Transfer pricing rules in Singapore
The disaggregation and internationalization of the firm’s activities will ipso facto result in intragroup, cross-border transactions among related companies that are controlled by the company. While establishing the contractual terms for these transactions, firm leaders often seek to lower the parent company’s overall costs and the aggregate taxes the firm has to pay. This tax optimization can often result in situations that may not be in the best interest of the individual subsidiary company but benefit the firm overall. For example, the parent may attempt to shift the profits made in a subsidiary company located in a high-tax jurisdiction (Sub A) to another subsidiary company that is located in a low-tax jurisdiction (Sub B). The taxes paid by Sub B will rise but the rise may be significantly lower than the reduction in taxes paid by Sub A, thereby reducing the overall tax paid by the parent company. Firms often consider the nitty-gritty details of these strategies to be their proprietary intellectual property and would like to keep these details away from the eyes of the public and the authorities.
The article includes the following topics:
- What is transfer pricing?
- The “arm's length” principle
- Singapore’s 3-step approach to applying the arm's length principle
- Transfer pricing documentation requirements
- TP documentation exemptions
- Indicative margin for group loans
- 2019 TP changes in Singapore
- What penalties do you risk when not complying with the TP rules?
What is transfer pricing?
When establishing contractual terms for cross-border transactions among related companies of an international enterprise, sometimes, firms can engage in strategies that have no underlying economic basis and are adopted purely for tax reduction. Most governments consider such strategies to be abusive because they deprive a country of tax revenue from a subsidiary while the subsidiary continues to impose economic burdens on the country due to its operating activities (e.g. use of the country’s roads, infrastructure, welfare system, financial incentive schemes, etc.).
To prevent such abuse, countries have developed a system to control intracompany deals, and this system is colloquially referred to as Transfer Pricing (TP) rules. Being a well-known international business hub, Singapore is home to many holding and subsidiary companies. To prevent the abuse of intracompany transactions by companies located in Singapore, the country has formulated a comprehensive regulatory system for Transfer Pricing. If you are involved in the management of a group of companies and at least one of them has any nexus to Singapore, it is essential that you know the local transfer pricing legislation. In particular, you should understand how transfer pricing regulations can adversely influence “family” transactions, how to follow the rules, and what documents you’ll need to prepare to be fully in compliance with the Singapore law.
Transfer Pricing (TP) is a mechanism that determines the price of goods, services, funds, rights or intangible assets that are transferred for sale or consumption to a related party.
Related parties refers to entities that either:
- Control one another directly or indirectly (branches and head offices), OR
- Are under the common control of another party, whether directly or indirectly (two subsidiaries having a common parent company).
Transactions between related parties in amounts that are more than certain thresholds (described in the sections below) are referred to as controlled transactions.
The key underlying principle governing TP is that although the parties involved are related and share common interests, they should play fair and settle on reasonable prices as if they were independent business partners. The law says that such related parties must deal with each other at “arm's length” and not be hugging or kissing each other while making the transaction.
The ultimate purpose of the TP regulations is to ensure that low-tax jurisdictions are not used merely for tax avoidance purposes and that profits are taxed where the real underlying economic activities are performed and the economic value is created.
The “arm's length” principle
The arm's length principle is an internationally accepted standard adopted for the purpose of pricing transactions between related parties; it is applied by the Inland Revenue Authority of Singapore (IRAS) as well. The principle means that entities that are related via management, control or capital should negotiate, in their controlled transactions, the same terms and conditions that would have been agreed between non-related entities for comparable uncontrolled transactions. If this principle is met, the terms and conditions of the particular transaction are considered to be “at arm’s length”.
For instance, a watch manufacturer may have several factories located in different countries, one plant producing mechanisms, another the case, and the third the watchband. As the case and the band move through the supply chain to a first plant that would assemble the mechanism, case, and band into a finished product, the manufacturer needs to assess the value of each component. According to the arm’s length rule, the price of the watchband should be the same as the company would pay on the open market from an unrelated supplier. If a similar band costs S$10 elsewhere, the watch manufacturer should set the price for the transfer of their bands at S$10 as well.
The arm's length principle is legally prescribed in Section 34D of the Singapore Income Tax Act. The rule is found as well in all of Singapore’s double taxation agreements, typically in the Business Profits Article and the Associated Enterprises Article.
Singapore IRAS monitors transactions between related parties, and where the authority determines that the pricing of such deals is not at arm's length and results in reduced profit and tax avoidance for a Singapore taxpayer, it may adjust the profit of such Singapore entity upward for tax purposes. The adjustment to reflect “arm's length” results may effectively increase the amount of income or reduce the amount of deduction (or loss) the Singapore company may claim.
To avoid breaching the arm’s length principle, you should assess your controlled transactions according to the IRAS’s 3-step approach described below.
Singapore’s 3-step approach to applying the arm's length principle
Singapore’s tax authorities advise that businesses that want to comply with the TP rules should check all their controlled transactions according to the 3-step procedure described below. Note that the recommended approach is neither mandatory nor prescriptive. A company can modify the recommended approach or adopt an alternative approach if its individual circumstances require such modifications to better arrive at the arm’s length result.
Step 1 – Conducting a comparability analysis
TP rules stipulate that an accurate independent (i.e. unrelated party) comparison for a a related party transaction must have similar economically relevant characteristics, taking into account the conditions of the transaction and the circumstances in which the transaction takes place. The transaction should be equivalent to one between independent parties in all aspects. Relevant aspects include:
The contractual terms of the transaction
Assess the contract terms, such as the price, responsibilities, and risks arising from the agreement. Not only must the written agreement be considered, but also verbal arrangements and the actual conduct of the related parties.
For example, Parent Co in Country A concluded a distribution agreement with its subsidiary, Sub Co, in Country B. Under the distribution agreement, Sub Co is to distribute Parent Co’s products and to conduct marketing activities in Country B. However, an analysis determined that all marketing activities are actually undertaken by Parent Co and Sub Co does not have the capability to perform such marketing activities; it merely distributes the products, without performing any marketing. In this situation, it can be concluded that the written agreement does not reflect the actual conduct of the parties. Such a contract structure is likely to be penalized.
The characteristics of goods, services, or intangible properties
Assess the specific characteristics of goods, services or intangible assets that play a significant part in determining their values. A product with better quality and more features would, all other
things being equal, fetch a higher price. For instance, you cannot sell original Rolex watches to a related party at the price of low-budget replicas and claim equivalence while setting the transfer price.
The functions performed, assets used, and risks assumed by the parties
When performing a functional analysis, you should assess the economically significant activities and responsibilities undertaken, assets used or contributed, and risks assumed by the parties to the transactions. Such conditions between interdependent parties should be equal to those between independent ones. For example, a trader selling microwave ovens with warranty bears higher risks than a trader selling the same ovens without warranty. Hence, the first seller, who grants a warranty, should set higher prices.
The commercial and economic circumstances of the parties
You should take into account the commercial and economic circumstances in which the related and independent parties operate. Prices may vary across different markets, even for transactions involving the same property or services. To make meaningful comparisons between related party transactions and independent party transactions, the markets and economic circumstances in which the parties operate or where the transactions are undertaken should be comparable. Such comparisons should take into account the availability of substitute goods or services, geographic location, market size, extent of competition in the markets, etc. For example, bananas in a northern country like Sweden will cost a lot more than in Thailand.
Step 2 – Identifying the most appropriate transfer pricing method
IRAS uses five internationally accepted methods for evaluating a company’s transfer prices, based on the prices adopted by independent parties in similar transactions. The choice can depend on circumstances and available data. You can apply these methods to check your transactions as well.
Comparable uncontrolled price method (CUP)
The CUP method compares the following two prices:
- The price of properties or services transferred in a related party transaction; and
- The price in an independent party transaction in comparable circumstances by the involved parties or by completely independent set of parties.
A difference between the two prices may suggest the related parties are not dealing at arm’s length. Therefore, authorities may replace the price in the related party transaction with the price of an independent party transaction. However, sometimes relevant data for use of CUP method is not available, particularly for unique one-time transactions.
The resale price method
This method is applied where a product that has been purchased from a related party is resold to an independent party. The first and the second prices are compared to determine whether the first one was fair and the series of transactions make economic sense.
Cost plus method
This method compares the cost of manufacturing and the gross markup in related and unrelated transactions. Sale prices of a product must not only cover the manufacturing costs but also generate additional profits to the company.
Transactional profit split method
This method compares how related parties split the profits and losses of the transaction depending on their relative contributions. Often, illegal schemes artificially transfer profits to low-tax jurisdictions, and, conversely, losses to the high-tax countries through contrived transactions that do not reflect the relevant economic contributions (or risk-rewards structure) for the parties involved.
Transactional Net Margin Method (TNMM)
The TNMM compares the net profit margin of a company arising from a non-arm's length transaction with the margins realized by arm's-length transactions; it also examines the net profit margin relative to an appropriate base, such as costs, sales or assets.
Step 3 – Determine the arm’s length results
Having considered one of these methods, you may apply the described arms’-length rules for related-party transactions and justify your prices to tax authorities. You must adjust the arm’s-length results annually.
Transfer pricing documentation requirements
If your Singapore company performs controlled transactions with related parties, it is required to prepare certain TP documents.
Who must prepare the documentation?
A Singapore company is required to prepare and keep the TP documentation if it meets either of the following conditions:
- Gross revenue derived from its trade or business is more than S$10 million for the tax basis period; or
- Transfer pricing documentation was specifically requested for the previous basis period.
Which documents are needed?
Your company should collect and keep the relevant documents that cover:
- An overview of the businesses of the group in which the company is a member, as they are relevant to business operations in Singapore; and
- The company's business and transactions undertaken with related parties, including functional analysis and transfer pricing analysis.
Find a complete list of requirements for documentation in the Second Schedule of the Income Tax (Transfer Pricing Documentation) Rules 2018.
When must documents be completed?
Singapore companies must complete TP documents by the filing due date of their tax return.
When must documents be submitted?
You do not need to submit the TP documentation when filing a tax return. You are, however, required to submit relevant documents within 30 days of a request for these documents by IRAS.
How long must documents be kept?
You should retain documents for at least 5 years from the end of the basis period in which the controlled transaction took place.
TP documentation exemptions
A general exemption applies when annual gross revenue of a company from its trade or business for the basis period does not exceed S$10 million or when the entity was not specifically requested to do so by IRAS.
Specific exemptions include related-party domestic transactions subject to the same tax rate, related-party transactions with value not exceeding certain thresholds, etc. The full list of exemptions is prescribed in Section 4 of the Income Tax (Transfer Pricing Documentation) Rules 2018.
Indicative margin for group loans
The IRAS has also introduced indicative margin rates for related-party loans, which companies may use to price the interest rate on such loans. The indicative margins are applied on each related-party loan not exceeding S$15 million. These margins are based on such international rate standards as LIBOR (London Interbank Offer Rate) or SIBOR (Singapore Interbank Offered Rate). If companies choose to apply the indicative margin for their related party credit, they do not have to prepare transfer pricing documentation for these loans.
The indicative margins are introduced by the IRAS for each calendar year. For instance, for 2020 this rate is the LIBOR or SIBOR rate + 2%.
2019 TP changes in Singapore
What penalties do you risk when not complying with the TP rules?
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