The Inland revenue board malaysia (IRBM) announced new updates to the Transfer Pricing Guidelines 2012, effective from 15 July 2017, which introduced changes to the chapters on Arm’s Length Principle, Intangibles, Commodity Transactions and Documentation. We check out the impacts.
By Abdul Razak Rahman
New updates to the Transfer Pricing Guidelines 2012 reinforce the application of the law on controlled transactions and provide guidance for taxpayers involved in Transfer Pricing (TP) arrangements to operate in accordance with the methods prescribed by the rules as well as to comply with the administrative requirements of the IRBM on records and documentation. To create awareness of the new updates, MIA called together industry experts, regulators and tax practitioners for a dedicated panel session on these issues at the 2017 Transfer Pricing Conference.
Shortfall in TP documentation: Regulators’ Perspective
One of the key aims of the updates is to enhance compliance with TP documentation. The IRBM Director of International Taxation Department, Wan Ramiza Wan Ghazali reiterated that taxpayers are expected to adhere to the comprehensive rules and guidelines outlined in the Transfer Pricing Guidelines 2012. Citing accounting services as an example, she said that the recipient of the service is expected to document and provide sufficient explanation on the nature of the services, the benefits derived, frequency of services as well as the organisation structure. The benefits derived must either improve efficiency and reduce costs, or increase the revenue. Frequently, these are not documented.
Another common shortfall is that the Functions, Assets and Risks (FAR) analysis is too brief and not complete. The risk analysis for example does not indicate how the risks are being controlled and managed and there was no clear indication on the assumption of risk. When selecting comparable organisations, they should not only be comparable function-wise but also in terms of the financials as well, such as comparable balance sheets. Since the TP document must reflect the actual position, it is also important to identify and justify to the IRBM the entity’s position within the group and how it is linked to the value creation. The group structure is also important to enable the IRBM to make a comparison. Finally to complete the picture, the group financial information must also be part of the TP documents to support the TP transactions.
The Practitioners’ Perspective
What should practitioners watch out for? Philip Yeoh of BDO Malaysia highlighted that the TP document must be contemporaneous and of high quality to meet the standards set by the IRBM as well as to avoid incurring any penalties arising from revised assessments.
Further, he noted that the group financial information must be filed under the Country-by-Country Reporting (CbCR) if the threshold is met. It is also important to align the information reported within the group with the local information and to ensure that the disclosure is consistent with the adopted TP policy.
In the event that the entity’s performance is found to be below the inter-quartile or median range of the selected comparables, the TP policy may need to be revisited if all the checks have been exhausted, said Hisham Halim of Ernst & Young Tax Consultants Sdn Bhd. In coming up with a robust TP documentation and selecting suitable comparables, the emphasis should not only be restricted to the quantitative information but it is also important to understand the qualitative aspect of the comparables. “If there is limitation in finding suitable comparables, working capital adjustment could be the solution, which is widely practised in the western countries,” he said.
In practice, there is frequently a gap between the implementation of the TP guidelines and the commercial reality, said industry experts. For conglomerates such as Daikin that have a presence in multiple countries and decentralised management, there is an added pressure for the commercial managers to meet their financial KPIs whilst at the same time complying with the TP guidelines. Daikin’s Chief Financial Officer, Chen Voon Ping argued that a strong foundation in corporate governance is crucial to ensuring TP compliance because preserving a good corporate image is as important as achieving financial results, especially for conglomerates and multinationals.
On the specific challenges in implementing BEPS recommendations, Hisham advised industry to be prudent in adopting Action 13: Guidance on Implementation of TP Documentation and CbCR. “The main challenge is the lack of clarity or grey areas on the implementation and application of the guidelines. Whilst the application of the guidelines is very clear on the manufacturing and services companies, it needs clarity for some others such as private equity funds.”
With regards to identifying intangibles and establishment of intangibles ownership through the Development, Enhancement, Maintenance, Protection and Exploitation (DEMPE) requirement, Hisham explained that the subject has not really come under scrutiny, with the exception of big multinationals. “As a result, most companies are not well versed with intangibles and the benefits that can be derived from intangibles.” According to him, the biggest challenge, after establishing and applying the DEMPE requirements, is working out how to attribute values and allocate rewards to the respective parties.
The moderator for the session, Thenesh Kannaa of TraTax, touched on industry-specific challenges arising from the introduction of the updated TP Guidelines.
One, payment of royalties for intangibles in a manufacturing industry. It is common practice for local manufacturers to pay royalties to the parent company or the related IP provider for the use of the intangibles. Unless it can be established that the local company has no R&D capabilities, it will be difficult to justify continuing payments of royalties because the local manufacturers are expected to have gained the necessary experience and contributed to the improvement and efficiency of the manufacturing processes over the years. IRBM may also disallow royalties paid if it is not proven that the royalties currently paid are for newly developed or enhanced intangibles as the original intangibles may became obsolete over the years.
Two, advertising, marketing and promotion (AMP) functions undertaken by Malaysian distributors. When the local distributor undertakes significant functions, and bears risks and costs associated with the AMP of the group’s products, it would be entitled to a higher return in the form of a share of profit associated with the enhanced value of the products, or a reduction in the royalty rate. On the other hand, if the local entity performs marketing activities on behalf of its principal, it should be compensated at cost plus service fee for the marketing activities in addition to the routine return of its distribution functions. The practical challenge then lies in selecting the right and suitable comparables that can withstand the IRBM’s challenges. For contract R&D service providers, a compensation based on reimbursement of cost plus will not be accepted if the service provider performs the control functions i.e. economically significant functions, providing assets and necessary funding, and bears associated risks relating to the development of the intangibles.