Introduction
Transfer Pricing (TP) is a worldwide issue. Currently, Malaysia’s TP legislation is based on the recommendations given in the OECD TP Guideline, which is also being applied in other member countries.
TP is such a big issue because it is a potential tool for tax avoidance. LHDN is charged with enforcing tax laws so as to ensure that no acts of tax evasion or avoidance goes unpunished. Therefore, LHDN is given the authority by the Government of Malaysia to sanction any companies for performing related party transactions (RPT) without applying the principle of arm’s length.
What is TP? What is RPT? What is this principle of arm’s length? To answer these questions, we explore the mechanism of RPTs in the next section.
1. RPTs in Malaysia
1.1 Defining RPT
It is best to begin by explaining what an RPT is. An RPT is any transaction carried out between related parties (RPs). In Income Tax Act 1967 (ITA 1967), it is better known as a controlled transaction.
An RPT involves the exchange of assets (tangible such as real property, or intangible such as goodwill or trademarks), services, or, financial assistance (such as intercompany loans and trade credit advances), for payments of price, fee, or interest charged.
RPs are companies that are related to one another because of any of the following:
(a) one owns the other, directly or via another company;
(b) both companies are owned or controlled by the same shareholder(s) and/or director(s); or
(c) all companies are owned or controlled by different shareholder(s) and/or director(s), but they are related to one another.
(d) The business operations of that person depending on the proprietary rights, such as patents, non-patented technological know-how, trademarks, or copyrights, provided by the other person or a third person;
(e) The business activities, such as purchases, sales, receipt of services, provision of services, of that person are specified by the other person, and the prices and other conditions relating to the supply are influenced by such other person or a third person; or
(f) where one or more of the directors or members of the board of directors of a person are appointed by the other person or a third person.
The opposite of an RPT is known as an uncontrolled transaction, where none of the companies involved are related to one another in any way.
1.2 Arm’s Length
We have dealt with the meaning of RPTs and RPs. What does the principle of arm’s length mean?
To answer that question, let us look back at uncontrolled transactions again.
In such transactions, none of the parties involved has a hold over the other. Therefore, each party would make decisions based on what is best for each individually. This is known as the principle of arm’s length.
1.3 TP
We have learnt that in uncontrolled transactions, both parties would deal with one another at arm’s length, making decisions independently of one another. What does this have to do with TP?
In uncontrolled transactions, both parties, at arm’s length, would bargain with one another for the best price, and that would be the market price.
Like these companies, RPs must also price their RPTs, and that pricing is known as TP.
Therefore, TP is how RPs determine the price or amount to be paid for the asset(s), service(s), or financial assistance to be exchanged in an RPT.
All right, so TP is how RPs price their RPTs. What does this have to do with tax avoidance?
1.4 TP and Tax Avoidance
Before coming to tax avoidance, you need to understand that the point of TP regulations is to ensure that TP is done at arm’s length. If it is not done at arm’s length, meaning there is a wide gap between the agreed RPT price and the market price, it will affect the income of the seller, and thus seller’s taxable income.
In order to better illustrate how TP affects taxable income, let us use a hypothetical example of an RPT involving two RPs, ABC Bhd and DEF Ltd. ABC Bhd is based locally, and owns DEF Ltd, which is based overseas.
Now ABC Bhd wants to transfer its inventory of goods to DEF Ltd, and this is done by selling the goods to DEF Ltd in order to ensure that ABC Bhd receives revenue and cash flow from its transfer. However, ABC Bhd charges only 10% of its market price for the goods to DEF Ltd.
Therefore, ABC Bhd loses 90% of its revenue from this sale and this means lesser taxable income from it. On the other hand, DEF Ltd saves cost by 90% because they paid only 10% of the full price for the goods. Thus, their taxable income rises.
Since ABC Bhd owns DEF Ltd, what difference does it make? There are at least two impacts.
Firstly, Malaysia loses 90% of tax revenue for this RPT.
Secondly, if the country that DEF Ltd is based in has very low tax rate, when compared to the equivalent in Malaysia, ABC Bhd virtually avoids paying taxes at the amount that they should by shifting their income to a foreign-based subsidiary.
In the final analysis, TP is the pricing of an RPT, and it must be done at arm’s length in order to avoid tax avoidance. Tax avoidance is not explicitly illegal? Will I suffer because I underpriced my RPTs?
2. Consequences of Underpricing RPTs
We have established that there is a temptation for RPs to underprice their RPTs, and that this underpricing gives way to tax avoidance. We have mentioned that LHDN is empowered to take actions against any companies for any underpriced RPTs.
Pursuant to that, for every RPTs, RPs are to prepare contemporaneous TP documentations. The law specifies that this documentation must be produced within 14 days after RPs are requested to do so by LHDN.
This documentation details out the relationships of the RPs involved in the RPT, the nature and reason for the RPTs, and most importantly, the pricing of the RPTs with justifications. With the documentation, LHDN would check and confirm whether the pricing was done at arm’s length.
If it is found that the pricing does not comply with the principle of arm’s length, LHDN will determine what should have been the correct price of the RPT, and the taxpayer must pay for the difference in income tax to be gained from the RPT, plus a surcharge of up to 5%.
So far we have only talked about the consequences of not complying with the arm’s length principle. What about not preparing the documentations? Can I get away with that?
The penalty for not producing the documentation on time (i.e. within 14 days after being asked to do so by LHDN) is:
All right then, perhaps I can just whip something up whenever LHDN asks for the documentation?
The time it takes to produce the required documentation correctly can easily go up more than 30 days. LHDN would not grant any extension for the deadline and no excuse would be accepted. Late submission simply means no submission.
The table below depicts the tax revenue collected from TP audits by LHDN from 2014 until 2018:
Source: IRBM, Nuarrual Hilal Md Dahlan, Abu Tariq Jamaluddin, and Rohana Abdul Rahman, Taxation Transfer Pricing law in Malaysia: Salient legal Issues, 2020 (https://www.researchgate.net/publication/341312717)
Summing up, the consequence for non-compliance with LHDN’s TP regulations are as follows:
3. Steps Towards Compliance
We have listed down the consequences that you may face for not complying with TP regulations in Malaysia.
Now we would like to share with you the steps that you may take to comply and avoid the troubles that we have mentioned.
Compliance means adhering to the principle of arm’s length in all of your RPTs. Primarily, you must achieve this by preparing correct TP documentation on time for every RPT.
There are 2 kinds of TP documentation, full and minimum. Before we delve into those, let us look briefly into who must prepare TP documentation and when.
3.1 Do you have to prepare TP documentation?
In order to know whether you are obliged to prepare TP documentation, there is a series of questions that you must ask yourself.
If you have no RPT as defined in Section 140A, ITA1967 or are not carrying on business, then you are not required to prepare any TP documentation.
Full-Minimal TP Documentation Threshold
If you do have an RPT and are carrying on business, then you must determine whether you meet any of the following threshold:
If you do not meet any of the two mentioned thresholds, then you are obliged only to prepare a minimum TP documentation.
There is a possibility that you might not even have to prepare TP documentation, provided that you fulfil the following conditions:
However, to err on the side of caution, it is advisable that you prepare minimum TP documentation.
Assuming that you actually meet the threshold, you must ask yourself whether you have any RPTs with related persons outside of Malaysia.
If indeed you do, then you must prepare full TP documentation.
Tax Chargeability
If you have no RPTs with related persons abroad, you may proceed with the next question. Is your income and that of your related persons chargeable?
If none are chargeable, and it is because you or they enjoy tax incentives or suffer from continual losses, then you are not required to prepare TP documentation. Nevertheless, you are encouraged to do so.
Should none be chargeable but none of you enjoy any tax incentives or suffer losses, then you must prepare full TP documentation.
Tax Incentives, Losses, and Different Tax Rates
If your income and that of any of your related persons are chargeable, the last question would be whether any of you are:
TP documentation would not be required if no is your answer. If yes is your answer, then you must proceed with preparing full TP documentation.
3.2 Full vs Minimum TP documentation
As mentioned earlier, there are 2 types of TP documentations, full and minimal.
The content of the documentation of each type is listed down in the following table:
3.3. Comparability Analysis
Given that you must adhere to the principle of arm’s length and so the TP must equal to prices set in uncontrolled transactions, the following are crucial details that must follow the same principles:
Included in your TP documentation is a section on comparability analysis. The purpose of this analysis is to show how different is your RPT from an uncontrolled transaction.
Remember that complying with TP regulations means to undertake all RPTs at arm’s length. Therefore, the pricing of your RPT must not lead to a price different from that of an equivalent uncontrolled transaction.
Hence, it is crucial that you choose the most appropriate uncontrolled transaction, and that should be based on the following conditions:
The similarities between your RPT and the chosen uncontrolled transaction should be in terms of the following:
The basis year of both transactions must be the same. However, if data is unavailable, LHDN may allow for different basis years for comparison.
In the case where there is a combination of RPTs in one, the prices of each must be determined separately, in accordance with prescribed methods. However, wherever that is not possible, LHDN may allow for one price for all RPTs in the combination, provided that it is standard industrial practice to do so.
For services, the charging for the following services shall be void:
With regards to cost contribution agreement for acquisition of asset or provision services among RPs, the allocation of costs must be made if the parties were independent.
3.4. TP Pricing Methods
LHDN classifies TP methods into two kinds: traditional transactional methods; and transactional profit methods.
The former can any of the following:
The latter can be any of the following:
Despite alternatives being available, there are conditions governing the choice of methods.
It is most preferable to use a traditional transactional method. Therefore, you are obliged to consider it first before looking into a transactional profit method. Only if it is not feasible, then the latter may be considered.
Method 1: Comparable Uncontrolled Price Method (CUP)
CUP method compares the price and conditions of products or services in a controlled transaction with those of an uncontrolled transaction.
Requirement: comparable data of a closely similar, uncontrolled transaction.
Challenge: identifying the most comparable uncontrolled transaction.
Recommendation: use whenever possible as it is the most effective and reliable way to apply the arm’s length principle to a controlled transaction
Kinds of CUP:
Hence, the internal CUP method is preferred.
Example of the internal CUP Transfer Pricing method
A Malaysian wholesaler of finished gold ornaments and jewelry products company needs to determine how to price the use of its brand name and logo by its Singaporean subsidiary. The company’s TP team must find an example of an agreement the company has made with an independent third party to use their branding. If that arrangement is sufficiently comparable, the wholesaler can apply the same price it charges the independent third party to its Singaporean subsidiary to use the brand and logo.
Method 2: Resale Price Method (RPM)
RPM uses the selling price of a product or service, the resale price. This figure is then reduced by a gross margin, calculated by comparing the gross margins in comparable transactions made by similar but unrelated organisations. The costs associated with purchasing the product—such as customs duties—are then deducted from the total. The final figure is considered an arm’s length price for a controlled transaction made between affiliated companies.
Requirement: appropriately comparable transactions are available.
Challenge: the resale price method requires comparables with consistent economic circumstances and accounting methods. The uniqueness of each transaction makes it very difficult to meet resale price method requirements.
Recommendation: a useful way to determine transfer prices as third-party sale prices may be relatively easy to access
Example of the internal RPM Transfer Pricing method:
An FMGC company distributes goods to Johor, Melaka and Negeri Sembilan. Their goods are supplied by a local related company. It also purchases similar goods from another unrelated supplier. Assuming that the terms and conditions of the related and unrelated party transactions are comparable, the RPM can be applied to ensure the RPs (i.e. the supplier and distributor) charge a price comparable to the price charged by the unrelated third-party supplier.
The RPM stipulates that the gross margin earned by the FMGC distributor on goods purchased from the related company must be the same as the margin earned on sales of shoes purchased from the unrelated supplier. For example, if the distributor makes a gross profit of RM10 on each rice pack from the unrelated supplier sold for RM100, the gross profit margin is 10%. This is the gross margin that must be used to determine the price of the rick pack the distributor purchases from its related supplier.
Method 3: Cost Plus Method (CPLM)
CPLM works by comparing a company’s gross profits to the overall cost of sales. It begins with determining the costs incurred by the supplier in a controlled transaction between affiliated companies. Then, a market-based markup—the “plus” in cost-plus—is added to the total to account for a reasonable profit. A company must identify the markup costs for comparable transactions between unrelated organisations to use the cost-plus method.
Requirement:The availability of comparable data and accounting consistency.
Challenge:If it’s not an apple to apple comparison, it will distort the results, and another method must be used.
Recommendation: useful for assessing transfer prices for routine, low-risk activities, such as the manufacturing of tangible goods.
Example of the internal CPLM Transfer Pricing method
A Malaysian manufacturer supplies products to their HK-based parent company and needs to determine the appropriate markup (gross cost-plus) for the goods it sells to its partner. Suppose that the manufacturer has made similar comparable transactions with third parties. In that case, the markup used for those transactions can be applied to the sales the company makes to their parent company. The manufacturer has made no comparable third-party transactions. In that case, the TP team can identify several companies similar to the manufacturer and apply those companies’ average gross cost-plus to the transactions with their parent company.
Method 4: Transactional Net Margin Method (TNMM)
TNMM helps determine transfer prices by looking at the net profit of a controlled transaction between associated enterprises. This net profit is then compared to the net profits in comparable uncontrolled transactions of independent enterprises.
Requirement: financial data
Challenge: It is a one-sided method that often ignores information on the counterparty to the transaction. LHDN is likely to take the position that the CPM is not a good match for organisations with complex business models, such as high-tech companies with intellectual property. Using data from companies that do not meet the OECD’s comparability standards creates audit risk for organisations.
Recommendation: effective for product manufacturers with relatively straightforward transactions, as it’s not difficult to find comparable data.
Example of the internal TNMM Transfer Pricing method:
A Malaysia-based clothing company establishes a Thailand distribution affiliate. The parent company supplies products, sets business strategies, finances the global operations, and owns the intellectual property (trademarks, designs, and operational know-how) for its global affiliates. They need to determine how much profit the Thailand distributor should earn for its operations. The TP team identifies similar distributors in Thailand, calculate their pre-tax profit margins, and establishes a typical profit margin range. Prices are set to allow the related Thailand distributor to earn a pre-tax profit that falls within that typical margin range.
Method 5: Profit Split Method (PSM)
In some cases, associated enterprises engage in transactions that are interconnected—meaning they cannot be observed on a separate basis. For example, two companies operating under the same brand might use the profit split method (PSM). Typically, the related companies agree to split the profits, and that’s where the profit split method comes in.
Requirement: terms and conditions of interrelated, controlled transactions by figuring out how profits would be divided between third parties making similar transactions
Challenge: it only applies to highly integrated organisations, equally contributing value and assuming risk. Because the profit allocation criteria for this method are so subjective, it poses a risk of the RPT not being done at arm’s length, and thus is disputed by the tax authorities.
Recommendation: useful when dealing with intangible assets, such as intellectual property, or in situations where there are multiple controlled transactions happening at a time. One of the main benefits of the PSM is that it looks at profit allocation in a holistic way, rather than on a transactional basis. This can help provide a broader, more accurate assessment of the company’s financial performance.
Example of the internal PSM Transfer Pricing method:
An energy solutions provider in marine, land, and aviation company affiliate performs R&D to bring a new energy solution to market. Their affiliate bears the costs and risks of launching the new energy solution. The two RPs need to determine the right profit split, and decide that they will use the contribution PSM to divide profits from sales of the new energy solution.
The two parties have invested a total of RM150 million in bringing the new solution to market. The R&D company invested RM75 million—or 75% of the total investment. Therefore, 75% of the profits will go to the R&D company, with the remaining 25% going to the manufacturer.
4. The Common Practical Issues of Transfer Pricing that SMEs Are Not Aware
There are a few common practices that many of the SMEs still practicing in their business and without considering the transfer pricing risks and the documentation readiness.
4.1 The pricing is fixed by the boss
There are many cases that we come across that the marketing staff or finance staff do not involve in pricing determination process for the related party transactions and the boss of the company is the one who determine the pricing that charge to related parties or customers. The boss may have certain calculation formular or costing structure in determining the pricing and there are no any documentation or clear policy that how the pricing is determined and what factors are taken into consideration in the process.
This kind of practice should be changed in view of the current stringent transfer pricing compliance. If in the event of tax audit or transfer pricing audit by Inland Revenue Board of Malaysia (IRBM) and the SMEs may have difficulties in explaining and justifying the pricing.
It is common that many SMEs always have this situation where the same products or services supplied to related and non-related parties that having different pricing and the issues is they cannot explain the basis and justification for the different pricing.
This would open a window for IRB to adjust the pricing and if the pricing adjustment result in any additional tax implications, it would have transfer pricing penalty risks.
There are some cases that we come across that the company just charge back the cost to the related party for the works that the employees have performed for the related party or the supplier charge to a company and the company charge back the cost to the related party as the services or goods are consumed by that related party. In fact, all these kinds of charge-back at cost must be studied in detailed in the perspective of transfer pricing as if the company has used its resources or its employee’s time in the charge-back process e.g., some administrative time or works performed, then there should be some fee to charge to the related party.
4.4 Sharing of office space or human resources
It is common that a few related parties sharing a common office building and, in some cases, they share the human resources for example an accountant is doing the accounts for a few companies within the same group. When they have this kind of sharing arrangement, the transfer pricing consideration must be taken are the basis of allocation of the cost to each related parties that consuming the services or the basis of charging the fee.
Inter-company, friendly financial assistance is also a common practice Malaysian SMEs. However, Paragraph 9.1 of the Transfer Pricing Guidelines 2017 did provide that the loans of financial assistances that between related parties should chare interest following the arm’s length principle. The interest-free financial assistance result in transfer pricing risks especially in the scenario that an Investment Holding Company under Section 60F of the ITA provides interest free loan to a related party which is a loss-making company. If the pricing adjustment is done by IRB on the loan by imposing the interest shall be charged, it will result in additional tax payable. The same goes to other scenario like interest free loan provided to a related party which is outside Malaysia or an investment holding company under Section 60F of the ITA and it used the loan to invest in a company, the dividend that generated from the investment is tax exempt.
The aboved statement is not fully correct and the Transfer Pricing Guidelines 2017 did provide that “the Guidelines need not apply to transactions between persons who are both assessable and chargeable to tax in Malaysia and where it can be proven that any adjustment made under the Guidelines will not alter the total tax payable or suffered by both persons”, a thorough evaluation has to be done before the conclusion is made. The evaluation should cover the tax implication of every related party’s transaction to each related party in view of their current tax position. The evaluation should also cover what will be the tax impacts if the worst scenario happen in case of the transfer pricing adjustment can be made by IRB.
5. TP Documentation: DIY vs. Hiring a Pro
We have given you an overview of what needs to be done in order to comply with TP regulations in Malaysia.
However, whilst you may decide to prepare the documentation yourself, we urge you to consider the pros and cons of doing it yourself.
Doing it yourself may be more economical and efficient because you would know your organisation and business better than anyone else. Furthermore, the learning curve enables you and your staff to know the business of TP inside and out.
However, cost-effectiveness should take into account not only the amount of money spent, but also time. Preoccupied with running your business, the task of preparing TP documentation will tax your time.
On average, a qualified, experienced TP advisor would take roughly a month to prepare minimal TP documentation for an RPT, and about twice the amount of time to prepare full TP documentation. If performed by anyone else, it would take even longer to prepare TP documentation.
Furthermore, apart from knowing your business, you must also know TP laws in and out in order to prepare correct TP documentation. In-depth knowledge and experience in TP allows a professional TP advisor to accomplish many tasks that even the most skilled taxpayers would first need to spend hours of research on.
Ultimately, the decision of whether to handle it yourself or hire a professional TP advisor lies with the cost and benefit entailed in each decision.
In order to better get a grasp of that, you would need to ask a series of questions. Some of these questions are mentioned in the following flowchart:
We hope we have made the process of TP compliance clearer to you. In addition, for your comparison and reference, click to button below to learn more of the TP services that we offer to you.
