Costly transfer pricing pitfalls: What are the common mistakes made by Malaysian companies?

MAY 24 — With the recent tightening in transfer pricing (TP) requirements and increasing tax audit activity in Malaysia, this is a good time for Malaysian companies to review and improve their TP practices.

TP is a tax concept which requires group companies to transact at market prices with one another, similar to transactions between independent companies. Since 2009, Malaysia has TP rules in place, which require companies to prepare TP documentation to demonstrate the arm’s length nature of their intercompany transactions (also referred to as “controlled transactions”), such as sale of goods/services, licensing of intellectual property, etc. Penalties are applicable for non-compliance of TP rules.

Even though TP rules have been in place for more than 10 years in Malaysia now, there are several common mistakes made by companies when it comes to TP compliance. Given that TP is not an exact science and that TP issues are often complicated in nature, these mistakes could be costly for taxpayers if not managed properly. Let us now explore a few of these common mistakes:

Delay/failure in preparing TP documentation

In line with Malaysian TP rules, TP documentation must be prepared when the taxpayer is developing or implementing any controlled transaction, and updated prior to the filing due date of the corporate tax return (seven months after the financial year end) where there are material changes to the controlled transaction. As such TP documentation complies to the level of timeliness required by law, it is also termed as “contemporaneous TP documentation”.

Unlike the corporate tax return, TP documentation does not need to be submitted unless the IRB requests for it in the event of a tax audit (which usually takes place several months after the submission of the company’s tax return, at the earliest).  In practice, preparation of TP documentation is an expensive and often lengthy exercise, with many taxpayers not having the ability to undertake this task in-house.  Hence, taxpayers may take a reactive approach by postponing the preparation of TP documentation until an audit is triggered by the IRB. 

However, taxpayers which take a reactive approach end up facing increased risks with the recent introduction of more onerous penalty provisions, which are aimed at increasing the level of TP compliance in Malaysia.  In light of the following provisions, which were effective from January 1, 2021, taxpayers should re-evaluate their priorities when it comes to TP documentation.

Furnishing TP documentation

Taking a “wait-and-see” approach would certainly be more risky with the new penalty provisions, taking into account the following:

A 14-day timeframe may be too short to prepare a robust set of TP documentation, especially if the nature of controlled transactions is complex and issues are present;

The IRB is able to audit up to seven years of assessment at any point in time, and hence, penalties for failure to produce TP documentation could go up to RM140,000 in a tax audit (based on the minimum penalty of RM20,000 per year); and

There are currently no exemptions or concessions for small and medium-sized enterprises (“SMEs”).  As such, SMEs are facing the same TP risks as larger taxpayers, in this aspect.

Failure to comply with the arm’s length principle

In the past, penalty rates were tied to additional tax payable.  Hence, many taxpayers which are not in a tax payable position (e.g. loss-making companies, companies which are granted tax incentives and not required to pay income tax) gave less priority to the preparation of TP documentation, given that TP adjustments proposed by the IRB would not give rise to additional tax payable.

With the new penalty provisions, it becomes more crucial for these categories of taxpayers to pay attention to their level of TP compliance, given that penalties could still be imposed even if tax audits ultimately do not result in additional tax payable.

Inconsistent/poorly prepared TP documentation

TP documentation should be prepared in accordance with requirements set out in prevailing TP rules in Malaysia. Many companies do not have personnel which specialise in TP matters and may struggle when preparing the documentation, in terms of determining the level of details required and content of the documentation.

Key areas to focus on include the following:

a) Pricing policy applied — manner in which pricing policy of the business is determined (such as pricing formula, cost components, profit margins applied, etc).

b) Functions, assets, risks (“FAR”) profile — ensuring that the FAR profile of the taxpayer is accurately explained as the FAR profile is the basis for determining the appropriate level of returns earned by the taxpayer (e.g. limited risk entities which perform limited functions and bear limited risks typically earn a lower margin).

c) If the taxpayer records a loss for a financial year, it is important for the taxpayer to explain in the TP documentation as to the reasons for the loss (eg external market factors, production inefficiency) and justify that such a loss is not due to transfer prices. From a TP perspective, an independent business would not generally operate in the longer term if it sustains persistent losses.

Inability to justify payments made for centralised or shared services

For groups of companies, it is typically more cost-efficient for corporate functions to be centralised within a company, with the company providing corporate services to other companies in the group (“recipient companies”). The challenge for businesses, however, lies in proving that these services meet the arm’s length standard.

In practice, certain businesses may have the understanding that a service agreement which documents the centralised services provided by the service provider to the recipient companies and the consideration for the services is sufficient.  However, from a TP perspective, the requirements are more onerous.

The following points should be considered from a TP perspective:

a) A service agreement is not sufficient to prove arm’s length.  Given that the provision of centralised services is a type of controlled transaction, TP documentation should be prepared to demonstrate that the transactions are carried out at arm’s length.

b) The IRB may request for evidence of services rendered in the event of an audit.  Hence, relevant documentation (e.g. reports, meeting memos, other deliverables) should be maintained to prove that the services rendered directly benefit the recipient companies.

As TP adjustments can be significant in terms of value and audit activities are expected to remain high in time to come, companies should not underestimate the additional costs which they may be exposed to if TP issues are not managed effectively.

Given the constantly evolving TP requirements in Malaysia, companies should keep abreast of legislative changes and prevailing IRB practices so as to maintain an appropriate level of TP compliance. A higher level of TP awareness also helps businesses to develop a more optimised TP approach and better defend its TP positions during an audit.

Source: Malay Mail