Introduction to Transfer Pricing
Territorial expansion of businesses that followed after globalization, has led to an increase in intra company transactions and cross border transactions between related companies. For instance, while manufacturing activities are managed by an entity of a larger group in one country, marketing of the manufactured products in another country are being handled by a different subsidiary belonging to the same group. In such cases, Transfer Pricing mechanism determines the price of the goods, services, funds, rights or intangible assets that are thus transferred for sale or consumption to a related entity.
Transfer pricing is the pricing of goods, services, and intangibles between related parties. The arm’s length principle should be adopted for transfer pricing between related parties. Taxpayers should prepare and keep contemporaneous transfer pricing documentation to show that their related party transactions are conducted at arm’s length.
What is Arm’s Length Principle of transfer pricing?
Transfer pricing is not limited to just pricing but also includes terms and conditions of such transactions between related parties. It is important to understand the transfer pricing mechanism because it largely determines the revenue of related entities and therefore their taxable profits under their respective tax jurisdiction. The fundamental guideline for transfer pricing is “Arm’s Length Principle”, that is, the pricing of cross-border transactions between related entities must be market based, and similar to the pricing that would have been charged if the parties were unrelated.
The arm’s-length principle of transfer pricing states that the amount charged by one related party to another for a given product must be the same as if the parties were not related. An arm’s-length price for a transaction is therefore what the price of that transaction would be on the open market.
In the case of unrelated entities the market forces such as demand and supply largely determine the commercial pricing of such cross border transactions, but in the case of related entities, because of the element of association and relationship, there is a propensity to set prices that are deviant from the actual market price. The selling entity may undercut the price, or the buying party may set a higher cost in order to lower their profits thereby affecting their taxable income. Such distortion of prices will impact the tax liability of the entities in their respective jurisdiction.
With businesses rapidly expanding beyond their domestic borders, leading to a spike in cross border transaction between related parties, tax authorities around the globe are stepping up their scrutiny on such transactions. Where a related party transaction is identified to be not in compliance with the arm’s length principle, tax authorities would make adjustments to the profits and tax liabilities. Such adjustments along with interest and in some cases penalty will always amount to increased tax liability of the entity.
Therefore, multinational corporations should now approach transfer pricing in a structured manner by identifying the jurisdictions in which they operate, the related party transactions being undertaken, revisiting the structures to ensure that they are compliant with the transfer pricing guidelines, aligning the returns of the group entities commensurate with the value creation and preparing a comprehensive transfer pricing documentation to avoid tax adjustment and penalties.
Transfer Pricing should not only consider the compliance with the rules and regulations but also the reputational risk associated with non-compliance.
Need more information on transfer pricing rules in Singapore?
Consult our taxation specialists who will run through Singapore's transfer pricing mechanism in detail with you, diving into the arm’s length principle and documentation that needs to be maintained for the purpose of audits.