Transfer pricing is the price that related parties transact goods, service and intangibles between them. Related parties could be of two sorts: Either one of them directly or indirect controls the other such as in the case of branches or head offices, or both are under a common control party such as in the case of 2 subsidiary entities having a common parent company.
A brief illustration of the use of transfer pricing would be in the scenario involving two related parties, Entity A and Entity B. Entity A manufactures Good A which is used by Entity B in the production of a finished product B. The price that Entity A sells Good A to Entity B is known as the aforementioned transfer price, which to Entity B is also its cost of goods that it can either choose to purchase from Entity A at transfer price or from the open market at the market price.
Transfer price is used for accounting purposes when these related parties of the same business are evaluated separately for profit and loss. The transfer price is usually set to a price that is close to the prevailing market rate, as too large a difference would lead to one of the parties being at a disadvantage and hence better off buying from the market itself. However in Singapore, the price set also has to follow certain guidelines set by the Inland Revenue Authority of Singapore (IRAS) which ensures that the prices set by related parties are fair. IRAS controls these related parties transactions in Singapore as well as those transactions operating outside of Singapore.
IRAS endorses the Arm’s Length Principle as the standard guide, which is an internationally accepted standard of transfer pricing. This is to ensure that profits are taxed where the actual economic activities generating these profits are performed.
Arm’s Length Principle
The Arm’s Length Principle is one that ensures proper transfer prices are established between related parties, such that transfer prices for goods and services are equivalent to prices that unrelated parties would charge in same circumstances. This involves the need to compare the transaction between related parties to similar situations undertaken by unrelated parties.
For example, with reference to the previous case, Entity A manufactures Good A which is used by Entity B in the production of a finished product B. According to the Arm’s Length rule, the price of Good A sold to Entity B should be the same as what the company would pay in the open market. If the same or similar Good A costs $100 in the market, then Entity A should also set their transfer price of Good A to $100. Thus, the manufacturer of Good A has to compare the value of Good A to determine its transfer price.
Transfer prices are closely monitored for accuracy within the company’s financial reporting so that profits of the company are made appropriately within the Arm’s Length rule and the taxes associated are paid correctly. If financial statements are found to be inaccurately documented or made to illegally reduce the reported profits in Singapore, IRAS will impose an increase in the taxable profits. This would lead to the company facing additional taxation, interest and penalties.
Three Step Approach to Apply the Arm’s Length Principle
To avoid breaching the Arm’s Length Principle and to correctly match transfer prices to that of the open market, IRAS recommends that taxpayers follow a three step “comparability analysis” to apply to transactions between related parties.
Step 1: Conduct Comparability Analysis
This beginning step ensures that transactions are compared and examined based on the following 4 aspects and that the company makes adjustments for the differences to come up with an appropriate transfer price.
- Terms of the transaction
- Characteristics of the goods, services or intangibles
- Functional analysis
- Commercial and economic circumstances
IRAS also requires that consideration of other relevant aspects should be taken into account for an accurate assessment, such as:
- The evaluation of transactions on a separate or aggregate basis
- Using data of multiple years
- Considering losses
- Selecting internal and external comparables (such as commercial databases, comparables with publicly available information, non-local comparables etc.)
Step 2: Identify the most appropriate transfer pricing method
- Traditional transaction methods (Comparing prices):
- Comparable uncontrolled price method (CUP)
- Resale price method (RPM)
- Cost plus method (CPM)
- Transactional profits method (Comparing profits):
- Transactional profit split method (TPSM) – Residual analysis or Contribution analysis
- Transactional net margin method (TNMM)
Step 3: Determine the arm’s length results
Transfer Pricing Documentation
Taxpayers who have a gross revenue of their business activities exceeding $10 million or those who require transfer pricing documentation to be prepared for the previous basis period have to ensure that they have kept and prepared all necessary documents relating to their related parties’ transactions. The documents prepared have to contain information as required in the Income Tax Rules 2018, including a relevant Singapore operations overview of the businesses of the group that the taxpayer is a member of. It also has to include the taxpayer’s business transactions with its related parties. There are exemptions from the document requirements such as related party domestic transactions with the same tax rate and transactions with value not exceeding specified amounts. The full list of requirements and documentation exemptions can be referred to in the Income Tax (Transfer Pricing Documentation) Rules 2018.
These documents have to be prepared by the filing due date of the tax return, but need not be submitted unless requested by IRAS, for which then the business has 30 days to submit the transfer pricing documents. However, even as transfer pricing documents do not always need to be presented, it should be retained for a period of at least 5 years from the end of the basis period.