Transfer pricing – what’s acceptable and what’s illegal

TRANSFER pricing occurs when goods and services are sold between related parties within a business enterprise. For example, if a subsidiary company sells goods or services to a parent company, the cost of those goods or services paid by the parent to the subsidiary is the transfer price.

Transfer pricing is not illegal or necessarily abusive. What is illegal or abusive is transfer mispricing, also known as transfer pricing manipulation or abusive transfer pricing.

Starting position of the tax authorities Tax authorities tend to start any tax scrutiny with the view that the related party transactions are suspect. The starting position is companies are driven by the desire to maximise their profits and minimise their payment of taxes and therefore the assumption is multinationals and domestic groups will take advantage of the different tax rates, tax laws, tax holidays, etc. to shift profits to the low tax or tax holiday enclaves through transfer pricing.

Extent of the abuse The Christian Aid report in May 2008 estimated that developing countries lose US$160 billion per year from transfer mispricing and false invoicing.

The United Kingdom tax authorities raised an additional £2.114 billion for the period from 2007 to 2009 from transfer pricing adjustments.

What is acceptable? When the group transacts internally with one another at prices equivalent to market prices (what two third parties pay each other as result of real negotiations), they are regarded to be dealing with one another at arm’s length, a principle accepted internationally by most countries in the world. If this test is met, then the transfer prices are legal and acceptable. Generally, because of their relationship and influence the parent can have over its subsidiaries, it is assumed that such transactions are not conducted on arm’s length basis and it is up to the companies to prove to the authorities that the transactions have been carried out on the comparable basis to third parties.

When does it shift to unacceptable avoidance and illegality? Illegality occurs when the intercompany transactions are organised with the intention to avoid tax without any substance or the transactions are a fictitious. For example, if the Malaysian company which has the technical capability and the personnel develops the digital platform and connects customers from Malaysia and overseas suppliers and earns a fee which is then booked into a Hong Kong subsidiary where it pays no tax on the basis that it is offshore income. The Hong Kong subsidiary has only 2 people to manage its bank accounts. Most of the profits are booked into the HK company and clearly there is an abuse of transfer pricing which will be regarded as illegal and fraudulent as this arrangement lacks substance and it is purely intended to evade tax.

Avoidance as opposed to illegality The most common situation is when companies within a group carry out real transactions but are not priced on an arm’s length basis. In such situations, tax authorities will adjust them to meet the arm’s length standard. For example, where the management fees are charged from the parent company to its subsidiaries and the basis of the charge could be a percentage of the turnover of the subsidiaries. In the event the basis of the charge cannot be supported with external evidence to prove its arm’s length nature, it will be treated as an avoidance matter as opposed to being illegal which will suffer a tax adjustment and penalty.

Watch out The tax authorities view transfer pricing transgressions as unethical, immoral and illegal at the slightest hint of preplanned mispricing of transactions.

This article was contributed by SM Thanneermalai, managing director of Thannees Tax Consulting Services Sdn Bhd and chairman of the Board of Trustees of Malaysian Tax Research Foundation.