Covid-19: How to manage transfer pricing risk?

SEPTEMBER 28 — As we near the end of 2020, many countries remain on high alert due to the Covid-19 pandemic. To contain spread of the virus, many countries still have varying forms of lockdowns in place, be it more targeted or country-wide restrictions imposed on their citizens, depending on how widespread the pandemic is within the country.

Malaysia is no different, with the government implementing various types of lockdowns, starting from March 2020. With the country currently in the recovery phase of the movement control order (MCO) stage until end of 2020, most companies have adapted to the “new normal” to varying extents.

Many companies are still struggling to revive sales, reduce operating costs and manage cash flow issues. Among the worst hit industries are the tourism and retail segments, but most other ndustries have also been affected due to large scale supply chain disruptions, as well as significant drop in consumer and industrial demand for products and services.

Amid the lingering challenges faced by companies in staying afloat during this tough period, companies must not forget to ask this ever-important question — how do I manage my company’s transfer pricing risks arising from this pandemic?

Transfer pricing rules, which require transactions among group companies to be carried out at arm’s length, remain in place in Malaysia. In short, transfer pricing is a tax concept where companies operating within a group are required to transact with one another at market prices, similar to how independent companies transact with each other.

Tax audit activity in Malaysia has largely resumed in the last few months, be it in the form of desk or field audits carried out by the Inland Revenue Board (IRB). Hence, taxpayers must manage transfer pricing risks carefully as there are various business, reputational and financial implications involved.

Let’s look at a few best practices for companies in managing transfer pricing risks:

Preparing contemporaneous transfer pricing documentation

Transfer pricing documentation is required for each company which enters into intercompany transactions in order to demonstrate arm’s length nature of such transactions, be it sale of goods/services, licensing of intellectual property, etc.

The documentation needs to be maintained on an annual basis, and should be ready by the time that the company files its tax return for the year of assessment (usually seven months after the financial year end).

Companies typically have to rely on multiple year data in preparing benchmarking studies, in order to prepare contemporaneous transfer pricing documentation. For example, data for financial year 2020 is not available right now and will likely only be available from 2021 onwards, at the earliest.

Since financial results for financial year 2020 are less likely to be favourable due to effects of the pandemic, comparison against preceding financial years’ results may reflect an inaccurate picture of the arm’s length nature of a company’s results.

This also increases the need for companies to emphasise the negative impact of commercial and economic challenges on their financial results during financial year 2020. This burden of proof may be less so if the company is able to update the benchmarking study once the data for financial year 2020 is available.

Given that companies would not be able to compare their financial results with that of comparable companies on a year-on-year basis until much later, preparation of transfer pricing documentation becomes even crucial in order to document and quantify the impact of this extraordinary event on companies’ financial results.

The documentation should also contain details of new related party transactions, changes in existing related party transactions and/or changes in transfer pricing policy, among others.

Documenting possible Covid-19-related factors which can be attributed to the company’s losses/low profitability

Certainly, the pandemic is an extraordinary event which no business could have ever predicted nor adequately prepared for. Many companies in Malaysia are forecasted to either incur losses or record significant drop in margins in relation to their operations due to Covid-19.

While it is inevitable that Covid-19 will affect profitability of most companies to some extent, companies which enter into related party transactions are still expected to ensure that transactions are conducted on an arm’s length basis. In short, pricing of these transactions should commensurate with the goods or services rendered.

Hence, it is important for companies to identify factors related to Covid-19 which can be linked to the company’s losses/low profitability.

Losses incurred by companies must be supported by legitimate business and operational reasons, as well as adequate documentation. This is even more crucial where the Malaysian company has significant cross-border related party transactions, to sufficiently address concerns on profit allocation across the group.

There could be various business and operational challenges such as delivery disruptions of key raw materials, decrease in contracts/new projects awarded and inability to service the company’s debts.

Where possible, companies should segregate and analyse their financial results by period (pre, during and post Covid-19 periods) to demonstrate that any losses suffered are primarily due to the pandemic.

In Malaysia, businesses were not allowed to operate during the lockdown in March and April, with gradual opening up of businesses from May onwards.

Businesses may incur exceptional expenses during the pandemic and post-pandemic period, such as compensation paid to customers due to delivery delays, bad debts written off, retrenchment and cleaning/sanitation expenses etc.

Other factors which contributed to the losses, such as discounts provided to customers, should also be documented and supported by commercial and/or business reasons (e.g. strategy to retain customers).

Each company’s approach may be different and should take into account the operating conditions which may be unique to their industry, but the key message in the documentation should be crystal clear — that the company’s losses, whether quantifiable or not, are exceptional in nature and would not occur under normal operating conditions, regardless of type and quantum of related party transactions undertaken.

Managing interest-free financing arrangements

Interest-free arrangements are typically not acceptable to the IRB as a group company lending funds to another group company is required to charge market interest rates.

Despite this, companies may have no choice but to implement such arrangements during the Covid-19 period to help cash-strapped related companies alleviate their cash flow problems.

Companies which choose to implement interest-free arrangements will face an uphill battle in terms of justifying such arrangements.

At the very least, companies should ensure that the interest-free period is not perpetual. There ideally should be a start and end date for the arrangement.

However, companies should be mindful of the fact that even if interest-free arrangements are indeed temporary in nature, the IRB could still reject such arrangements and seek to tax companies based on the deemed interest income.

These are just a few key questions that businesses must start asking and addressing in a proactive manner, from a group-wide and local level. It will likely be a case of “a little too late” if companies take a wait-and-see-approach instead, given the varying level of complexities involved in tax audits with the IRB.

This is not easy, but companies which are able to achieve this feat should be in a better position to defend their transfer pricing positions. While most countries continue to ride out this pandemic, addressing these questions upfront can provide companies with some peace of mind that their transfer pricing risks have been effectively managed.

Source: Malay Mail

About the Author:

Sarah Chew

Sarah Chew
Executive Director

[email protected]

For more information, please contact:

Celine See
Tricor Services (Malaysia) Sdn Bhd
Director, Business Development

Tel: +6 03 2783 9191
Email: [email protected]

For other Tricor services, please email to [email protected] or visit to www.tricorglobal.com

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