As governments worldwide struggle with record deficits and declining tax revenues, the pressure to generate more taxes is leading to increased scrutiny by the tax authorities, particularly in the area of transfer pricing.
Predominantly, to satisfy tax authorities of a competent jurisdiction, transfer pricing must customarily meet an “arm’s length” standard. In other words, the prices charged in an intercompany transaction must yield results that are similar to what would have occurred if two unrelated parties had engaged in the same transaction under the same circumstances.
The primary concern among tax authorities is whether the businesses operating in their jurisdiction are paying “fair share” of taxes. In certain jurisdictions where tax authorities concluded that they deserve a larger pie of the taxable income or argued that tax deduction claimed on expenses incurred were excessive, transfer pricing adjustment may be made, alongside an unwelcomed surcharge/ penalty.
Thus, transfer pricing is a pivotal global issue and a key consideration of the jurisdictions in which the global entities operate in, whether it is recognition of their taxable income or claiming tax deduction on expenses incurred.
In light of this persistently evolving transfer pricing environment, Puah Mei Pin (Tax Director) and Chintan Shah (Transfer Pricing Senior Manager) discuss five ways to reduce transfer pricing risk below:
1. Appropriate Intercompany Agreements in Place
Merely having agreements in place may not be sufficient. Practically, some clients either do not have any intercompany agreements in place or drawn up one-pager agreements that do not adequately detail the related party transaction on hand.
Treating each related party transaction similar to third-party arrangement, businesses should document the commercial terms and conditions of various related party transactions through formal intercompany agreements. This is particularly important in relation to intercompany financing arrangements, licensing of intangible property as well as services transactions as these areas have come under the scrutiny of tax authorities globally in recent times.
In the event of a tax audit, it is common for tax authorities to request for such intercompany agreements. Notably, the Singapore transfer pricing guidelines has specifically mentioned that intercompany agreements should form part of the contemporaneous transfer pricing documentation itself. Therefore, businesses should review and update intercompany agreements periodically.
2. Assess Intercompany Pricing Outcome Before Closing the Books
Before closing the financial accounts for the year, businesses should review their group entities’ financial data and operating results to assess if the operating results for the related party transactions meets the intended year-end outcomes in line with their functional profile. For example, did the intercompany pricing for a low-risk service provider yield an outcome for that related entity that is within the arm’s length range? If not, should the entity be volunteering transfer pricing adjustment(s) upfront, before the books close? Should qualitative reasons for not falling within the arm’s length range be investigated and documented now? Or should the entity make a tax provision now for potential transfer pricing adjustment that the tax authority may make?
Many times, transfer pricing audits may occur two, three or even five years down the road and those executives who may be aware of the related party transaction/ arrangement, may have left the company. The key is to act now, instead of deferring this exercise only to such time when the transfer pricing audit commence.
3. Tax Efficient Transfer Pricing Policies
At first instance, the application of the transfer pricing rules seems complex as they impulse several onerous documentation requirements. Contrary to this belief, transfer pricing also presents significant planning opportunities for businesses to highlight areas of tax inefficiencies and attempt to repair and relieve their excessive tax burden.
For example, in order to avoid protracted litigation, the Singapore HQ may deem a ballpark mark-up of 25% as being adequate for certain support services performed by the India subsidiary. Effectively, this means that service income is subject to tax in India at 30% while Singapore HQ will only claim tax deduction on such service expense at 17% – a delta of 13%. On hindsight, if a benchmarking study is carried out, the mark-up for such transaction could potentially be only 12%-15%, instead of 25%.
4. Aligning Transfer Pricing with Value Creation
The IRAS subscribes to the principle that profits should be taxed where the real economic activities generating the profits are performed and where value is created. In line with Singapore’s participation to the Inclusive Framework for Implementing Measures against Base Erosion and Profit Shifting (BEPS), the tax authority will look at substance over form in determining arm’s length pricing and conditions.
Businesses should therefore undertake a careful analysis of both the contractual relations (as set out in the intercompany agreements) and actual conduct between the related parties. The entities performing important functions, controlling risks and contributing assets should be entitled to an appropriate return reflecting the true value of their contribution. All in all, businesses should ensure that their actual conduct and contractual relations are coherent with the information presented in the transfer pricing documentation.
5. Keep Current on Local Regulations
The landscape of transfer pricing is ever-changing, especially in the post COVID-19 environment. This is why it is important to keep abreast of the latest compliance requirements issued by various tax authorities in the jurisdictions where business operations are located. Businesses should monitor which transfer pricing regulations have changed/ modified and whether the local entity is still compliant.
If you need further assistance on strategies to build up your defence against a TP audit or would like to seek advice on specific transfer pricing issues, please reach out to the tax professionals at CCS for a discussion.