THERE is a general perception that transfer pricing is largely confined to multinationals which trade across borders, and therefore this is an international tax issue that does not affect domestic companies undertaking purely domestic transactions.

Domestic groups do not pay much attention to transfer pricing on the assumption that the group as a whole is paying taxes. Therefore, transfer prices between the related parties domestically should not be an issue.

The above assumptions are incorrect. Transfer pricing covers domestic transactions.

With the introduction of the surcharge up to 5% of any adjustments made to the transfer prices, it will be foolish of the domestic companies to ignore transfer pricing because the introduction of the surcharge is an exception in the Income Tax Act where penalties are only imposed on any additional taxes. When it comes to transfer pricing, there need not be any additional taxes for the surcharge to kick in. The difference here is the surcharge will be imposed on the gross adjustment, and not on the additional taxes.

The ultimate requirement of the Inland Revenue Board (IRB) in transfer pricing is meeting the arm’s length test. The arm’s length test requires the taxpayer undertaking the transfer pricing transaction to prove that the transaction is comparable to a transaction undertaken between two or more independent third parties under similar circumstances.

Domestic companies treat the arena of transfer pricing and preparation of transfer pricing documentation very lightly. In many cases, the transactions do not meet the arm’s length test, and the transfer pricing documentation remains silent on this point. Silence is not golden here but will be expensive if not addressed properly.

Where is the abuse?

There are many opportunities to transfer profits to tax shelters in Malaysia such as groups with companies/operations enjoying tax incentives such as pioneer status, investment tax allowance, Malaysia Digital incentive, Bionexus status incentive, special region incentives, halal incentives, etc. Similarly, tax shelters can also be found where there are companies/operations in the group with tax losses, excess unutilised capital allowances, unutilised investment tax allowances, different tax rates such as petroleum income tax at 38% versus corporate income tax at 24% versus SME tax rates from 15%, 17% and 24%.

There is a tendency for the groups to use transfer pricing to move profits into these tax shelters without meeting the arm’s length test.

How to defend challenges by IRB?

There is nothing wrong in moving some of the profits within the group to companies/operations with tax shelters provided that the taxpayer is able to show that the profits are equivalent to the value created by the companies/operations enjoying the tax incentives. This must be clearly evidenced with the necessary supporting documentation such as agreements, underlying documents such as invoices, purchase orders, bench marking against similar transactions undertaken by third parties under the same conditions.

In order to support the value creation in the tax shelters, there must be substance in the form of people, activities and assets, and there must be clear demarcation of the risks and functions undertaken by the relevant parties. The heavy burden of proof lies with the taxpayer. Comparable data and information from the marketplace must be used to defend the arm’s length nature of the transactions.

The preparation of the transfer pricing documentation in anticipation of any transfer pricing audit by the authorities should be taken seriously and should meet the comprehensive requirements of the transfer pricing rules and guidelines.

The task of convincing the IRB that the transactions meet the arm’s length test when taxpayers are using tax shelters is not easy because the IRB will come up with counter-arguments that excessive profits have been allocated to the tax incentivised entity or operations.

Ultimately, the cost of mispricing although a group may already be in an overall tax paying position will not save them from the surcharge if there is any adjustment to the transfer prices.

This article is contributed by Thannees Tax Consulting Services Sdn Bhd managing director SM Thanneermalai (