INTERNATIONAL trade is dominated by multinationals who have operations around the world. In 2020, the US estimated that related party trade accounted for 42.6% (US$1.60 trillion) of total goods trade (US$3.76 trillion).
Whenever there are transactions between related parties (ie between parent company and subsidiaries/affiliates), transfer prices have to be established for the transactions. The key problem here is since the related parties are connected with one another and it is likely that one of the party have significant influence over the other, there is no guarantee that the transfer prices follow the open market pricing (that is, adopting the principle of “buyers beware”).
The tax authorities around the world including Malaysia’s start from the position that transactions between related parties are not conducted on an open market basis. Therefore, the onus of proving the transactions do not result in shifting of profits to benefit from tax breaks or tax shelters rests with the taxpayers. The ultimate objective of the tax authorities around the world is to ensure that the correct level of profits is accounted for in the respective companies in their jurisdiction.
The standard adopted by all countries is the arm’s length principle. In simple terms, this standard requires the transfer prices between related parties to replicate the conditions of transactions taking place in the open marketplace between independent parties.
The basic concept
The arm’s length principle is based on three fundamental pillars: Firstly, each entity in a related party transaction should be treated as a separate independent entity; Secondly, understanding the contractual relationships between the related parties and the separation of the functions, risks and assets of the transactions between the related parties; Thirdly, comparing the related party transactions with transactions carried out between independent parties under similar circumstances.
How do you meet the arm’s length test?
The starting point of setting arm’s length prices is to first understand the relationship and nature of the transaction between the related parties. At this stage, you need to segregate the responsibilities between the related parties in a transaction. In analysing the responsibilities, you need to identify the functions performed, risks assumed, and assets used by the respective related parties.
Once you have completed the process, you can profile the companies involved in the related party transaction such as whether the company is a contract manufacturer, limited-service provider, or a full-fledged trader, etc.
This will then assist you in comparing your related party transfer prices against transactions undertaken by independent parties or comparing the financial results of the related parties against third parties.
Why do the tax authorities look at this closely?
Despite the presence of voluminous legislation, regulations, and guidelines across the world, the loss of tax revenues as an intentional result of transfer mispricing runs into several hundred billion dollars as identified by the Tax Justice Network in 2015.
The key problem here is that there is no one correct answer to determine the transfer price because there is a range of prices for transactions between independent parties and the availability of data and information in the public domain surrounding independent transactions of companies is limited. The ultimate test of comparing the transactions between related parties and between independent parties will never be 100% accurate.
Although the underlying principle around the arm’s length standard is simple and centres around open market pricing, the interpretation of the standard is very subjective, and it requires substantial documentary evidence to satisfy the tax authorities.
This problem can be avoided if the tax authorities are willing to engage the taxpayers to vet their transfer prices before they are implemented. However, majority of the tax authorities in the world only want to look at this issue on a post-event basis which regularly leads to disputes.
This article is contributed by Thannees Tax Consulting Services Sdn Bhd managing director
SM Thanneermalai (www.thannees.com).