Today, as businesses grow in complexity along their value and supply chain, they look to countries with cheaper resources or where there could be more favourable tax incentives or countries with low tax rates.
Hence, as a business owner, it is essential to understand transfer pricing works and how it can affect your business. Transfer pricing has the ability to shape a more efficient business model as you reduce risk and compliance risk and tax burdens legally.
Read on to understand transfer pricing and why it is important.
What is transfer pricing?
Transfer pricing is a process of establishing appropriate prices between two or more related enterprises as if they are independent unconnected third parties. This process is referred to as arm’s length principle.
These enterprises are related when they have pre-existing connections that make them interdependent. These connections can be either direct or indirect. The two enterprises can be related as wholly-owned or majority owned subsidiaries, or affiliates with shareholdings held by another group or company or they can be commonly controlled by a larger, overarching enterprise.
Between these related enterprises, they may exchange goods and services such as sales or purchase of goods, licensing of software rights or secondment of manpower services under each enterprise.
Why is transfer pricing important?
Transfer pricing rules are meant to promote international trade and ensure a level playing field in the competition for tax revenue between countries while preventing tax evasion or abusive practices.
For example, A Ltd, a food and beverage manufacturer in country A produces candy bars for distribution to its subsidiary, B Ltd in country B where B Ltd sells to third party customers. Country A has a higher tax rate than Country B.
A Ltd sells the manufactured products to B Ltd at a price lower than the market price, thus allowing more profits to be booked in Country B where tax rate is lower. The difference in pricing creates arbitrage opportunities for profit shifting and leakage of tax revenue which otherwise would have been collected.
Ways to ensure transactions are following the arm’s length principle
Have a Transfer Pricing Policy: This is where the written policy will clearly set out the basis, rationale, and operating mechanism as a result of intercompany pricing agreement.
Conduct a Functions, Assets and Risk Assessment (FAR): there must be an assessment performed to evaluate the key functions undertaken by the business, actual or assumed risks resulting from undertaking the transactions, and the types of assets deployed to earn a return by the taxpayer.. For example, a business selling products with warranty bears higher risks as compared to one marketing goods without warranty. As such, it is necessary for the business with warranty to sell products at higher prices.
Understand the Characteristics of the Goods’ and services involved: All services and products showcased on the market differ extensively in terms of their quality, features, and availability, which explains the difference in cost. This helps in determining the appropriate market price.
Evaluate the commercial and economic circumstances: The market conditions, specifics, and restrictions should be duly considered in each country. The geographical location of the country and the product’s availability on the market can influence the prices greatly.
In addition, there are many other ways that companies have to consider as well like:
- Economies of scale;
- Competitors of the business
- Historical financials and operational data
- Taking operating losses into account
- Selection of internal and external market data for comparison
- Assessment of transactions aggregately or separately
What documents do I need for transfer pricing administration?
Firstly, you will carry out a proper search study of suitable comparable companies by doing a benchmarking analysis or study which is part of the transfer pricing documentation report that shows the transactions between you and the related party are conducted at arm’s length. These analyses or studies are important as they facilitate reviews by tax authorities and prevent any possible instances of a transfer pricing audit by the authorities.
The transfer pricing documentation report will be due on the date of the corporate tax return but it is not required to be submitted with the tax return unless requested by IRAS. There will be penalties for non-compliance.
We can help you to manage your transfer pricing risks while adhering to local and international transfer pricing guidelines.
Transfer pricing may be a complicated process, especially if you are unfamiliar with the various documents and procedures. You can engage a professional consultant to help you manage your transfer pricing risks legally and efficiently.
Aside from transfer pricing advisory, Max Lewis Consultants Pte Ltd also specialises in other services, such as valuation of intellectual property right, business and assets valuation, and complex financial instruments like derivatives & Employee Share Options (ESOS) valuation. Enquire now to learn more as you transform your business with us.