Transfer pricing is and will continue to be a major challenge for all companies doing business domestically or globally. The reason is simple: Transfer pricing is viewed as one of the easiest avenues for companies to shift profits to other countries or shift profits to low tax or no tax entities within a group.
Consequently, governments and multilateral institutions such as the OECD have enacted measures to bring these profits to tax so that every country can have its fair share of taxes. This situation is compounded by the increasing proliferation of digital enterprises which can undertake cross border business without having any business presence in the customer’s countries.
Superficially, transfer pricing may appear simple but in practice, it is extremely complex with many variables impacting on prices that are acceptable to the tax authorities. Companies therefore need a measured approach, an approach that mixes practicality so that prices used can be easily implemented, with complexity that is in accord with theory, exactitude that is in conformance with the law and an approach that is acceptable to the tax authorities.
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What is Transfer Pricing?
Transfer pricing (TP) is the term used for the science and art of determining transfer prices. Transfer pricing comes into the picture when two or more parties which are related transact goods or services with one another (these are known as “controlled transactions” in Transfer Pricing). In such cases, the tax authorities would expect taxpayers to follow the arm’s length principle and apply an arm’s length price.
What is an arm’s-length price?
An arm’s-length price refers to the price that independent parties will enter into for similar transactions under similar terms, conditions and circumstances. In practice, arm’s- length prices are not easy to arrive at because hardly any transactions are identical e.g., export sales terms and conditions are usually different from those for domestic sales. Even if the transactions are identical, prices can fluctuate not only from day-to-day but also throughout the day e.g. commodity prices.
Why apply the arm’s length price?
When two parties are not related, they are at liberty to transact at any price (i.e., market price) agreed between the parties without any interference by the tax authorities. These transactions are known as uncontrolled transactions. However, if related parties transact with each other, the tax authorities will expect an arm’s- length price to be applied. This is to ensure that the related parties do not shift profits (accidentally or intentionally) to different jurisdictions or domestically to loss-making entities or entities with tax incentives resulting in a loss of tax revenue to the government.
How to determine an arm’s length price?
The arm’s length price can be determined by using the traditional transactional methods such as the Comparable Uncontrolled Price Method (CUP), Resale Price Method (RPM) or Cost Plus Method (CPM). If the aforesaid methods cannot be used, methods based on profits may instead be applied. The methods used for calculation of arm’s-length profits are known as transactional profit methods such as the Profit Split Method (PSM) and the Transactional Net Margin Method (TNMM).
These five (5) transfer pricing methodologies prescribed in the Malaysian Transfer Pricing Guidelines (“MTPG”) are as depicted below:
Traditional Transactional Methods
Transactional Profit Methods