Treatment of pass-through costs in Malaysia
DP Naban and S Saravana Kumar of Rosli Dahlan Saravana Partnership describe how pass-through costs are treated in Malaysia to align with the OECD TP Guidelines.
In Malaysia, tax legislation make no reference to the treatment of pass-through costs. However, the Malaysian tax authority through its transfer pricing (TP) guidelines which is based on the OECD TP Guidelines provide some guidance on the treatment of pass-through costs.
Currently, there are no decided Malaysian cases on the concept of pass-through costs although this is an area of interest for the tax authorities in a TP audit. However, there are notable cases from India which discuss the concept of pass-through cost, which would be persuasive in Malaysian courts.
What are pass-through costs?
Pass-through costs are external costs incurred by a taxpayer on behalf of a related party or in some instances, on behalf of a third-party customer in relation to the taxpayer’s business. It is useful to examine the Indian cases of Dy Commissioner of Income-tax v M/s Cheil Communications India Pvt Ltd (2010) 29 CCH 0853 and DelTrib and John Matthey India Private Limited v Deputy Commissioner of Income Tax (2015) 94 CCH 0067 DelHC which have described this concept.
In Cheil Communications, the taxpayer was a subsidiary of Cheil Communications Inc (Cheil Korea) and the taxpayer company acts as an agent for Cheil Korea in undertaking advertising services for its customers.
There were payments made to third-party advertising agency which were made on behalf of the customers. These payments were ultimately reimbursed by the customers. The Indian tax tribunal found that the payments were pass-through costs and did not represent value-added functions undertaken by the taxpayer. The taxpayer was merely an intermediary between the ultimate customers and the third-party service providers. The tribunal commented that:
“The assessee simply acts as an intermediary between the ultimate customer and the third-party vendor in order to facilitate placement of the advertisement. The payment made by the assessee to vendors is recovered from the respective customers or associate enterprises. In the event customer fails to pay any such amount to the advertisement agency, the bad debt risk is borne by the third-party vendor and not by the advertising agency i.e. the assessee”.
In Johnson Matthey, the taxpayer was engaged in the manufacturing and sale of automobile exhaust catalysts. They entered into an arrangement with Maruti Udyog Limited (MUL) where they would sell the finished products to vendors pursuant to the instructions given by MUL.
The taxpayer notably bore no risk pertaining to the sale of the products. The price of the product sold on behalf of MUL was passed to the customers and did not affect the profits of the taxpayer. The Indian High Court held that the cost incurred for the transaction between the taxpayer and MUL should be treated as pass-through costs with no mark-up.
The observation from these cases is that expenses incurred in a transaction are considered pass-through costs when the following attributes are present:
The taxpayer does not bear risk in relation to the expenses incurred; and
The taxpayer does not add value to the services or products provided by third-party service providers or vendors – the taxpayer merely functions as an intermediary or an agent.
Treatment of pass-through costs
Generally, low value intra-group services must receive a 'mark-up' rate to reflect the market value of the services. However, this does not apply to pass-through costs. Since pass-through costs are incurred in relation to transactions that are already within arm’s-length, the pass-through costs should not be adjusted with a ‘mark-up’ rate. This position is illustrated in the Malaysian guidelines, which echoes the position adopted in the OECD TP Guidelines:
“When applying the cost-plus method to an associated enterprise which assumes the role of an agent or intermediary to obtain services from independent enterprises on behalf of its group members, it must be ensured that the arm’s-length return is limited to rewarding the agency/intermediary function only. It is not appropriate to charge a service fee based on mark-up on cost of the services obtained from independent enterprises".
The OECD TP guidelines draw a stark distinction between the costs incurred in the performance of agency function and the pass-through costs of the services provided by third parties. The former should receive a mark-up in accordance with the arm’s-length principle whereas the latter, being pass-through costs, should not receive any mark-up.
Various countries have acknowledged the concept of pass-through costs and applied the treatment of pass-through costs in accordance with the OECD TP Guidelines.
Even though there are no reported Malaysia cases on pass-through costs, the case of Maersk Malaysia Sdn Bhd v Ketua Pengarah Hasil Dalam Negeri is instructive as the courts will give due regard to the OECD TP Guidelines in relation to TP matters.
Hence, it is likely that the Malaysian courts would take the OECD TP Guidelines’ approach. As the guidelines are clear, it is hoped that Malaysia’s courts will take cognisance of them.
Senior partner, Rosli Dahlan Saravana Partnership
S Saravana Kumar
Partner (Tax, SST & Customs), Rosli Dahlan Saravana Partnership