Concluding a contract with a subsidiary, businessmen often hope to get a lower price, to reduce the costs and to keep the matter of the contract away from the eyes of the state. To prevent that, countries developed a system to control “family business” and internal deals, which is called transfer pricing rules. Let’s see how the transfer pricing influences taxation, how to obey the rules of transfer pricing and what documents to produce.
What is transfer pricing in taxation?
Transfer pricing is a method that helps to determine how much goods and services must cost when the parties that buy and sell them are “related”. Persons or entities are related to each other if:
- one of them directly or indirectly controls the other (branches and head offices)
- or both are under common control of another person or entity (two subsidiaries having a common parent company).
Although the related parties are interdependent, they should play fair and maintain reasonable prices as if they were regular business partners. It means that no preferential pricing is allowed, and neither are hidden profits.
Preferential conditions mean that the parties underpay taxes. Of course, Singapore would like to prevent that. So, Inland Revenue Authority of Singapore (IRAS) controls related parties and fair pricing. IRAS also controls related party transactions with entities operating outside of Singapore. It ensures that profits are taxed in the same country where they were made.
How to define the arm’s length principle?
The arm’s length principle is an international standard of transfer pricing. It states that a company must sell goods or services to its related party for the same price as it would sell them to unrelated contractors in the same circumstances.
The arm’s length principle also applies to any case where different subsidiaries perform a variety of tasks to benefit the parent firm, such as conducting marketing campaigns or retail activity.
A shoe manufacturer may have several factories located on each continent, one plant producing laces. As the shoelaces move through the supply chain to a plant that would put laces and shoes into a finished product, the manufacturer needs to assess the value of each shoelace and how much profit was made by each party. According to the arm’s length rule, the price of the shoelace should be the same as the one the company would pay on an open market. If a similar shoelace costs S$1 elsewhere, the shoe manufacturer should set the price for the transfer of their shoelace at S$1 as well.
If an entity fails to comply with the arm’s length principle and illegally reduces the reported profits in Singapore, IRAS will unilaterally increase the taxable profits and decrease the deduction or loss. The company will have to pay additional taxes. Such enforced changes may also be accompanied by interest and penalties.
How to avoid the breach of the arm’s length principle?
IRAS advises that companies that want to comply with the rules to follow these 3 steps:
Step 1. Compare conditions of the related party transaction (RPT) with the same transactions between independent parties and the circumstances in which the transaction takes place.
The following aspects help to evaluate the transaction:
- Terms of the transaction. Assess the written contract: the price, responsibilities and possible risks posed by the agreement. As long as the contract may not cover all the aspects of the deal, the actual conduct of the parties also matters. When there is no written agreement at all, consider how the parties actually transact, what goods and services they provide and at what price. For example, a restaurant purchases seafood from its subsidiary company without a contract in writing. It does not mean that they don’t have an agreement. Verbal deals also count for the purpose of transfer pricing. The authority will assess factual supply of the seafood and money paid.
- Characteristics of products or services. All goods and services presented on the market differ in their features, quality and availability, so they cost differently. This determines the fair price. For example, you cannot sell brand new Gucci bags at the price of low-budget replicas.
- Functions, assets and risks assessment. Analyse the responsibilities of the parties, the type of assets they use and the actual risks undertaken by the taxpayer. While it is obvious how functions and assets may influence the price, the risk is just as important. For example, a trader selling refrigerators with warranty bears higher risks in comparison to a trader selling the same refrigerators without warranty. Hence, the company granting warranty on the products must set higher prices.
- Commercial and economic circumstances. The markets in every country have their specifics and restrictions that should be considered. For example, the country’s geographical position and availability of a product on the market cannot help but influence the prices. A mango in a northern country like Sweden will cost a lot more than in Thailand.
IRAS also suggests that companies consider additional factors to make an accurate assessment, like:
- evaluating transactions on a separate or aggregate basis,
- using data from several years,
- considering losses,
- selecting internal and external data for comparison.
Step 2. Identify the most suitable transfer pricing method
IRAS advises choosing any of the following methods for transfer pricing. The choice can depend on the circumstances and the available data.
|Traditional transaction methods (compare prices)||Comparable uncontrolled price method (CUP)||Compare the price in a related party transaction with the price stated for an independent party transaction. The characteristics of the goods and services and the circumstances must be the same.|
|Resale price method (RPM)||The method applies when a company purchases a product from a related party and resells it to an independent party. Compare the gross profit margins obtained from both transactions to identify if the price is fair.|
|Cost plus method (CPM)||The method usually applies to manufacturers. Compare the cost of manufacturing and the gross mark up in related and unrelated transactions. The selling of a product must not only cover the manufacturing costs itself but also generate additional profits to the company. Focus on the assessment of functions, assets, risks and economic environment of compared transactions, so far it mostly affects the gross mark up.|
|Transactional profits methods (compare profits)||Transactional profit split method (TPSM)||Compare how interrelated parties split the profits and losses depending on their relative contributions.|
|Transactional net margin method (TNMM)||Compare the net profit obtained from transactions.|
Step 3. Determine results and set a fair transfer price
As a result, you may apply the arms’ length rules to related transactions and justify the prices. You must adjust the arm’s length results annually.
What documents should I prepare for transfer pricing?
If the gross revenue from your activities exceeds S$10 million for the tax basis period or IRAS specifically request to prepare the documentation for the previous basis period, you must collect and keep all relevant documents in regard to related party transactions. Your accounting company in Singapore must be in the know.
The documentation should contain an overview of the business group, especially on entities dealing in Singapore, and description of taxpayer’s transactions with related parties alongside the transfer pricing analyses. Find a complete list of requirements to documentation in the Second Schedule of the Income Tax (Transfer Pricing Documentation) Rules 2018.
Provide transfer pricing documents only upon IRAS request. Even if IRAS does not ask for them for the relevant basis period, keep them safe for at least 5 years.
- Set a reasonable price when contracting a related party.
- Compare related party transactions with similar independent transactions. Use a step-by-step guide and methods proposed by IRAS.
- Collect all documents relevant for transfer pricing and control the value of transactions in order not to miss filing of additional forms.