continual losses or is taxed at a different rate, such that the transaction would result in adjustments that alter the total tax payable.
Transfer pricing documentation
Transfer pricing documentation required in Malaysia are extensive and should include, inter alia, organizational structure, group financial report, nature of the business/industry and market conditions, controlled transactions, pricing policies, selection and application of the transfer pricing method.
Contemporaneous transfer pricing documentation has to be prepared annually based on the most current reliable data and be updated at the end of the relevant year of assessment. While transfer pricing documentation is not required to be submitted with the filing of the tax returns, it should be made available to the IRB within 30 days upon request. The documents should be prepared contemporaneously meaning, at the time when developing or implementing any arrangement with the associated person, or if there are major changes to such arrangements subsequently, to record the intent of the arrangement at the time of the transaction. In preparing the documentation, the arm’s length transfer price must be determined before pricing is established based upon the most current reliable data that is reasonably available at the time of determination. Other supporting documents should also record organizational structure, nature of business and strategy, industry and market conditions, pricing policies, comparable data and of course, proper legal agreements or resolutions on arms’ length terms.
Taxpayers who fall within the scope of the transfer pricing laws should engage professional tax advisers to assist in determining the appropriate transfer pricing policies, and in preparing the transfer pricing analysis. To comply with the transfer pricing laws, taxpayers should always maintain proper documentation on controlled transactions.
Tax adjustments as a result of transfer pricing audit are subject to penalty. For example, taxpayers who did not prepare the contemporaneous transfer pricing documentation may be subjected to 35% penalty, and taxpayers who prepared the transfer pricing documentation but did not fully comply with the requirements under the Guidelines may be subjected to 25% penalty.
While transfer pricing adjustments made by the IRB from transfer pricing audits can subject taxpayers to a high amount of penalties, knowing and fulfilling your obligations under the law will help you to be prepared for the tax audits.