Transfer pricing during an economic slowdown

Singapore transfer pricing requirements

Whilst transfer pricing guidelines were introduced within Singapore a while back, the legal requirements requiring Singapore taxpayers to prepare and maintain transfer pricing documentation came into force only from Fiscal Year (FY) 2018 onwards.  Accordingly, from FY 2019 onwards:

• Taxpayers with annual revenues over SG$10 million must annually prepare formal transfer pricing documentation (unless they are exempt from documentation requirements in accordance with specific Rules to this effect); and
• Taxpayers must retain the transfer pricing documentation for at least a five-year period

The regulations impose penalties for non-compliance, as well as for adverse adjustments made to the taxpayer’s inter-company pricing arrangements.

Given this context, a large number of taxpayers will be in various stages of preparing their transfer pricing documentation for FY 2019 and/or planning their policies for FY 2020.

Impact of COVID-19 of Singapore businesses

Business operations of multinationals are largely based on cross-border trade and commerce. With the COVID-19 virus having spread across geographies, impacting every continent possible, its spread could have a significant impact on multinationals. With several countries going into complete or partial lockdowns, multinationals have started operating at reduced capacities.  This has consequentially led to cross-border trade almost coming to a standstill, various new projects being put on the back burner, and production being severely reduced. 

This is likely going to have significant implications for the revenues as well as the profitability of multinationals, including their Singapore entities. In all likelihood, the Singapore arms of MNCs will see a sharp dip in revenues and profits for the years
FY 2019 and FY 2020 as well as run into significant cash-flow issues.

Transfer pricing implications

With the background of operational disruption and the consequential impact on their financial performance, Singapore companies engaging in cross-border trade will still need to justify their inter-company pricing arrangements and justify the arm’s length nature of their pricing policy in their transfer pricing documentation through these stressful periods. 

While defending transfer pricing arrangements during such difficult times can always be a challenge, there are certain measures that Singapore companies can adopt to help defend their inter-company pricing arrangements.

Review of existing transfer pricing policies

Corporates typically price their intercompany transactions for products, services, Intellectual Property (IP) and financing arrangements by adopting policies that have been put in place by the Group for various geographies or/and various entity profiles.  Often, these policies are set through a transfer pricing analysis conducted to determine acceptable arm’s length pricing arrangements for various transaction types within various geographies. 

These policies were likely set in place to presume a “business as usual” situation, and they often do not factor pricing to be adopted during a business slowdown. 

It would be prudent for MNCs to review their policies and re-align their pricing arrangements, to the extent necessary, to consider the impact that such slowdown may have. 

Example – A Singapore company could be paying royalties to its US parent for exploitation of trademark to the value of SG$ 1.5 million.  At the time of determining such an amount, the presumption would be that the Singapore entity would achieve a turnover of around SGD150 million in a particular year and a royalty of 1% of turnover would work out to the number of SGD1.5 million agreed between the entities.

In this example, a review of the policy would allow the Group to re-project the revenue numbers, considering the potential slowdown, and to arrive at more realistic turnover projections, consequentially leading to the application of a more reasonable royalty value. 

Avoiding overall/entity level aggregation

Whilst the Singapore transfer pricing guidelines require the arm’s length pricing in respect of each transaction to be analysed separately, corporates often tend to aggregate multiple transactions together (including transactions with independent parties) and analyse the arm’s length price for these multiple transactions at an entity level.  This involves comparing the overall profitability of the entity with its peers.  Where the profitability of the entity is found to be sufficient, the presumption is that the pricing arrangements of the various individual transactions would also be adequate and at arm’s length.

Not only is this approach technically flawed, but it creates significant risks to an entity, more-so during an economic slowdown. Often, the Singapore arm of a multinational would have transactions with its affiliates as well as independent third parties. Transactions with affiliates could only be a fraction of the entity’s total turnover.  During an economic slowdown (and otherwise as well), overall profitability may be impacted by several factors including fall in demand, inefficiencies in operations, significant bad debts, forex losses, etc., none of which have anything to do with faulty transfer pricing policies.  This could lead to the entity having insufficient profits (vis-à-vis its peers) or even suffering operating losses.  At such times, adopting an aggregated / entity level analysis of multiple transactions could create significant transfer pricing risks for the taxpayer, leading to transfer pricing adjustments and consequential penalties. 

To minimize risks and the get a fair sense of the appropriateness of pricing arrangements with affiliates, it would hence be imperative to move from an entity-level analysis to a transaction-by-transaction analysis.

Adjustments to reflect economic slowdown

A transfer pricing analysis is based on comparing an entity’s pricing arrangements/ margins for a particular related party with comparable third-party pricing arrangements/margins to benchmark its arm’s length nature. Often, the data used for such comparisons relate to prior years.

This could create risks for Singapore companies, as one will be comparing transactional margins for a slowdown period with comparable margins relating to years where business was not adversely impacted.  In such cases, it is advisable to adjust comparable data appropriately to ensure this mismatch is minimized to the extent possible.  This could possibly entail:

• Adjusting for period – making necessary adjustments to account for the slowdown period, using latest available data. Whilst published accounts for comparative data may not be available for the present period at the time transfer pricing analysis is being conducted, one could get a sense of the adjustment factor to the comparative data using supplemental data such as quarterly financials, etc.  This would provide a sense of the impact comparable companies would have during the slowdown period and can be used to adjust their margins pertaining to earlier periods.  Alternatively, the analysis could endeavour to identify comparable companies who faced financial distress (for reasons other than COVID-19 impact) during earlier years and apply their results to put in perspective acceptable results for the taxpayer during such stressed times.
• Adjustment for operations – this can be used either as an alternative or supplemental approach to the ‘period adjustment’ articulated above. This entails reviewing the operational differences between the taxpayer (during the slowdown) vis-à-vis the comparable companies with whom the results are to be benchmarked.  These could include significant unutilized capacities, adverse working capital, significant forex fluctuations, etc.  Suitable adjustments could be made to comparable data to align the business realities between the taxpayer and identified comparables to make such comparable data more realistic.

Documenting reasons for insufficient profits/losses

In cases where it's not possible to carry out the adjustments indicated above, or where the adjustments do not reflect the true impact of a business slowdown, it is desirable to document, in detail, the factors that led to business losses / insufficient profits. This could include an articulation of factors leading to losses / insufficient profits as well as, to the extent possible, a quantification of the potential impact on account of such factors. 

It is important for taxpayers to plan their transfer pricing approach during the slowdown period. Whilst this article aims to discuss certain strategies that can be adopted to identify reasonable data points for taxpayers, these strategies (and other such strategies) need to be reviewed in light of each taxpayer’s business realities and need to be adopted in a judicious manner.  We recommend taxpayers look at transfer pricing planning and compliance more proactively to ensure adequate time is invested to articulate and analyse transfer pricing positions appropriately.