TP controversy in Southeast Asia – trends, focuses and risk management
Deloitte TP specialists from across Southeast Asia provide expert analysis of the controversies spanning the region, as tax authorities ramp up enforcement activity.
As global economies and businesses strive to recover from the pandemic, they find themselves faced with a new set of challenges as we enter 2023. These include rising inflation and interest rates, economic disruption caused by the Russia–Ukraine war and looming recessionary trends.
In this environment of unprecedented complexity, it is unsurprising to see tax administrations globally augmenting their enforcement activities. Southeast Asia (SEA) is known to be a region where tax administrations are investing a great deal in their transfer pricing (TP) capabilities. In this article, Deloitte SEA provides a high-level overview of the TP controversies in SEA, the focus areas of the tax authorities and the possible risk management strategies.
Within Asia-Pacific and specifically SEA, Indonesia’s tax authority, the Directorate General of Taxation (DGT), is known to be very active in scrutinising TP arrangements. While most of the scrutiny manifests itself through tax audits, in recent years, the DGT has been using other avenues to review TP arrangements of multinationals. This includes compliance checks which ask taxpayers to submit the TP documentation soon after the deadline for preparation of contemporaneous documentation.
Outside of an audit, the DGT is regularly conducting the pre-audit consultation process (SP2DK). This process often challenges the TP documentation of the taxpayers, leading to TP adjustments and revision of the tax returns to settle the underpaid tax. While the nature of this process is generally a ‘consultation’, SP2DK processes in most cases are as complex as tax audits. Additionally, this SP2DK is a ‘fast-track’ process which brings into the DGT’s purview many taxpayers who would have otherwise not been subjected to a tax audit.
In terms of the intensity of audits and consultations, recent trends demonstrate that the DGT is increasingly adopting a stricter approach in their enforcement, commonly challenging the ‘substance’ and supporting documents of the intercompany arrangements.
Another complexity brought in by Indonesia’s 2021 Harmonized Tax Law relates to the introduction of the secondary adjustment, namely “constructive/deemed dividends”, as a result of primary TP adjustment. With this regulation in place, every TP adjustment necessarily leads to a secondary adjustment by recharacterising the primary adjustment as a “deemed dividend” subject to withholding tax. The taxpayers are thus exposed to the additional tax burden once a TP adjustment is imposed.
In terms of the risk management strategies, robust TP documentation and clearly laid out intercompany agreements will always be the first line of defence. The alignment between the documentation and the actual substance and the taxpayers’ ability to demonstrate the same will be important. The taxpayers may consider advance pricing agreements (APAs) as a preventive measure. In a case where disputes eventually arise, there are multiple options. These include the domestic litigation route, and the international dispute resolution measure of mutual agreement procedures (MAPs), both of which have pros and cons that may need to be considered against the specific circumstances of the case.
From a surface-level scrutiny of tangible goods and services transactions, to a sophisticated analysis of business restructuring, permanent establishments, and financial assistance arrangements, the TP controversy landscape in Malaysia has evolved tremendously in recent years. There is a clear focus on ‘cooperative compliance’ and ‘compliance by design’, as observed from the introduction of the Tax Corporate Governance Framework and the minimum documentation template as well as the significant additional TP disclosures required.
Business restructurings have attracted intense scrutiny in recent audits, with the primary challenge being around commercial rationality, leading to de-recognition in some cases and higher post-restructuring compensation in others. There have also been successful challenges around taxability of IP transfers, although there is no capital gains tax regime.
Other emerging trends include:
Outbound compensation for centralised procurement hubs (limited cost plus preferred to value-based remuneration);
Inbound compensation for sales and marketing service providers (commission based preferred to limited cost plus);
Ex-post results lower than policy, although consistent with arm’s length range;
The use of customs data for alignment on true-up or down adjustments for inbound distribution entities; and
A strong emphasis on arm’s length pricing arrangements for incentivised companies, through the imposition of a surcharge.
Due to the quantum of the adjustments and the issues in dispute, the number of cases being litigated has also increased in recent years, with both taxpayers and the tax authority having their fair share of wins. In parallel, the OECD BEPS Action 14 has stimulated the interest in MAPs as a worthy dispute prevention alternative, with the inventory of both unilateral and bilateral arrangements showing high growth in recent years. Through a significantly reduced surcharge, the tax authority is also encouraging taxpayers to undertake voluntary disclosure, instead of engaging in protracted audits.
In recent years, the Bureau of Internal Revenue (BIR) has been increasing its efforts to investigate potential TP issues during general tax audits. This follows its recognition that a significant amount of tax revenue is lost to transfer pricing schemes. While there are several TP issues that have been raised during audits, two consistent and interlinked issues that are dominating the audit landscape are:
The extraction of residual profits from a subsidiary in the Philippines; and
The characterisation of year-end adjustments for limited risk entities.
Extraction of residual profits to a foreign parent entity
An entity earning more than an arm’s length margin may extract excess profits by making payments to its principal. When a taxpayer fails to substantiate the extraction of residual profits during a tax audit, the BIR may characterise this as either payment for services or payment for royalties. If construed as service fees, the BIR may look for evidence that the services are rendered and are beneficial, as well as the basis for calculation of the service fee.
On the other hand, if the BIR deems that an intangible asset is transferred or used, it may construe the extraction of residual profits as a royalty payment. In this case, the taxpayer will need to present evidence that such royalty payment is arm’s length. In both cases, the BIR may argue that the payment is subject to withholding taxes, and failure to withhold such may be ground for non-deductibility of the payments.
To avoid such challenges, intercompany contracts should describe the contributions of the entity receiving the residual profit in the value chain. This could be the performance of certain strategic or management services, or the provision of valuable intangible assets. This will enable the entity to substantiate which portion of the residual profit relates to services and to intangible assets, respectively, and thus lessen the tax exposure. Aside from the contracts, there should be evidence of what exactly was provided to support the contractual stipulation.
Characterisation of year-end adjustments
An entity may perform year-end TP adjustments to bring its related party transactions to the acceptable arm’s length amount. However, the BIR may challenge such adjustment when it results in lower taxable profits or re-characterises the nature of such adjustments. Without appropriate supporting documents, such year-end adjustments may be re-characterised as a service fee or royalty and therefore expose such adjustments to similar requirements as described above.
It is therefore recommended to ensure that intercompany contracts clearly document the scenarios where year-end adjustments are allowable and whether such adjustments relate to goods or services. In addition, the entity should document the calculation of the adjustment. It should also ensure that other tax impacts, such as VAT, custom duties and withholding taxes, are appropriately considered when performing year-end TP adjustments.
In Singapore, the focus on TP controversies has significantly increased during the past few years, primarily due to the many audits undertaken by the Inland Revenue Authority of Singapore (IRAS). Although there has been a steady increase in APA and MAP cases, TP audits by IRAS have now become more frequent, with a good number of these audits resulting in TP adjustments.
TP audits have focused on intercompany service transactions, expense recharges, R&D activities, valuation of intangible assets, business restructuring, intra-group loans, financial guarantees, adequacy of the contents of local files and preparation of local files within the contemporaneous timeline. In addition to TP adjustments made, in several cases, penalties were imposed on such adjustments. TP audits for the years which have been impacted by the pandemic have also started with a focus on losses incurred by limited risk entities and treatment of government grants. Taxpayers who have put in place contemporaneous TP reports following guidance issued by IRAS on COVID-specific TP issues stand a good chance of justifying their intra-group pricing approaches during the impacted years.
Given the heightened scrutiny, taxpayers need to adopt a proactive approach to mitigate and minimise their risk exposure. Potential bilateral or unilateral APAs should be considered for transactions that are perceived to be of medium to high risk or involve significant amounts. IRAS has substantial experience in negotiating and concluding APAs and MAPs with many jurisdictions globally, and on average, a majority of these have been completed within a reasonable timeframe.
Adequate TP documentation, having all necessary information relating to the Singapore local entity and its related party transactions, should be prepared on a contemporaneous basis. Intercompany agreements which are aligned with related party dealings in substance should be put in place as these are often the initial documents sought by IRAS during a TP audit.
After the introduction of the new TP laws in 2019, TP audit activities in Thailand have noticeably increased. The Thai tax authority can now exercise its power to reassess the taxable income and expenses of related party transactions to be consistent with the arm’s length principle based on the pricing observed in independent dealings.
The Thai tax authority has also started to use TP disclosure forms which are required to be submitted by the new TP laws as a risk assessment tool. Specific related party information declared in disclosure forms, including a list of all related party companies in and outside Thailand, and the value of respective related party transactions, are shown to be useful for screening TP audit targets.
Circumstances leading to TP audits typically include tax refund requests, significant related party transactions, payment of management and royalty fees, extended low profits or losses, fluctuating profits or tax payments, and pricing adjustments during the year or at year end.
One of the most challenged arrangements is a typical residual profit model. The Thai tax authority often challenges the payment of service fees or royalties made by Thai companies with routine characterisation to align their year-end results with benchmarked profit margins. This is done on the basis that the Thailand Revenue Code prohibits any expense payable from profit after the end of an accounting period for corporate income tax (CIT) purposes, a view which may possibly be challenged on technical grounds.
When the residual profit model is challenged by the Thai tax authority, it is important to have robust TP analysis and documentation to prove arm’s length profits of Thai entities as well as other supporting evidence. This can include written agreements and service reports to prove the receipt of underlying services or royalties. Where contradictory or different interpretations of tax and TP provisions are evident, further actions with the Board of Appeal or Tax Court may be necessary to resolve the dispute.
The TP controversy landscape in Vietnam is becoming aggressive.
It is observed that the Vietnamese tax authority tends to challenge the benchmarking study approach, especially on the comparability level in terms of functionality and jurisdiction of comparables. Specifically, the tax authority expects taxpayers to follow the guidance on the expansion of the comparability analysis. The tax authority requires use of local comparables to the extent possible, before expanding to other countries with similar economic conditions.
Moreover, the use of technology in TP audits is now seen. The tax authority has subscribed to a commercial database to assist in effective tax control and management since 2021. This increases the transparency between tax authority and taxpayers, mitigating unwarranted tax disputes.
In respect of focus areas for TP audits, the tax authority is paying more attention to those with high risks, such as taxpayers who record consecutive operating losses for a period or enjoy CIT incentives. On the transactional basis, the tax authority increasingly adopts the internal comparable uncontrolled price (CUP) or internal transactional net margin method (TNMM) as opposed to the external CUP and TNMM. Furthermore, they may also question the arm’s length nature and supporting documents of special intra-group service transactions, such as management service or royalty fees.
As a risk management strategy, taxpayers are recommended to ensure the compliance with transfer pricing documentation requirements, monitor the latest audit trends to prepare in advance for potential challenges, as well as carefully plan any future related party arrangements.
Acknowledging that TP controversy is becoming more cumbersome, taxpayers should reflect on whether they are adequately prepared and can respond to the intense TP scrutiny in their respective regions. While compliance with TP laws in all countries cannot be emphasised enough, what could help taxpayers face such audits more confidently is an efficient and well-defined tax governance framework which lays down the right practices, processes, and execution of the intercompany arrangements. Taxpayers may consider operational transfer pricing (https://www.deloitte.com/global/en/services/tax/services/operational-transfer-pricing.html) as a viable option for the proactive management of transfer pricing.