This is an overview of transfer pricing mechanisms, providing guidelines to follow arm’s length principle and documentation to be maintained for the purpose of audits

1. TRANSFER PRICING
IN SINGAPORE

2. OVERVIEW
Territorial expansion of businesses that followed after globalization, has led to an increase in intra company
transactions and cross border transactions between related companies. For instance, while manufacturing
activities are managed by an entity of a larger group in one country, marketing of the manufactured
products in another country are being handled by a different subsidiary belonging to the same group.
In such cases, Transfer Pricing mechanism determines the price of the goods, services, funds, rights or
intangible assets that are thus transferred for sale or consumption to a related entity.
Transfer pricing is not limited to just pricing but also includes terms and conditions of such transactions
between related parties. It is important to understand the transfer pricing mechanism because it largely
determines the revenue of related entities and therefore their taxable profits under their respective tax
jurisdiction. The fundamental guideline for transfer pricing is “Arm’s Length Principle”, that is, the pricing
of cross-border transactions between related entities must be market based, and similar to the pricing that
would have been charged if the parties were unrelated.
In the case of unrelated entities the market forces such as demand and supply largely determine the
commercial pricing of such cross border transactions, but in the case of related entities, because of the
element of association and relationship, there is a propensity to set prices that are deviant from the actual
market price. The selling entity may undercut the price, or the buying party may set a higher cost in order
to lower their profits thereby affecting their taxable income. Such distortion of prices will impact the tax
liability of the entities in their respective jurisdiction.
With businesses rapidly expanding beyond their domestic borders, leading to a spike in cross border
transaction between related parties, tax authorities around the globe are stepping up their scrutiny on
such transactions. Where a related party transaction is identified to be not in compliance with the arm’s
length principle, tax authorities would make adjustments to the profits and tax liabilities. Such adjustments
along with interest and in some cases penalty will always amount to increased tax liability of the entity.
Therefore it is of utmost importance to familiarize with the transfer pricing regulations of the local tax
jurisdiction as well as that of the related party’s jurisdiction.
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3. BACKGROUND
This is an overview of transfer pricing mechanisms, providing guidelines to follow arm’s length principle
and documentation to be maintained for the purpose of audits.
Due to the nature of relationship that exists between related companies there is a potential for artificially
shifting profits from an entity in higher tax jurisdiction to a related entity in lower tax jurisdiction, in
order to reduce the overall tax liability. To prevent the practice of such tax reduction strategies by related
entities engaging in cross border transactions, tax authorities of various countries required a regulatory
framework. Following the initial efforts by United Nations, the Organization for Economic Cooperation
and Development (OECD) Council originally approved the Transfer Pricing Guidelines for Multinational
Enterprises and Tax Administrations in 1995. The OECD transfer pricing guidelines, is widely acknowledged
by tax authorities around the globe to determine transfer pricing. It is a powerful tool for the tax authorities
to attribute taxable profits to their jurisdiction.
The OECD guidelines recommend several methods that taxpayers may use to derive an arm’s length
price or allocation, for the valuation, for tax purposes, of cross-border transactions between associated
enterprises. In 2010 there were some elaborate additions to the guidelines on the selection of the most
appropriate transfer pricing method, on how to apply transactional profit methods and on how to perform
a comparability analysis. Many OECD member countries and non-member countries follow the OECD
guidelines on transfer pricing, it must be noted that although the OECD guidelines are widely adopted, its
interpretation, application and emphasis may vary between jurisdictions.
The OECD guidelines are based on arm’s length principle defined in Article 9 of the OECD Model Tax
Convention, which also forms the basis of many bilateral tax treaties involving OECD member countries and
non-member countries. The application of the arm’s length principle is generally based on a comparison
of the prices or margins used by related parties with those used by arm’s length parties engaged in similar
transactions.
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4. TRANSFER PRICING METHODS
The OECD guidelines provide for several methods to determine the arm’s length price or allocation and
these methods can be classified into two groups namely traditional methods and transactional profits
methods. Traditional methods include the Comparable Uncontrolled Price (“CUP”) method, the Resale
Price Method (“RPM”), and the Cost Plus Method (“CPLM”). The transactional profits methods are the
Profit Split Method (“PSM”) and the Transactional Net Margin Method (“TNMM”).
Each method has its own merits and demerits and choice of the right method depends on the
following factors
• Nature of transaction
• Tax jurisdiction’s local tax laws & guidelines
• Availability of accurate data
• Possibility to make accurate adjustments
Transfer Pricing
Methods
TradiƟonal TransacƟonal
Methods Profits Methods
Comparable TransacƟonal
Resale Price Cost Plus Profit Split
Uncontrolled Net Margin
Method Method Method
Price Method Method
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5. Comparable Uncontrolled Price Method
The price charged in controlled (related party) transactions is matched against a comparable uncontrolled
transaction, that is, a similar transaction between unrelated parties. It is considered as the most effective
method as it involves direct price comparison, and it is applicable for transactions involving goods,
service, funds or other intangibles. Where strong comparability of product, is established CUP provides
a good indication of transfer pricing. The comparability of transaction is determined based on analysis
of the following aspects
• Characteristics of goods, services and intangible properties;
• Analysis of functions, assets and risks undertaken;
• The terms and conditions of the contract; and
• Commercial and economic circumstances pursuant to the transactions.
Resale Price Method
The resale gross margin percentage of related party transaction is compared with the resale gross margin
percentage realized in a comparable arm’s length transaction. This method is particularly useful in
determining transfer pricing in distribution transactions, where the reseller has not made any alteration
or value addition to the product involved. An arm’s length gross margin percentage is applied to the
net sales of the taxpayer in order to determine the arm’s length cost of goods sold. The comparability
analysis focuses more on functions performed, risks undertaken, and assets used by each transacting
party. The similarity of product is of less relevance in this method.
Cost Plus Method
This method determines transfer pricing by comparing gross returns on costs of related party transaction
with gross returns on costs of comparable independent/unrelated (arm’s length) party transactions.
Gross cost-plus margin of a comparable arm’s length transaction is applied to the cost of goods of a
taxpayer’s related party transaction to determine the transfer price. This method is usually applied in
contract manufacturing / service scenario.
Product comparability is of least significance, whereas the comparability of functions performed and
risks undertaken is emphasized. Likewise comparability of cost base terms of contract and commercial
circumstances surrounding the transaction is of relevance for applying this method.
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6. Profit Split Method
The method is applied to evaluate if the allocation of combined profit/loss to related parties is in
concurrence with arm’s length principle. The relative value of contributions made by each related entity
is taken into account, in order to split the combined profit/loss resulting from the whole transaction
between related entities.
The method is used when transactions are highly integrated, complex or involves non-routine intangible
assets. Careful evaluation of information is required from all dimensions of the transaction to determine
the relative value of contributions made by each related party, and it requires information from all levels
of the supply chain. It must be noted that the method will not yield a highly accurate result.
The profit can be split based on two approaches:
• Contribution analysis
• Residual analysis
Contribution analysis relies largely in third-party data to generate contribution data and it is complex
and difficult to implement. Residual analysis basically looks at splitting the residual profits, that is, the
profits that remain after allocating the routine profits attributable to each entity. The residual profits
that remain after such allocation is assumed to be arising from non-routine intangibles, and it is split
based on allocation factors such as the capitalized cost of intangibles, discounted cash flow etc.
Transactional Net Margin Method
This method compares the operating net profit arising from an arm’s length transaction to that of a
related-party transaction. It examines the net profit margin relative to an appropriate base such as costs,
sales or assets. It requires a level of comparability similar to that required for the application of the cost
plus and resale price methods, but while the focus there is on gross profit, this method focuses on the
net profit. It must be noted that the management efficiency and other factors may distort the net profit
of the entities that are being compared so the method requires a highly accurate data.
The choice of appropriate base will depend on the nature of business, availability of reliable data and
special circumstances surrounding each case. Comparisons at the net profit level can be made on a
single transaction or in relation to some aggregation of dealings between associated enterprises.
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7. SINGAPORE’S TRANSFER PRICING REGIME
Legislation Overview
Singapore does not have specific transfer pricing legislation. Sections 33 and 53(2A) of the Singapore Income
Tax Act may be applied to transfer pricing. Section 33 has provisions relating to general anti-avoidance and
endorses the arm’s length principle. It empowers IRAS to disregard or reverse any arrangement in order to
counteract any tax advantage obtainable under the current arrangement.
Section 53 applies where a resident and a non-resident are closely connected and conduct business in such
a way that produces profits to the resident that are less than the ordinary profits that might be expected
to arise in such transactions. Where the profits cannot be accurately determined IRAS is empowered to
assess tax on a fair and reasonable percentage of the turnover of the business done between the resident
and the non-resident.
The Inland Revenue Authority of Singapore (IRAS), issued The Singapore Transfer Pricing Guidelines on
23 February 2006, and they are consistent with the OECD Transfer Pricing Guidelines. The guidelines are
applicable where at least one related party is subjected to tax in Singapore. The guidelines reinforce the
OECD stand on transfer pricing that requires adherence to arm’s length principle. Singapore endorsed the
OECD guidelines realizing that concurrence and compliance with this internationally accepted principle
would reduce the incidence of transfer pricing adjustments and improve the resolution of transfer pricing
disputes. As a result, the potential for double taxation would also be reduced. The guidelines help to clarify
Singapore’s position on Transfer Pricing and promote voluntary compliance by spreading awareness about
risks of non-compliance while operating across borders.
The IRAS does not have a specific preference for any of the five prescribed methods outlined in the OECD
guidelines. Although the IRAS guidelines does not explicitly approve a particular method, in practice the
regulator is receptive towards the traditional methods and accepts the Cost Plus Method for transactions
relating to services and Comparable Uncontrolled Price method for all other transactions.
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8. IRAS Requirements
IRAS recommends that taxpayers adopt the 3-step approach to apply the arm’s length principle in their
related party transactions:
Step 1 – Conduct a comparability analysis
Step 2 – Identify the appropriate transfer pricing method and tested party
Step 3 – Determine the arm’s length results
Comparability Analysis
To comprehensively assess the transactions of related and independent parties being compared, to
ensure that they have substantially similar economic characteristics. The objective of the step is to
determine that:
• None of the differences (if any) between the situations being compared can materially affect the
price or margin being compared, or
• Reasonably accurate adjustments can be made to eliminate the effect of any such differences.
Identify the appropriate transfer pricing method and tested party
The guidelines recommend the adoption of the method that produces the most reliable results, taking
into account the quality of available data and the degree of accuracy of adjustments. A tax payer is also
allowed to adopt even a modified version of a method listed above to comply with the arm’s length
principle, as long as the taxpayer maintains and is prepared to provide sufficient documentation to
demonstrate that its transfer prices are established in accordance with the arm’s length principle.
The use of the transfer pricing methods, excluding the Profit Split Method, would first require identifying
the party on which to apply the transfer pricing analysis. This party is known as the tested party. IRAS
recommends that the party with the smaller scope of functions and less complex operations be used as
the tested party. Such a decision will make it easier to find comparable data and require fewer adjustment
and greater accuracy.
Determine the arm’s length results
Once the appropriate transfer pricing method has been identified, the method is applied on the data
of independent-party transactions to arrive at the arm’s-length result. More likely, the transfer pricing
analysis would lead to a range of prices or margins. IRAS is prepared to accept the use of ranges, to
determine an arm’s length range provided that the comparables are reliable. The outcome of this last
and final step will then be used to guide or justify taxpayers’ transfer pricing practices.
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9. DOCUMENTATION
A taxpayer engaging in related party transactions must maintain documentary proof to demonstrate
that adequate analysis and efforts have been undertaken to conform to the arm’s length principle. Such
adequate documentation will facilitate reviews by tax authorities on taxpayer’s transfer pricing analysis
and hence assist in resolving any transfer pricing issues that may arise.
The extent of documentation required is solely left to the taxpayer’s discretion, and the taxpayer must
take into consideration the substantiality and complexity of the related party transactions as well as the
costs of compliance arising from such documentation.
IRAS does not impose penalty specifically for the lack or insufficiency of documentation but nevertheless
quality and timely documentation practice will facilitate easy discharge of proof of compliance and also
determine the outcome of the taxpayer’s application for the mutual agreement procedure (MAP) with
the IRAS.
There is no specific requirement regarding disclosures in tax returns. Records of documents must be kept
in accordance with the record keeping requirements, which also includes transfer pricing documentation.
From year of assessment 2008, the statute of limitation is reduced from 7 to 5 years.
Documentation is not required to be prepared by a certain time, however, the IRAS does recommend
that documentation be prepared in a timely manner, particularly to support the transfer pricing position
in the event of a future dispute with the IRAS or with overseas tax authorities.
Typical transfer Pricing Documents includes the following:
GROUP INFORMATION
• Worldwide organisational structure
• Group’s line of business
• Group’s business models and strategies
• Principal business activities and functions of each party in the group
• The business relationships amongst all related parties; and
• Group’s consolidated financial statements of the group
SINGAPORE ENTITY INFORMATION
• General information such as company registration number; address, etc.
• Entity’s line of business
• Entity’s business models and strategies
• Entity’s functions, risks and assets employed; and
• Entity’s financial statements
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10. TRANSACTION INFORMATION
• Detailed information on all transactions with related parties;
• Contracts or agreements to show the terms of the transactions; and
• Segmented financial accounts with respect to the transactions, including
explanations on the assumptions used.
TRANSFER PRICING ANALYSIS
• The choice of the tested party and reasons supporting the choice;
• Details on comparables and the screening criteria for choosing the
comparables;
• Comparability analysis of the related party transactions and the
comparables;
• Details of the adjustments to be made to achieve comparability;
• The transfer pricing method chosen and rationale for the choice
• The determination of the arm’s length price/margin, with computation
and explanations.
Audit & Penalty
The risk of transfer pricing audit is only moderate in Singapore at present but with the neighboring
economies and key trading partners tightening their transfer pricing requirements, it is likely that over
time there will be an increase in the number of tax audits that involve transfer pricing.
There are no specific penalties regarding transfer pricing. Under general tax provisions relating to
understatements of income, the penalty range is from 100% to 400% of the tax underpaid.
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