Malaysia: FRS 139 and its bearing on transfer pricing
COME Jan 1, the Malaysian Accounting Standards Board’s Financial Reporting Standard 139 – Financial Instruments: Recognition and Measurement (FRS 139) will finally be implemented in Malaysia. Four years since its implementation date was set, it is still considered uncharted waters for many corporations. This is not surprising since FRS 139 is considered the “mother” of all standards by some.
Under FRS 139, many financial assets and financial liabilities are required to be carried at fair value. This will have a significant impact on loans between related parties, which generally can be interest-free or carry interest rates which are well below the market rates.
The definition of fair value under FRS 139 is “the amount for which an asset could be exchanged, or a liability settled, between knowledgeable, willing parties in an arm’s length transaction”. Paragraph 48A of FRS 139 further states that “The best evidence of fair value is quoted prices in an active market … Valuation techniques include using recent arm’s length market transactions between knowledgeable, willing parties, if available … ”
Interestingly, it loosely echoes the Organisation for Economic Cooperation and Development’s guide for an arm’s length interest rate:
“… an arm’s length interest rate shall be an interest rate which was charged, or would have been charged, at the time the financial assistance was granted, to uncontrolled transactions with or between independent persons under similar circumstances.”
It could well imply that the measurement of related party loans initially at their respective fair values and subsequently at amortised cost using the effective interest method, may be deemed to be in line with the arm’s length principle since market interest rate is used.
Following the introduction of Section 140A of the Income Tax Act 1967 (ITA) which basically requires taxpayers to ensure that their related party transactions are carried out at arm’s length, would this then mean that an assessment of the fair value of related party loans by the auditors under FRS 139 can serve as contemporaneous documentation for transfer pricing purposes?
The corporate taxpayers do not have an option as to whether to accept the fair value accounting treatment in their financial statements – it is a requirement of FRS 139 and also the Companies Act 1965.
Further, requiring corporations to measure related-party loans initially at their respective fair value may not only affect the income statement. However, for certain, the subsequent amortisation amounts, measured at amortised costs, will represent accounting interest income or interest expense in the income statement. Book entries are generally not the actual receipts or payments, and in tax terms are not real costs or income earned.
At this point, it would be helpful to look at what other tax jurisdictions have done under similar circumstances. Hong Kong, Singapore and New Zealand tax authorities have issued departmental interpretation and practice notes on the income tax implications arising from the adoption of IAS 39 or its local equivalent.
While in general most tax authorities require the tax treatments to follow or be consistent with the accounting treatment under FRS 139 as far as possible, they also acknowledge that the revenue versus capital consideration would need to be considered in determining the tax treatment.
As an example, in Singapore, the tax adjustment is such that the discount on the interest-free loan recognised in the income statement will not be allowed as a tax deduction and the interest income recorded will not be taxed because these are merely book entries.
The auditor’s primary role is still that of expressing an opinion as to the true and fair view of the financial statements. This means that corporations would still need to provide auditors with supporting evidence of the fair value of the related-party loans to enable auditors to express an opinion.
The fair value measurement rests on the rebuttable presumption that effective interest rates used in the amortised cost method is the market interest rate and is thus, at arm’s length. While this is generally true, loan arrangements made with unrelated parties in the current business environment should be considered as arm’s length, although they may not carry the same market interest rates due to various factors such as level of credit risks, tenure, size of collaterals, etc.
So, what would corporations provide to the auditors? Section 140A of the ITA provides that the acquisition or supply of property or services with related parties be conducted at arm’s length, failing which the Director General of Inland Revenue may adjust the transfer prices.
Since 2003, transfer pricing guidelines have been issued, setting out the extent of information required in a transfer pricing report. The guidelines also stipulate that it is a pre-requisite that a comparable analysis (benchmarking) be carried out to substantiate the arm’s length pricing.
To ensure that corporations provide auditors with the correct arm’s length and market rate interest for related-party loans in the FRS 139 measurement of fair value, it is very likely that a comparable analysis would need to be carried out. This should then provide the setting not only for the auditors but for the tax authorities in support of the argument for arm’s length. Any fair value book entries put through the financial statements should then be met with minimum queries from the tax authorities.
● Janice Wong is tax partner and head of transfer pricing services at Ernst & Young Tax Consultants Sdn Bhd.
Source: The Star Online 11 November, 2009
India: Finance ministry may delay safe harbour rules notification
The Delhi Income-tax Appellate Tribunal (ITAT) has held that difference of opinion cannot be a ground for levying penalty in transfer pricing issues. The ITAT said there should be sufficient ground to believe that the assessee had malafide intention before levying a penalty under section 271 (I) (C) of the Income-tax Act. The ITAT decision, given in October 2009, was on an appeal filed by Vertex Customer Services, which runs a call centre.
The company incurred a loss of Rs 4.3 crore after making adjustments for cost of first year operation, cost of excess capacity and a provision of doubtful debts towards sum due from the parent company. The adjustments were on the premise that these are extraordinary costs that need to be excluded while estimating arm’s length price under transfer pricing regulations.
The transfer pricing officer, however, rejected the third adjustment on the premise that provision for doubtful expenditure could not be construed extraordinary in nature. On this ground a penalty was levied on the company. Explanation 7 to section 271 (I) (C) of the Income-tax Act provides that in the case of an assessee, who has carried out a cross-border transaction, the amount added or disallowed be deemed to represent income in which particulars have been concealed or inaccurate particulars furnished unless the assessee shows that that income was calculated in good faith and with due diligence.
Vertex moved the first appellate authority, the commissioner (appeal), which allowed the appeal, holding that the company had disclosed the full facts of the transaction and the adjustment was only on account of difference of opinion and therefore penalty could not be levied on the transaction.
Following this, the income-tax department moved the ITAT. The tribunal too dismissed the levy of penalty and observed that there can be more than one opinion on the issue of whether provision for bad debt is to be classified under ordinary item or extra ordinary item.
It cited the Supreme Court decision in the case of Hindustan Steel to hold that penalty under 271 (I) (C) cannot be imposed where there is only a difference of opinion. Moreover, penalty is warranted only if assessee’s intention is proved malafide.
Source: Economic Times 10 November, 2009
Hwuason Lawyers Urges Companies to Heed Transfer Pricing Deadline
China’s first tax law firm has taken the unprecedented step of urging companies to pay attention to the 31 December 2009 transfer pricing deadline in order to avoid adverse penalties from the Chinese taxation authorities. Liu Tianyong, Managing Partner of Hwuason Lawyers, China’s first specialist tax law firm, has reiterated, in a series of speeches given over the last month, the need for companies to take a cautious approach to the new transfer pricing documentation requirements. The new documentation requirements have arisen out of two separate pieces of regulations issued by the tax authorities this year; the Implementation Measures for Special Tax Adjustments (Trial) and Circular No 363 entitled “Strengthening the Monitoring and Investigation of Cross-Border Related Party Transactions, Guo Shui Han [2009] No 363) (“Circular 363”)
“2009 is the first year for compliance with China’s new transfer pricing provisions and under the relevant transitional arrangements the deadline for submitting contemporaneous documentation in accordance with those provisions is 31 December 2009” Liu said. Not all companies are required to submit such documentation but it is important for all companies to ascertain “whether they fall within the category of companies that are compelled to submit documentation” noted Liu. Unfortunately, in Liu’s experiences, many companies do not fully understand the implications of the new requirements, or have not taken them seriously, which threatens to place these companies in a very precarious position come the end of the year. Many companies do not also appreciate the amount of time required to prepare the requisite documentation. “Some clients have told me that they will wait until December to start” comments Liu with a smile.
Double taxation threats for multinationals
Taxand, the world’s largest independent global network of specialist tax advisors to multinational businesses, today warns that multinational companies could be at risk of double taxation.
Taxand also warns that in extreme cases multinationals face investigation as tax authorities worldwide seek to prevent revenue loss through the implementation and enforcement of transfer pricing regulations.
Taxand has co-authored, with the IBFD, a comprehensive guide on Transfer Pricing to help multinational companies deal with the complex tax issues sparked by the recent widespread restructuring across the world.
The onset of recession brought widespread business restructuring, swiftly followed by a raft of transfer pricing issues for multinational companies scurrying to rationalise supply chains and maximise synergies.
This, often cross border, deployment of functions and transfers of valuable intangibles has meant that transfer pricing has become one of the most important issues facing these companies today.
Antoine Glaize, Head of Transfer Pricing at Taxand, said:
“Companies are facing a reduction of their taxable profits in these difficult economic times. Further changes in structure, as the global economy starts to recover, means multinationals could be at risk of double taxation or, worse still, investigation as tax authorities worldwide seek to prevent revenue loss, through the strict enforcement of transfer pricing regulations.”
Taxand experts believe that in the post credit crunch world commercial transactions between different parts of a multinational group may not be subject to the same market forces shaping relations between two independent firms, bringing consequences for the division of tax revenues between governments.
The need for help is even greater since the OECD introduced further changes in September to its guidelines – “OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations” – the official text of which is incorporated within the guide along with information provided by Taxand specialists on transfer pricing in 29 countries.
Glaize added:
“Keeping up to date with transfer pricing regulatory change worldwide is a big challenge for all multinationals, made worse by the rapid onset of recession and then the subsequent impact on groups’ consolidated and affiliates’ profit. Effective and secured international transfer pricing policy is essential to guide companies through this maelstrom, especially as we witness the divergence of transfer prices from the observable market, a situation that is sure to draw attention from tax authorities looking to ensure they get their share of international profits.”
Source: Director of Finance Online 3 November, 2009
Surviving Tax: How to Face the Complexities of Tax in Europe
Complexities and opportunities seem to multiply constantly when it comes to tax. Trying to address an ever changing tax environment, changing regulation and legislation, and pressures to be more transparent and commercially viable are taxing taxation executives. Patrick Ellingsworth, the Chairman at the marcus evans European Tax Summit 2010 in France, 7-9 March 2010, shares his thoughts on the challenges facing tax executives, how they can minimise their exposure to tax risks and the latest developments in transfer pricing.
What are the most prominent tax issues in Europe at the moment?
Pat Ellingsworth: I think there are three sets of issues in Europe right now; the first relates specifically to the European community and whether or not it is going to go forward with the common consolidated tax base. I don’t think that is directly affecting businesses much right now, but it will in the future so companies have to pay attention to it.
The most immediate issue right now is transfer pricing. It’s a bit odd, because if the common consolidated tax base comes into play, transfer pricing will be of less consequence. But right now it’s a major consequence, because the various rules of the European countries, as well as those outside Europe, are not yet coordinated enough. As a result tax executives have been spending a lot of time on the documentation of transfer pricing, as well as trying to determine what kind of transfer pricing policy works in the current environment.
The third issue is tax rates, and the impact of the financial crisis on national budgets and whether or not there’s going to be a significant increase in the tax rate applicable to either value added tax or income tax to fill the budget gap.
What are the top tax risks in Europe, and how can tax executives minimise their exposure to them?
Pat Ellingsworth: Globally, the biggest risks relate to the increased coordination by tax administrations. The second risk is increasing detail behind the various tax rules that tax executives need to deal with, and those rules differ by jurisdiction.
The first risk relating to increased coordination, you see the impact of it in the exchange of information practices of the countries, but for business, that is of lesser consequence than the mere fact that the tax authorities are exchanging information about tax planning techniques. That I think has enabled a number of tax authorities, particularly in Europe, to better understand how taxpayers have been structuring their businesses worldwide to minimise taxes. And that exchange of information and coordination of techniques by the tax administrations has made it more difficult for taxpayers to know what works and what doesn’t work. I think the principal technique for dealing with this on the part of taxpayers is to engage very actively with the tax authorities in order to be able to really know what they’re concerned about and what are the matters they’re coordinating with the other jurisdictions. So that when you do have a dispute, you can know better what approaches to take in order to resolve that dispute, and also know more in advance what areas of emphasis the tax authority is going to have in connection with an audit. Exchange of information with tax authorities is generally a good idea, as long as the tax administration is forthcoming with respect to their perspective as well.
The other risk is what I call the “US risk”; the US has for a long time had very detailed tax rules on just about everything, and that practise has been taken up by a number of other jurisdictions in Europe, particularly the UK. They are each adding their variation to the rules, and as a result, if you’re trying to plan something globally, you’re faced with not just general rules that are different, but very specific rules that are very different from jurisdiction to jurisdiction. That makes it difficult for taxpayers to plan their affairs. Depending on the size of what it is that the taxpayer is doing, that means that they have to have more advisors, specific to each jurisdiction they’re dealing with.
What are the major developments in transfer pricing at the moment?
Pat Ellingsworth: The major one is the increased emphasis by the tax authorities on documenting transfer pricing positions in advance. If you don’t have advanced documentation of your transfer pricing position, that is held against you in an audit. I know there has been a group of large adjustments proposed by tax authorities against taxpayers, solely on the grounds that the taxpayer did not file the documentation at the time that the audit commenced.
What are your projections for 2010? What upcoming tax related developments do you expect or predict?
Pat Ellingsworth: I think two areas are going to be the major topics for discussion in 2010; one relates to permanent establishments. Permanent establishments are portions of a company not in its resident country, but operating in another country, and to determine whether or not they’re taxable in that other country and if they are taxable, what is the competition of the income. The reason I think that’s going to be a significant area is that the OECD has two major projects dealing with that in particular, and they’re both likely to be finalised in 2010 and to cause companies to have to adapt their practises to deal with the new rules, particularly the rules relative to the attribution of tax.
The second area of development I think that there’s going to be a lot of continued work on, is value added tax. I think that Europe finally is looking at whether or not the cross-border rules it has are very well coordinated and whether they’re efficient overall. And there is a major project at the OECD about guidelines for value added tax and better administration of the value added tax that I think will be a major area of work in 2010. For companies, I think this is especially welcome as the administration of the value added tax is a very expensive proposition and the ability to administer it more efficiently is going to significantly improve cost structure.
OECD releases a proposed revision of Chapters I-III of the Transfer Pricing Guidelines
On 9 September 2009, the OECD released for public comment a proposed revision of Chapters I-III of the Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations (hereafter “TPG”). This follows from the release in May 2006 of a discussion draft on comparability issues and in January 2008 of a discussion draft on transactional profit methods, and from discussions with commentators during a two-day consultation that was held in November 2008.
This represents an important update of the existing guidance on comparability and profit methods which dates back to 1995. The main proposed changes are as follows:
– Hierarchy of transfer pricing methods: In the existing TPG, there are two categories of OECD-recognised transfer pricing methods: the traditional transaction methods (described at Chapter II of the TPG) and the transactional profit methods (described at Chapter III). Transactional profit methods (the transactional net margin method and the profit split method) currently have a status of last resort methods, to be used only in the exceptional cases where there are no or insufficient data available to rely solely or at all on the traditional transaction methods. Based on the experience acquired in applying transactional profit methods since 1995, the OECD proposes removing exceptionality and replacing it with a standard whereby the selected transfer pricing method should be the “most appropriate method to the circumstances of the case”. In order to reflect this evolution, it is proposed to address all transfer pricing methods in a single chapter, Chapter II (Part II for traditional transaction methods, Part III for transactional profit methods).
– Comparability analysis: The general guidance on the comparability analysis that is currently found at Chapter I of the TPG was updated and completed with a new Chapter III containing detailed proposed guidance on comparability analyses.
– Guidance on the application of transactional profit methods: Proposed additional guidance on the application of transactional profit methods was developed and included in Chapter II, new Part III.
– Annexes: Three new Annexes were drafted, containing practical illustrations of issues in relation to the application of transactional profit methods and an example of a working capital adjustment to improve comparability.
Interested parties are invited to submit comments (in Word format only) by 9 January 2010 to Jeffrey Owens, Director, CTPA (jeffrey.owens@oecd.org).
Proposed revision of Chapters I-III of the Transfer Pricing Guidelines
Also available: Proposition de révision des chapitres I-III des Principes en matière de prix de transfert
KPMG Flash News: Since the income attributable to the PE of a non resident engaged in the business of computer reservation system was less than the remuneration paid to the distributor, no further income was taxable in India
Recently, the Delhi Income-tax Appellate Tribunal (the Tribunal) in the case of Sabre Inc. ruled on the taxability of the income earned through Computer Reservation System in India. The Tribunal after following the decision of the Delhi High Court in the case of Galileo International Inc held that since the income attributable to the Permanent Establishment in India was less than the remuneration paid to the distributor in India by the taxpayer no income was taxable in hands of Sabre Inc.
From CFO Magazine: Transfer Pricing: A World of Pain
From CFO Magazine:
Yet another unwelcome side effect of the global recession: hungrier international tax authorities. Experts say that officials in previously tax-friendly countries, including China and India, are looking to fill their coffers by extracting more from U.S.-based multinationals. Among their favorite areas to probe: transfer pricing, or the pricing of sales between subsidiaries and subsequent allocation of taxable income among various countries. Long a focus of the U.S. Internal Revenue Service, transfer pricing is “the lowest-hanging fruit, because it’s very subjective and most companies don’t have adequate documentation to back up their assertions,” says Larry Harding, CEO of High Street Partners, an international business-expansion consultancy.
Changes are perhaps most dramatic in China, where foreign businesses enjoyed favorable treatment (even surpassing that of local companies) until last year. In January, China’s tax authorities issued new rules requiring foreign multinationals to submit extensive transfer-pricing documentation by year-end. More recently, they circulated a notice to local tax authorities urging rigorous enforcement on a variety of business-tax issues, including transfer pricing. “A lot of U.S. companies will be exposed,” predicts Harding.
China is hardly alone. “There’s an explosion of transfer-pricing controversies out there,” says Garry Stone, global transfer-pricing leader for PricewaterhouseCoopers. The number of such disputes among his clients doubled over the past year, he says, with India, Canada, Turkey, and Greece among those bringing more scrutiny to bear. The areas that often lead to controversy include intellectual-property values, costs of back-office functions, and losses of any type, he says.
Meanwhile, the IRS is maintaining its aggressive approach to transfer pricing. The agency recently fought through the courts to force semiconductor company Xilinx to allocate stock-option expenses to its Irish subsidiary, boosting the company’s U.S. tax bill by about $40 million and leading many other tech firms, including Apple, Cisco, and Cadence Design Systems, to take additional income-tax expenses. Stone says he understands that the IRS is adding 1,200 people to its international staff this year; the 2010 budget calls for another 800.
How to cope? Stone says more companies are seeking advance pricing agreements in which a company gets preapproval for its transfer-pricing methodology from tax authorities. Failing that, updated documentation and clear explanations of methodologies are critical. Despite such efforts, in some cases it may be impossible to avoid a penalty. “Even if you have the documentation and it is perfect, it could be challenged,” says Harding. “A lot of governments go in there planning to get something.”
Source: CFO Magazine 1 September, 2009
New Transfer Pricing Regulations on Overseas Royalties Released
Local tax bureaus around the country are scrutinizing outbound royalty payments to related parties overseas, in response to Circular No.363, “Notice of SAT on Reinforcing the Monitoring and Investigation of Cross-Border Related-Party Transactions.”
This circular requires that loss-making, single function entities prepare transfer pricing documentation for the years in which they incurred losses and to submit this to their local tax bureau before the 20th of June of the subsequent year, regardless of transaction amount.
Tax authorities will also be monitoring taxpayers’ outbound payments to their related parties overseas, especially for royalty payments for services such as use of trademarks, patents and similar billable items.
This practice has been more noticeable within the industries of: contract manufacturing, distributors, contract research and development services. It is recommended that companies involved in providing royalty payments for services rendered by related parties, or the parent company for example, prepare full supporting documentation to anticipate possible requests for clarification from the local tax bureau.
Source: China Briefing 1 September, 2009
