Transfer pricing and shifting taxes
May 13, 2009
By Nicolaos Giannopoulos
(Published in’Campus & Beyond’, a weekly column written by Swinburne academics in the Borneo Post newspaper)
To speed up the economic development of Malaysia, the government has opened its domestic market and invited multinational companies (MNCs) to come to Malaysia to do business. In exchange, MNCs provide Malaysia with much needed capital investment, management and technical expertise and jobs, with the ultimate aim of making a profit.
These profits in return generate tax revenues for the Malaysian government. In fact RM34 billion was paid in taxes by Malaysian companies and foreign MNCs in 2008.
Yet if the Malaysian government is to maintain and rely upon tax revenues from MNCs, they need to keep a vigilant watch of a practice known as transfer pricing.
What is transfer pricing? It is simply the price one company charges another related company for a supply of goods or services: a related company being a company which has more than 50% of its capital owned by another company.
When two related companies transact across international borders, the transfer price charged between the two can affect the amount of taxes collected by the Malaysian government. That is because a transfer price can shift pre-tax profits from Malaysia to another country, resulting in lower tax revenues for the Malaysian government.
For example, say a Singapore company is invited to invest and conduct business in Malaysia. It establishes a Malaysian subsidiary company in Kuala Lumpur which buys car parts from its parent company in Singapore for RM300 million. The Malaysian company markets and sells the car parts in Malaysia for RM500 million and makes a profit of RM200 million. It pays Malaysian company tax at 25%, RM50 million in taxes to the Malaysian government.
For the Singapore parent company, if it cost them say RM200 million to manufacture the car parts, then their profit is RM100 million. With a company tax rate of 17% in Singapore, their tax bill is RM17 million. The two related companies’ total tax paid is RM67 million and total after tax profit RM233 million.
But what if the Singapore parent company wanted to minimize the group’s tax bill and maximize profits? It could do this by simply selling the car parts at an inflated price to the Malaysian company, say RM450 million (instead of RM300m). In this scenario the Malaysian companies profit is now RM50 million and Malaysian tax paid only RM12.5 million (a loss of RM37.5 million to the Malaysian government in tax revenue).
In this instance, the Singaporean parent company has made a profit of RM250 million and pays RM42.5 million in taxes to the Singapore government. Now the group’s total tax paid has been reduced to RM55 million (instead of RM67 million) and total profit after tax increased to RM245 million (from RM233 million). The group as a whole has saved RM12 million in taxes on this one transaction.
What the related companies have managed to do is to shift the groups’ profits from high tax (25%) Malaysia, to lower tax (17%) Singapore, by lowering the amount of profit taxed by Malaysia. This is achieved by the simple manipulation of the transfer price. From the Malaysian government’s perspective, tax revenue which should have been theirs has been ‘shifted’ to the Singapore Treasury.
In an effort to counter the practice of transfer pricing, the Malaysian government has issued transfer pricing rules. The aim of these rules is to ensure an accurate amount of profit and fair amount of tax is paid in Malaysia by multinationals. These rules outline five acceptable methods which can be used by multinationals to price a transaction between related companies. These methods, in a nutshell, aim to apply a transfer price equal to prices charged by unrelated companies in similar type transactions of goods and services.
But when unique companies transact in unique goods and services, how can the transfer price be compared and valued with other transactions and companies? Take for example a recent Australian tax case involving the Swiss based pharmaceutical giant Roche. Roche had established activities in Australia through an Australian subsidiary company. The Australian subsidiary sold in Australia pharmaceutical products purchased from the Swiss parent company. After an Australian Tax Office (ATO) audit of related company transactions, the ATO decided that prices paid by the Australian subsidiary to purchase the parent company’s products were too high. The effect was that the company’s Australian profit and tax were minimized.
The Australian company conceded that the prices paid to its parent for these products were excessively high. But neither party could (or would) agree as to an acceptable transfer price. The ATO imposed a A$126 million increased tax adjustment but Roche did not agree with the transfer prices as valued by the ATO, so both parties went to court.
In trying to determine fair transfer prices, the ATO had to compare the prices charged between the related companies and prices charged in similar type transactions between unrelated parties. But when you are a company with the sole patent for a product such as Valium and only sell, market and distribute this product in Australia through your related company, how can comparisons be made? No other company produces a like product which it also markets and distributes in Australia. In this case there were no or very few transactions of similar type in the Australian market for the ATO to make a comparison, making it next to impossible to determine an acceptable transfer price.
Because of the subjective nature of transfer pricing, instead of the A$126 million adjustment the ATO was hoping for, the court awarded a tax adjustment of only A$45 million. However, the victory for the ATO is the message sent: the Australian government will not tolerate multinationals engaging in transfer pricing to avoid paying Australian taxes.
As the Malaysian government invites more multinationals here to do business, the occurrence of transfer pricing in Malaysia is inevitable. Some multinationals may attempt to manipulate the transfer price of their related company transactions in order to reduce their Malaysian tax liability and increase group profits. To avoid this, transfer pricing will need to be a strong focus of attention for the Malaysian tax authorities going forward in order to protect the government’s revenue and continue the economic development of Malaysia.
Nicolaos Giannopoulos is a lecturer with the School of Business and Enterprise at Swinburne University of Technology Sarawak Campus. He can be contacted at firstname.lastname@example.org.