As multi-national companies transact or engage in international trade transactions between their parent and its related entities, such related party transactions are subject to tax authority’s scrutiny based on what we call the arm’s length principle, a concept that underpins the practice of transfer pricing. This principle is often used by tax authorities to assess companies who sell or purchase or charge for intra group services at a price that result in lower tax bill in tax jurisdictions like USA, UK, Australia or China but yet booking huge profits from these transactions into countries that taxed at a lower tax rate like Netherlands, Luxembourg, Singapore or Hong Kong. Such arrangements are not in accordance with the arm’s length principle and are deemed as harmful tax practices that are not acceptable in the international community because they represent loss of tax revenue to the taxman. Can you imagine a large MNC paying little or no tax on their profits despite having millions or even billions of dollars of revenue!
As international trade grows, more MNCs establish their operations in other countries, the right steps will ensure these MNCs are paying the right amount of taxes or risk being slapped with penalties for non-compliance with the arm’s length principle.
Below, you’ll understand what are the key considerations to getting a transfer pricing study or report done properly, according to the Inland Revenue Authority of Singapore (IRAS).
Step 1: Compare the conditions of your transaction with that of a third party.
This ensures you comply with the arm’s length principle, as explained in one of our earlier articles. The arm’s length principle helps you identify the actual economic value of your transaction by comparing it to a transaction in the open market between two independent parties. Adhering to the arm’s length principle ensures that business owners do not under-declare their payable taxes.
Here are some points you can use to compare your transaction:
- What is the relationship between you and the related party? How do your individual services benefit each other?
- What are the characteristics of the product or service being exchanged? Consider its overall availability, demand, and quality.
- What are the commercial and economic conditions under which the controlled transaction occurs? Goods and services are valued differently in various parts of the world. For example, different mobile phone models appeal to different countries with varying states of development.
- What is the company’s operating history and whether it is making profits or losses?
Step 2: Identify the most suitable transfer pricing method.
There are many ways you can calculate the appropriate transfer pricing. Here are five popular methods many firms utilise, and they fall into two different categories; traditional transaction methods, which compare prices; transactional profits methods, where profits are compared.
1. Comparable uncontrolled price method (CUP)
This method compares the price charged for services or properties transferred in controlled transactions to the amount charged for property or services under a similar uncontrolled transaction. It is based on the arm’s length principle to assess the true market value of the transaction.
2. Resale price method (RPM)
This method determines the gross profit divided by net sales earned by a distributor on the resale of products purchased from one or more third-party suppliers. This demand-driven method is especially useful when there is a weak relationship between the costs incurred and the sales price of a product or services. An example would be a product or service that is demand inelastic.
3. Cost-plus method (CPM)
This method is popular among manufacturers. It compares the gross profit mark-up earned by the party in question to the gross profit mark‐ups attained by similar companies. Transactional comparisons are especially relevant as more information about controlled and uncontrolled transactions is available. Assessing the gross mark-up becomes easier when data about risk, assets, and contractual terms are readily available.
4. Transactional net margin method (TNMM)
This is the most common method that compares net profit margins in a controlled transaction versus one between two independent parties. It is especially useful when intangible assets, services and property are involved, as this method requires less product comparability than the traditional transaction methods. Hence, it has a greater tolerance to product differences and cost accounting differences as only net profit is taken into account.
5. Transactional profit split method (TPSM)
This method, like TNMM, is useful when intangible resources are employed in the transaction. However, the key difference is when the parties have varying contributions and stakes in the transaction, and profits must be split according to their vested interest.
Step 3: Determine the arm’s length result and keep track of all relevant documents.
The various methods are suitable for different transactions, so rigorous analysis is necessary to ensure the best method and possible results. Also, ensure you have all the necessary documents recorded and kept for future reference.
Transfer pricing planning doesn’t always have to be difficult. With proper analysis and a strong understanding of your product, value chain and its relevant business or geographical market, you can analyse the appropriate pricing for your cross-border transactions. If you are still confused, talk to us today as we have many years of international transfer pricing advisory in Singapore and in the region.
Aside from transfer pricing services, Max Lewis Consultants Pte Ltd also offers services such as business and asset valuation, valuation of intellectual property rights and complex financial instruments like options, convertibles loans and derivatives and GST ASK review services, local and international tax planning. For more information, you can enquire with us to get your business started smoothly.