Transfer pricing (TP) refers to the pricing of assets, tangible and intangible, services, and funds transferred within an organization or group of companies. For example, goods from the production division may be sold to the marketing division, or goods from a parent company may be sold to a foreign subsidiary. Since the prices are controlled and set within an organization, the typical market mechanisms that establish prices for such transactions between third parties may not apply.
The choice of the transfer price will affect the allocation of the total profit among the parts of the company. Tax authorities are concerned that multinational corporations including companies with group entities located outside its own tax jurisdiction (MNCs) may set transfer prices on cross-border transactions to reduce taxable profits in their own jurisdiction.
On the other hand, MNCs are under constant competitive pressures to structure their worldwide business operations effectively and efficiently. They are always in search for tax efficient corporate structures, low cost raw materials and supply of labor to meet earning per share targets set by shareholders and investors as well as to achieve the most effective global tax rate. Consequently, MNCs have to balance between focusing on the most efficient global entity structures, operations and transactions while striving to achieve a defensible and competitive effective global tax rate.
Arising from these situations is that governments around the world are cooperating with each other to share taxpayer and industry information, to assist other countries with document and information requests and to participate in cross border audits. Resulting from this is the rise in transfer pricing regulations and enforcement, making transfer pricing a major tax compliance issue for MNCs.
More than 50 countries have enacted TP documentation regimes with Singapore joining the ranks recently.
Transfer Pricing Guidelines issued on 23 February 2006
Singapore issued its first TP guidelines on 23 February 2006. With this, the Inland Revenue Authority of Singapore (IRAS) endorses the Organization of Economic Cooperation and Development (OECD) TP guidelines and the use of the arms length principles. The TP guidelines provide a framework to treat related and independent transactions equally for tax purposes. The arm’s length principles provide that transactions with related parties should be done based on a commercial basis that is comparable to arrangements and prices adopted for similar transactions with independent or third parties.
What all these means is that taxpayers are required to adopt the arm’s length principles and to take reasonable efforts to put in place proper documentation that supports intra-group operations. In Singapore there is still no specific penalty yet for lack of documentation for TP. IRAS is prepared to consider that TP policies put in place by taxpayer prima facie are on arm’s length basis when the taxpayers can demonstrate that reasonable efforts have been made to substantiate the arm’s length nature of their intra-group transactions.
Transfer Pricing Consultation released on 30 July 2008
Singapore as a tax treaty partner to more than 60 countries wants to ensure compliance with the arms length principle. It also wants to protect and defend its tax base from more aggressive tax jurisdictions. Another consideration for IRAS is that creative tax planning may have led to increase use of tax havens thereby eroding its revenue base.
Consequently, following the issuance of TP guidelines in 2006, IRAS released on 30 July 2008 the request for TP consultation (TPC) through desktop and field reviews. The TPC is also used as a platform by IRAS to assess level of taxpayers’ compliance with arm’s length principles and to identify areas to improve intra-group TP policies.
In a TPC process, IRAS sends information requests to assess if a TPC should be undertaken. It targets taxpayers with substantial cross-border related party transactions as well as taxpayers making continued losses. Details of activities, group chart, nature and amount of related party transactions and level of documentation kept are requested. Should IRAS requires further clarification on certain information provided and to make available copies of contracts and details of TP documentation, IRAS may proceed with a TPC and request taxpayer to host a meeting with IRAS. At the end of the TPC process, IRAS will assess the adequacy of the taxpayer’s compliance with the arm’s length principles for intra-group transactions and may make adjustments if profits are not at arm’s length.
Supplementary Administrative Guidance on APA issued on 20 Oct 2008
Within the same year after the release of TPC, IRAS issued the Supplementary Administrative Guidance on Advance Pricing Arrangement (APA) on 20 Oct 2008.
An APA is an agreed arrangement between taxpayer and the relevant tax authority made in advance of actual related party transaction with a view to resolve potential tax disputes in a cooperative manner. The agreement is on the TP method and their application for a certain time period in the future. APA may cover a wide variety of transactions such as sales, purchases, use of tangibles assets, transfer and use of intangibles, provision of services, loan transactions, amongst other things. An APA can be bilaterally or unilaterally done.
The key advantages to obtain an APA are that it provides maximum certainty, in other words, no unpleasant surprises that the tax authority will challenge the basis of recognizing the profits for intra-group transactions. It is a very cooperative and pro-active approach that avoids adversarial and lengthy disputes with tax authorities. It is also binding on the tax authorities and this allows the suspension of any audits and ensuing penalties. It also allows the taxpayer to moderate the effect of an opposing Competent Tax Authority by getting them to negotiate reasonably with the other Competent Tax Authority, and in doing so the understanding and objectives of the tax treaty that bind both countries are also achieved in the process.
On the other hand, in applying for an APA, the biggest hurdles are that it is both time consuming and costly. The taxpayer will have to engage professional and legal advisors, tax consultants, valuation and TP specialists as well as rope in its management as well as operational teams from within its organization to get this process underway and in order this to be successful the taxpayer will require the full support and cooperation from them to make the APA work. In addition, taxpayer must be fully prepared to disclose all information and be open to scrutiny by the relevant tax authorities.
Another way to TP dispute resolution is the Mutual Agreement Procedures (MAP) that is prescribed and authorized under Article 25 of OECD Model Tax Convention. It is a means through which Competent Tax Authorities consult and negotiate to resolve the basis of applying the double tax treaty conventions. MAP are used to eliminate double taxation that could arise from TP adjustments.
Supplementary Transfer Pricing Guidelines from Related Party Loans and Related Party Services issued on 23 February 2009
Finally, IRAS issued the Supplementary TP Guidelines for related party loans and related party services on 23 Feb 2009. It laid to rest some of the following questions often faced by the taxpayers.
- Can interest free loans be accepted?
- Can taxpayer apply a 5% mark up on provision of services without conducting benchmarking analysis?
- Should third party costs be passed at no mark up to the recipient of the services?
Related Party Loans
The Supplementary guidelines provide that the borrower must be charged arm’s length rate of interest for the use of the borrowed funds.
Before the Supplementary guidelines were issued, Singapore companies were free to extend interest free loans to domestic as well as overseas related companies. Continuing with this practice, IRAS in its guidelines agrees to allow interest free loans to be extended to domestic companies. This is on the basis that currently there is a mechanism by which the taxpayer will be disallowed a portion of the interest costs incurred in extending interest free loans as non deductible tax expenses. Therefore, IRAS is unlikely to lose out by giving this concession to allow interest free loans to be made available to domestic entities.
On the other hand, loans extended to overseas related companies require interest charge to be applied on an arm’s length basis. As a transitional measure, such cross border loans will start attracting interest charge from 1 Jan 2011.
Related Party Services
The Supplementary guidelines confirm the acceptance of the 5% mark up for the provision of services as arm’s length provided that the services in question are routine services and the service provider does not render similar services to unrelated parties. Routine services are prescribed as accounting, IT, budgeting, HR support, Administration, recruitment, tax, payroll, legal services, training, etc. The list of routine services is provided in Annex A to the Supplementary guidelines.
The 5% mark up should be applied to direct and indirect costs incurred in providing the routine services: direct costs such as salary and related costs of employees performing the services including a reasonable allocation of fixed overheads, for example office rental, utilities, property costs, depreciation, etc as well as cost of external suppliers or service providers used in providing such services.
Non-routine services are not defined. They should include higher value added services such as sales and marketing, research and analysis and technical support. IRAS expects provision of non-routine services to be charged and recovered on arm’s length basis that is commensurate with the industry practice and/or substantiated by proper benchmarking studies or analysis.
Cost pooling arrangement
In the Supplementary guidelines IRAS has also clarified on the basis and criteria for a cost pooling arrangement. A cost pooling arrangement entails the sharing of mutually beneficial services amongst group entities. Provided the following conditions are satisfied, IRAS is prepared to accept that charges under a cost pooling arrangement to be allowed without any mark up.
The conditions for a cost pooling arrangement are:
- The services in the cost pooling arrangement are not provided to third parties outside the group entities;
- The services do not constitute the principal activity of the service provider in other words such costs should be 15% or less of total expenses of the service provider;
- The services should comprise only routine services only; and
- The cost pooling arrangement must be properly documented to substantiate that the parties to the arrangement plans to share the resources before implementation.
Strict Pass Through Costs
IRAS also clarified that costs that service provider did not add value can be passed on to the recipient of the service without a mark up. This is provided that the payment is legally and contractually the obligation of the recipient of the service. Under these circumstances, the payer acts merely as a paying agent. Typical examples of pass through costs could be professional fees, airfares and accommodation and disbursements.
In conclusion, Singapore wants to enhance and secure international economic working relationships that assure OECD and the world that Singapore is a fair and equitable trading partner. It needs to share information with other tax jurisdiction, and this has led to greater vigilance of TP in Singapore. Therefore it is of utmost importance that taxpayers ensure that they have taken reasonable steps and effort to document that their related party and intra-group transactions are conducted based on the arm’s length principles and that they will be able to defend and substantiate this when called upon to do so.
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