Transfer Pricing (Part 1)

Key Principles, Analysis and Methods

Course Objective
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Course Objective

Synopsis
Transfer Pricing (TP) is an area of tax that regulates the price charged in a transaction entered
by one member of a multinational enterprise with another member of the same organisation.
The price charged in the controlled transaction can impact the business model and the
effective tax rate of the multinational enterprise.

This e-learning module aims to:

• provide foundational knowledge on the key principles and concepts of transfer pricing, and
an understanding of the key elements and stages of a typical transfer pricing analysis.

• discuss the key aspects of transfer pricing through the use of case studies and real
examples to illustrate its importance to multinational groups and tax administrations.

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Course Objective

Learning Outcome

Upon completion of this module, you will be able to:

• Understand what is transfer pricing and why is it important

• Get insights on the implication of transfer pricing for taxpayers and tax authorities

• Learn about Singapore’s approach to transfer pricing

• Understand the arm’s length principle, the concept of comparability and the transfer
pricing methods

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Course Outline
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Course Outline
1. Fundamentals and Key Concepts/Principles
- What is transfer pricing and its importance
- Overview of Singapore Transfer Pricing

2. Arm’s Length Principle

- Singapore’s application of the arm’s length principle
- Singapore’s Three-Step approach to transfer pricing

3. Comparability Analysis and Transfer Pricing Methods

- How to apply the key comparability factors
- The key to selecting and applying the five transfer pricing methods

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Transfer Pricing
– Fundamentals and Key Concepts/Principles
What is Transfer Pricing (TP)?
• Transfer pricing provisions regulate the price charged in a transaction entered
between related parties

• Transactions can be goods, services, loans, intangibles

• “Price” must comply with the arm’s length principle

• Major concerns to tax authorities as it can cause tax leakage due to tax
arbitrage

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What is Transfer Pricing (TP)? (Cont’d)

Related parties Independent party

Price must be similar

if the transactions
are comparable

Taxpayer Independent party

Transfer price Arm’s length price

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Why is TP important?

• BEPS initiatives - OECD:

Base erosion and profit shifting (BEPS) refers to tax avoidance strategies that exploit
gaps and mismatches in tax rules to artificially shift profits to low or no-tax locations.
Under the inclusive framework, over 100 countries and jurisdictions are collaborating to
implement the BEPS measures and tackle BEPS (http://www.oecd.org/ctp/beps/).

• More countries have implemented local TP laws and guidelines

• Increase in local TP audits and risks

• An effective tax planning tool when implemented properly

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What is the scope of TP?

• Condition One: Controlled parties.

• Condition Two: A transaction between the controlled parties either domestic or cross
border.

• Transfer pricing provisions regulate the price of transactions between controlled parties.

• Why? They need to follow the arm’s length principle which is the international standard.

• Why? Price can be manipulated to shift profits from high tax entities to low tax entities.

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Who are Related Parties?
• “Related Party” is determined based on shareholdings, common control and
common management among others.

• Singapore: Section 13 (16) of the Singapore Income Tax Act:

“related party”, in relation to a person, means any other person who,

directly or indirectly, controls that person, or is controlled, directly or
indirectly, by that person, or where he and that other person, directly or
indirectly, are under the control of a common person;

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Example: Related Party Due to Ownership
Company A
(Germany)

100% 100%
Company B Company C
(Australia) (Singapore)

100%

Company D All companies are related parties

(New Zealand) as they are controlled, directly or
indirectly by Company A (Germany)
as the common shareholder.

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Example: Related Party Due to Management Control

100% ownership 100% ownership

Common Director
Company A and B are related parties as
they are under common control of one
person which is the Director of both
companies.

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Types of Intercompany Transactions
Tangible goods
• Sale & purchase of finished
goods
• Manufacturers to distributors
to retailers
• Sale & purchase of raw
materials / semi finished
goods
Financing / Others
• Intercompany loans,
guarantees
• Cash pooling
Intangibles
• Trademark / patent / franchise
• License of intangible property
• Royalty / Knowhow
• R&D activities to develop
intangibles
• Business processes
Services
• Routine services
• Cost sharing arrangement
• Stewardship / shareholder
services
• Mid / high value services
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Implications of TP

End
Manufacturer Customer
(China)

Selling price: $150

Opex cost: $100
Tax rate: 25%

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Implications of TP

Related End
Manufacturer Distributor Customer
(Singapore) (China)

Selling price: $150 Selling price: $400

Opex cost: $100 COGS: $150
Tax rate: 25% Tax rate: 17%

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Implications of TP (Cont’d)

TP can affect the taxable income of a taxpayer by :

➢ Decreasing income
➢ Increasing deductions
➢ Increasing losses

The ultimate effect is in the level of tax paid by a taxpayer in a particular country.

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Transfer Pricing
– Arm’s Length Principles
What is the Arm’s Length Principle (ALP)?

• When independent companies transact with one another, the terms and conditions
are negotiated independently and driven by market forces, the pricing therefore
reflects the true economic value of the contributions made by each party in the
transactions.

• When related companies within a Group transact with one another, the price that is
charged may not be driven by market forces but could be motivated by tax factors
such as allocation of profits.

• If the transfer price between the related parties are set above or below the price what
independent entities will normally charge in a similar or same circumstances solely
because of their special relationship, the transaction will not be arm’s length and IRAS
can make TP adjustments to the taxable profits.

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What is the Arm’s Length Principle? (Cont’d)

Sells Fertiliser Products Company B

Related Party

Company A
(Singapore)

Company C
Sells Fertiliser Products Independent Party

The price to the related party should be the same to the price to an
independent party under similar or same (comparable) circumstances.

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Why does IRAS apply the ALP on related parties transactions?

• Prices set up between independent entities are considered as fair and driven by
market forces of supply and demands.

• ALP is an acceptable principle accepted by different tax regimes.

• Provides a common platform for Tax Authorities to deal with intercompany

transactions, improve resolution of TP disputes and thus, avoid double taxation.

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Transfer Pricing
– Comparability Analysis and Transfer Pricing Methods
Application of Arm’s Length Principle
The Three Step Approach

• The approach is neither mandatory nor prescriptive – a taxpayer may have a different approach.

• Main objective is to present a logical, coherent and consistent basis that the transfer prices between
related parties are arm’s length.

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Transfer Pricing – Three Step Approach
– Step 1: Comparability Analysis
Step 1: Comparability Analysis

Related Parties Independent Parties

• Identify the commercial or • Identify the commercial or
financial relations financial relations

• Identify the five • Identify the five

comparability factors comparability factors

Compare

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Step 1: Comparability Analysis
• Internal comparable – Under similar circumstances, the taxpayer compares the TP
that he sells to its related party (related party transaction) to the price that he sells to a
3rd party

• External comparable – compares the related party transaction to the transaction

made between two 3rd parties

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Step 1: Comparability Analysis
• Internal comparable – Under similar circumstances, the taxpayer compares the TP
that he sells to its related party (related party transaction) to the price that he sells to a
3rd party

• External comparable – compares the related party transaction to the transaction

made between two 3rd parties

Related party transaction

Taxpayer Related party

Internal comparable

3rd party

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Step 1: Comparability Analysis
• Internal comparable – Under similar circumstances, the taxpayer compares the TP
that he sells to its related party (related party transaction) to the price that he sells to a
3rd party

• External comparable – compares the related party transaction to the transaction

made between two 3rd parties

Related party transaction

Taxpayer Related party

Internal comparable

3rd party 3rd party

External comparable

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Five Comparability Factors

1 2 3 4 5

Characterisation Functions
Contractual Business Economic
of the performed,
terms strategies circumstances
property/service assets, risks

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Factor 1: Characteristics of Goods,
Services and Intangibles
• Differences in the characteristics may result in differences in the open market price or value

• Evaluate if the basis characteristics of the property that is being transferred (in a controlled and
3rd party transactions) is similar

• Physical Goods:- Physical feature, quality and reliability, availability and volume of supply

• Service:- Nature and extent of services provided

• Intangibles:- nature of the Intellectual Property (IP), sales or licensing of IP, duration and degree
of protection, expected benefits

• Inter Company (IC) Financing:- nature and objective of the loan, payment terms, currency

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Factor 2: Functional Analysis - FAR
• Key step in the Comparability Analysis exercise

Functions Assets Risks

• Economically significant • Type of assets used such • Types of risks
activities and as plants and machinery,
responsibilities valuable intangibles, • Functions performed that
undertaken financial assets give rise to such risks

• What the parties actually • Nature of the assets such • Who “assumes” the risks
do and the capabilities as age, market value, is entitled to the upside
they provide location, property right benefits and bears the
protections downside costs
• Example decisions on
business strategy and • Assume a risk: Control
risks the risk and has the
financial capacity to
assume the risk

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Factor 3: Contractual Terms

• Intercompany agreement is a good starting point to identify the commercial or

financial relations between the related parties

• Contract sets out the scopes of works, responsibilities and risks bear by the related
parties, how the transactions are priced etc

• Contractual terms must align with the actual conduct of the related parties with
regard to the transaction (i.e. accurate delineation of the transaction and risk)

• If the contractual terms are not consistent with the actual conduct,

Identify the actual transaction

– what is the party really doing?

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Factor 4: Business Strategies

• Innovation and new product development

• Diversification

• Risk strategies

• Market penetration

• New Market

• Branding

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Factor 5: Commercial and Economic Circumstances

• Different markets affect pricing even for transactions of the same property of services

• Identify relevant commercial and economic circumstances taking into account available
substitute goods or services

• Industry overview and analysis, Location, Market size, Market share

• Government regulatory control

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Transfer Pricing – Three Step Approach
– Step 2: TP Methods and Tested Party
Step 2: Transfer Pricing Methods
Comparable Uncontrolled Price (CUP)
Resale Price Method

Cost Plus Method

The Profit Split (“PS”) method

The Transactional Net Margin Method (“TNMM”)

There is no prescribed preference for any particular methodology. Key to
address:
• Strengths and weakness of each of the five methods
• Nature of transaction
• Availability of reliable data
• Degree of comparability

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Step 2: Transfer Pricing Methods
Traditional Transaction
methods
Traditional Transaction
methods compared the
price of the related party
transaction with 3rd party
prices on similar transaction
Transactional Profits
methods
Transactional Profits
methods examines the
overall net operating profits
that arise from the
intercompany transactions
under review
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• Compares “the price for property or services transferred in a controlled transaction to the price
charged for property or services in a comparable uncontrolled transaction”

• The most important comparability factors are:

o Similarity of product,
o Contract terms, and
o Economic / market conditions

• Preferred method as it provides the most direct comparison

• Internal and External CUPs

• Due to the very high standard of comparability required, it is difficult in practice that reliable
CUPs can be identified

• It is commonly applied to test intercompany loans and license agreements

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 Sells semiconductors Company B
Price per product $10 (Indonesia)
Related Party
Company A
(Singapore)
Company C
(Indonesia)
Sells semiconductors
Price per product $10 Third Party

The price of $10 can be used as an internal CUP to demonstrate

that the price offer to Company B (related party) is a market price,
and therefore it is in compliance with the arm’s length principle.

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• The RP Method:
o Seeks to establish the price at which a product purchased from an overseas affiliate
is resold to an independent party. The resale price is reduced by the resale price
margin. The remainder can be regarded, after adjustment for other costs associated
with the purchase of the product as an arm’s length price of the original transfer of
property between the related entities.

• Close physical similarity of property not required – only need same product
category or industry

• It involves an analysis on Gross Profit Level

• Commonly used for resellers / distributors that do not add any value to the
product before selling to the customer

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 Total Gross Profit
Reseller margin =
Sales

Related $80 Related $100

3rd party
party party
Customer
(Supplier) (Reseller)

20% resale price margin

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• Company C is a distributor and purchases products from Company A and Company B.
• Company A is the parent company and Company B is unrelated.
Parent Unrelated Party
Company A Company B
(US) (China)
Company C purchases
products from A and B

Company C
(Singapore)

Sells sealed products

for industrial purposes
End Customers

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Company C’s net profit for the FYE was negative and is making losses as below:
2020
SGD
Sales 20,000,000
Cost of sales (13,000,000)
Is the reseller margin made on the
Gross profit 7,000,000
sale of products from related party is
Gross margin 35%
the key factor associated with the
Operating expenses loss?
Employment costs (4,000,000)
Depreciation (500,000) Is the price paid to related party at
Repairs and maintenance (1,000,000) arm’s length?
Travel (500,000)
Other expenses from ordinary
(2,000,000)
activities
Total operating expenses (8,000,000)

Operating profit/(loss) (1,000,000)

Operating margin -5%

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Company C’s net profit for the FYE was negative and is making losses as below:
2020 SGD
Sales Sales purchases
SGD purchases from from
Sales 20,000,000 unrelated parties related parties
Cost of sales (13,000,000) Total Sales 8,000,000 12,000,000
Gross profit 7,000,000
COGS 6,000,000 7,000,000
Gross margin 35%
Gross Profit 2,000,000 5,000,000

Operating expenses Gross Margin 25% 42%

Employment costs (4,000,000)

Depreciation (500,000) ➢ Company C is transacted at arm’s
Repairs and maintenance (1,000,000) length as it is earning higher gross
Travel (500,000) margin in the related party transaction.
Other expenses from ordinary
(2,000,000) ➢ The losses are not associated with the
activities
transfer price paid to the related party
Total operating expenses (8,000,000)
supplier for the products.
Operating profit/(loss) (1,000,000)
Operating margin -5%

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• It requires the estimation of an arm’s length consideration by adding an
appropriate profit mark-up to the supplier’s cost. The profit mark-up is
ideally determined by reference to the profit mark-up earned by the same
supplier in a comparable dealing with an independent party.

• The costs applicable are direct and indirect costs of producing relevant goods or
services.

• Gross Profit Level Analysis

• CP method is particularly applicable in cases of:

o Semi-finished products sold between related parties
o Joint facility arrangements or long-term buy and supply arrangements
o Where a subsidiary performs the role of a sub-contractor
o In the provision of a service

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• Company A is a contract manufacturer of spare parts.
• It sells to related party, Company B.

Related Party
Company A
(Indonesia) Company B
(Singapore)
Contract Manufacturer
Sells to related party
cost plus 42%

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Company A’s profit results for the FYE is as below:
2020
USD ➢ Testing of cost plus
Sales 10,000,000 margin – whether it is
Cost of Goods Sold (7,000,000) in accordance with
Gross profit 3,000,000 the arm’s length
Gross Margin 30% principle
Cost Plus Margin 42%
➢ Look at external data
Operating expenses
and search for
Employment costs (1,000,000)
comparable contract
manufacturer
Depreciation (100,000)
Total operating expenses (1,100,000)

Operating profit/(loss) 1,900,000

Operating margin 19%

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Step 2: Transfer Pricing Methods
Traditional Transaction
methods
Traditional Transaction
methods compared the
price of the related party
transaction with 3rd party
prices on similar transaction
Transactional Profits
methods
Transactional Profits
methods examines the
overall net operating profits
that arise from the
intercompany transactions
under review
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Step 2: Transfer Pricing Methods
Traditional Transaction Transactional Profits
methods methods
It might not be possible or practicable to use
traditional methods because:
Traditional Transaction Transactional Profits
methods compared the methods examines the
• Insufficient reliable data to analyse comparability overall net operating profits
price of the related party
so as to determine an arm’s length outcome that arise from the
transaction with 3rd party
other than through a profit split or profit intercompany transactions
prices on similar transaction
comparison at the net profit level under review
• Product or service is unique or contains out of
the ordinary intangible property
• Traditional methods may not be practical
because of the complexity of the business
situation

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• The PS method divides profits or losses derived or incurred by relevant
transacting group entities on the basis of what would be economically
anticipated if the entities had been transacting at arm’s length.

• Profits can be split using a contribution analysis or residual analysis.

➢ Contribution analysis: combined profits are allocated based upon the

relative value of functions performed.

➢ Residual analysis: divides the combined profits in 2 stages;

(1) Profits allocated based on basic return for types of transactions
(i.e. TNMM);
(2) Residual profits allocated based on analysis of facts & circumstances.

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Contribution Profit Split
• Company A is located in the Australia and is the
owner of the core IP (designs and special features). Company A
(Australia)
• The Group manufactures and sells wallets with Owner of core IP
specific designs and features.
• Company A expands to Asia. The market was first
tested by a sales representative in HK. The wallets
were accepted by consumers. Customisation for local
market is recommended to sell more volumes in HK Company B
and South East Asia. (Hong Kong)
• Company B was incorporated as the regional Head
Office and will also perform design functions for the
Asian market.

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Contribution Profit Split

Split overall profit based on

$ Company A relative value contributed by
Overall profit
each party
$$$ Company B
– how to assess depends on
facts and circumstances

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Residual Profit Split

➢ Residual analysis: divides the combined profits in 2 stages;

(1) Profits allocated based on basic return for types of transactions
(i.e. TNMM);
(2) Residual profits allocated based on analysis of facts & circumstances.

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Residual Profit Split

Developer of micro processor IP and patent

Company A (Singapore) manufacturing technology
Manufacturing of IP and Sales Purchase mobiles from Company B to sell to
third parties

Company B (Malaysia) Exclusive manufacturer to use core IP and

manufactures final mobile product
Contract R&D and Manufacturer

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Residual Profit Split

• The Group manufactures and sells mobile phones.

• Company A is the owner of the core IP and purchases the final products
from Company B, then sells to end customers.

• Company B is the exclusive manufacturer of the mobiles. It licenses the

core IP and designs the final product.

• Companies A and B contribute to the success of producing the final product.

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Step 1: Determine the Group Profit

SGD Company A Company B

Total Sales 125 100

COGS (100) (60)

Gross Profit 25 40

Operating Expenses (15) (5)

Operating Margin 10 35

Group Profit 45

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Step 2: Determine the Routine Contribution

Company A: Wholesaler of mobiles

Benchmarking indicates that a resale margin of 25% is at arm’s length.

Company B: Manufacturer of mobiles

Benchmarking indicates that a cost mark-up of 10% is an arm’s length
remuneration.

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Step 2: Determine the Routine Contribution (Cont’d)
The total routine profit of the group is S$17.25
SGD Company A Company B
Total Sales 125 66
Resale margin Cost mark-up
COGS of 25% (60) of 10%

Gross Profit 31.25 6

Operating Expenses (15) (5)

Routine
16.25 1
Operating Margin

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Step 3: Divide the Residual Profit
Total profit S$45 − Residual profit S$17.25 = S$27.75

SGD Company A Company B

R&D and marketing

12 3
expenses value
% 80% 20%

Residual profit allocation 22.20 5.55

Routine profit 16.25 1

Adjusted operating profit 38.45 6.55

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Adjusted Tax Accounts

SGD Company A Company B

Total Sales 125 71.55
COGS (71.55) (60)

Gross Profit 53.45 11.55

Operating Expenses (15) (5)

Operating Margin 38.45 6.55

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Residual
Residual profit
Contract R&D
services
Entrepreneur
Limited risk
procurement
Call centre
services

Contract
manufacturer
Limited risk sales
and distribution
Routine
returns

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• The TNMM is a transactional profit method that compares the net profit margin
achieved by a company on its controlled transactions with the returns derived
by a company engaging in uncontrolled transactions.

• Comparisons at the net profit level can be made on a single transaction, an

aggregation of transactions or at the whole of entity level.

• The TNMM is the most commonly used transfer pricing method.

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Profit Level Indicator (PLI) Numerator / Denominator*

Operating profit margin Operating Profit (OP) / Sales

Full cost mark up OP / Total cost (Direct, Indirect and Opex)

Return on assets OP / Operating assets

Berry Ratio Gross Profit / Operating expenses

* Numerator and denominator should include operating items that are directly
or indirectly related to the tested transaction and should be excluded if they
are not similar to the independent party transaction being compared.

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• Company A is incorporated in the US and develops organic beauty products. It is the
owner of IP of the products, the packaging and labels.

• Company A has set up a distributor network in Singapore and Malaysia.

• Company A wants to know what is an arm’s length profitability for the distributors.

Company A
(US)

Company B Company C
(Singapore) (Malaysia)

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Company B’s P&L as below:
2020
USD ➢ The application of
Sales 10,000,000 TNMM involves
Cost of Goods Sold (7,000,000) testing of the profit
Gross profit 3,000,000 level indicator (PLI),
Gross margin 30% i.e. the 5% operating
margin in this
Operating expenses example.
Employment costs (1,500,000)
➢ Perform comparability
Sales, Admins and Marketing expenses (1,000,000) analysis with internal
Total operating expenses (2,500,000)
or external data to test
whether the 5% is a
Operating profit/(loss) 500,000
market distribution
Operating margin 5%
margin

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Step 2 (Cont’d): Tested Party

• Smaller scope of functions TP method

can be
• Least complex operations applied
reasonably
• Least complex entity

Tested Party

• Reliable comparable data

is easily available Comparables
data
• Data available can be used • Which related party
with minimal adjustment to apply the transfer
pricing analysis

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Application of Arm’s Length Principle

The Three Step Approach

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Transfer Pricing – Three Step Approach
– Step 3: Arm’s Length Results
Step 3 – Determine the Arm’s Length Results
• Comparables with publicly available information

• Local comparables where possible of the tested party

• Use of multi-year – 3 to 5 years depending on the company’s business cycle

• Interquartile range (IQR) – “Range” Concept. The IQR is the range from the
twenty-fifth to the seventy-fifth percentile of the results derived from the
uncontrolled comparables.

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Step 3 – Determine the Arm’s Length Results
Example Arm’s length result
Range Overview
Profit Level Indicator (PLI): Operating Margin = Operating Profit / Revenue
Quartile Calculation Method: Interquartile Range (Excel)

Comparable Taxpayer 2020 2019 2018 Weighted Average

Company A 4.43% 4.40% 6.27% 5.04%
Company B 4.49% 4.32% 4.80% 4.52%
Company C 6.03% 6.95% 9.46% 7.42%
Company D 21.29% 11.99% 10.99% 14.95%
Company E 6.52% 4.85% 4.74% 5.37%
Company F 0.99% 13.55% 7.90% 7.11%
Company G 9.10% 28.10% 28.12% 18.78%
Company H 11.70% 10.46% 11.80% 11.34%
Company I 7.55% 11.30% 14.77% 10.79%
Company J 28.50% 25.62% 19.20% 24.69%
Company K 9.22% 7.88% 7.94% 8.35%

Range 2020 2019 2018 Weighted Average

Minimum 0.99% 4.32% 4.74% 4.52%
Lower Quartile 5.26% 5.90% 7.09% 6.24%
Median 7.55% 10.46% 9.46% 8.35%
Upper Quartile 10.46% 12.77% 13.29% 13.15%
Maximum 28.50% 28.10% 28.12% 24.69%

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Three Step Approach – Flow Chart

https://www.iras.gov.sg/irashome/uploadedFiles/IRASHome/e-
Tax_Guides/etaxguide_Income%20Tax_Transfer%20Pricing%20Guidelines_5th.pdf

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Recap - Learning Summary

In this module, you have learnt the following:

• Understand what is transfer pricing and why is it important

• Get insights on the implication of transfer pricing for taxpayers and tax authorities

• Learn about Singapore’s Three-Step approach to transfer pricing

• Understand the arm’s length principle, the concept of comparability and the five transfer
pricing methods

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2021 ISCA ISCA
Key Learning Points

The arm’s length principle is mandatory in Singapore for all taxpayers that
entered into controlled transactions (both domestic and international).

Tax authorities are enforcing compliance with the arm’s length principle to
combat tax leakages as a result of aggressive structures.

Taxpayers in Singapore should applied the three step process to have a robust
evidence of compliance with the arm’s length principle.

A robust comparability analysis in combination with the application of an

appropriate transfer pricing method are key for a reliable transfer pricing
analysis.

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