EY Tax Alert - Malaysia updates its Transfer Pricing ... of intangibles in combination with other...

Special Edition

In line with the Base Erosion and Profit Shifting project (BEPS)

Actions 8 -10 and 13 issued by the Organisation for Economic Co-

operation and Development (OECD), the Inland Revenue Board of

Malaysia (IRB) has released supplementary updates to the existing

2012 Malaysian Transfer Pricing Guidelines (IRB Guidelines) in

respect of the following chapters:-

• Chapter II – The arm’s length principle (updated on 7 July 2017);

• Chapter VIII – Intangibles (updated on 11 July 2017);

• Chapter X – Commodity transactions (updated on 3 July 2017);

and

• Chapter XI – Documentation (updated on 4 July 2017)

The following section provides a summary of the updates made to

Chapters II, VIII, X and XI of the IRB Guidelines.

EY Tax Alert

July 2017 - Issue 04

Malaysia updates its

Transfer Pricing

Guidelines and

introduces Master File

requirements

Key highlights

1 | EY Tax Alert 27 July 2017 Special Edition

Arm’s length principle

• More focused and a robust analysis of functions performed, assets employed and risks assumed with

emphasis on substance and value creation between the affiliates to ascertain the transfer price

outcomes;

• Introduces measures that taxpayers can consider such as working capital adjustments and

recognition of Berry Ratio as a profit level indicator;

• The IRB has the right, based on factual substance, to accurately delineate actual transactions where

actual conduct of taxpayers do not substantially conform to terms of the written contract;

• Introduction of Risk Analysis Framework for the purpose of accurately delineating actual transaction

in relation to risk.

Intangibles

• In addition to the manufacturing and marketing of intangibles, the definition of intangibles has been

broadened to cover government licenses and contractual rights under certain circumstances, which

grant companies special privileges or exclusivity;

• Introduction of the Development, Enhancement, Maintenance, Protection and Exploitation (DEMPE)

concept to analyze transactions involving intangibles, and to identify the legal owner and economic

owner who are entitled to an arm’s length remuneration for their contribution towards the

development and exploitation of intangibles respectively;

• Further guidance on how to determine arm’s length compensation for research, development and

process improvement arrangements, distributors and manufacturers;

• Further guidance on transfer pricing analysis involving the use and transfer of intangibles, i.e.

transfer of intangibles in combination with other business transactions, and sale of goods or

performance of services;

• Introducing the application of valuation techniques in addition to Comparable Uncontrolled Price

(CUP) and Profit Split Method (PSM) to estimate the arm’s length price for intercompany transfer of

intangibles.

Commodity transactions

• Consideration for taxpayers to use quoted prices obtained from domestic or international commodity

exchange markets in applying the CUP method, for the purpose of pricing intercompany commodity

transactions;

• Evidence of price-setting policy, price adjustments and/ or other relevant information to be included

as part of the transfer pricing documentation in order for the IRB to reasonably assess arm’s length

pricing of intercompany commodity transactions.

Key highlights


Documentation

• Introduces the Master File as part of the transfer pricing documentation for taxpayers who are

required to comply with the Country-by-Country Reporting requirements;

• Provides definition and clarifies what constitutes “material changes” in the preparation of

contemporaneous transfer pricing documentation;

• Clarification on the application of the transfer pricing penalty regime and penalty exemption, if

transfer pricing documentation is furnished to the IRB within 30 days upon request, subject to

fulfilment of requirements under the 2012 Transfer Pricing Rules and IRB Guidelines;

• Increase in the list of required information / documentation to be included as part of the transfer

pricing documentation;

• To ease compliance burden and costs to taxpayers, the benchmarking study may be updated once

every three years, as long as the taxpayer’s operational profile remains unchanged. The Financial

data and suitability of the existing comparable companies should be reviewed and updated every

year;

• Further clarifies the duty of taxpayers to prepare transfer pricing documentation for domestic

controlled transactions, whereby one party enjoys tax incentives or suffers from continual losses or is

taxed at a different rate.

Introduction of the Master File under Chapter XI of the Malaysian Transfer Pricing Guidelines


Taxpayers that are obliged under the Income Tax (Country-by-Country Reporting) Rules 2016 to prepare

the Country-by-Country Report shall prepare the Master File and submit it together with the transfer

pricing documentation upon request by the IRB. The requirement to prepare Country-by-Country Report

comes into effect 1 January 2017.

The Master File is focused on providing a broader overview of the business group’s operations. The

information that should form part of the Master File includes:-

• Ownership structures and charts as well as the geographical locations of each operating entity;

• Description of the MNC Group’s business;

• The MNC’s intangibles;

• MNC’s intercompany financing activities; and

• MNC’s financial and tax positions.

A detailed list of specified items that should be included in the Master File is provided in Chapter XI of the

Malaysian Transfer Pricing Guidelines. These include:-

• Chart illustrating the MNC Group’s legal and ownership structure, and geographical locations of

operating entities;

• In relation to taxpayer’s controlled transactions, the supply chain wherein the group’s five largest

products and/ or service offerings by turnover, and any other products and/ or services amounting

to more than five percent of the group taxpayer’s turnover, are to be described;

• A list and brief description of important service arrangements between members of the MNC Group,

other than research and development (R&D) services, including a description of the capabilities of the

principal locations providing important services, and transfer pricing policies for allocating services

costs and determining prices to be paid for intra-group services.

In cases where the parent of the MNC Group prepares a Master File for the Group, a copy of the Master

File should be submitted together with the transfer pricing documentation by the subsidiary company. To

the extent this functional analysis duplicates information in the Master File submitted, a cross-reference

to the Master File is sufficient.

Summary of the chapters released by the IRB


Chapter II – The arm’s length principle

Substance of conduct over contract

• Written contracts serve to define the responsibilities, risks and anticipated outcomes of

interactions between affiliates;

• Taxpayers need to ensure transactions have commercial rationality reflecting economic reality

supported by actual decision-making, hence supporting documentation is essential in evidencing

the factual substance and actual conduct;

• Capital without functionality will generate no more than risk-free return, assuring that no premium

returns will be allocated to “cash boxes” without substance;

• IRB retains the right to describe the actual transaction in accordance to the taxpayer’s functional

profile.

Functional analysis

• Concept of aligning value creation with transfer pricing outcomes;

• Significant functions undertaken should reflect increased remuneration;

• Emphasis on financial capacity to assume risk and control over risk;

• Permanent establishment status may arise in a controlled transaction, whereby relevant Double

Tax Agreements (DTA) may apply;

• The form of remuneration cannot dictate inappropriate risks assumptions and allocations;

• IRB may disregard transactions that are commercially irrational.

Risk Analysis Framework

IRB has introduced and defined the following concepts:-

1) Risk management, whereby the party possesses the capability to assess and manage risk;

2) Risk assumption, whereby the party bears the consequences of risks, inclusive of the principal risk

bearer and party engaged to manage risk;

3) Financial capacity to assume risk, whereby party possesses funds to manage risks, may it be in the

form of executing mitigation functions or bearing consequences;

4) Control over risk, whereby party undertakes decision-making function in managing risks;

5) Risk mitigation, whereby measures are undertaken to reduce or contain the adverse effects of

risks.

Steps for analyzing risks in a controlled transaction:-

Step 1: Identify economically significant risks with specificity*

Step 2: Contractual assumption of risks

Step 3: Functional analysis in relation to risks

Step 4: Interpreting steps 1-3

Step 5: Allocation of risks

Step 6: Pricing of the transaction

*Strategic risks or marketplace risks, infrastructure or operational risks, financial risks, transactional risks, hazard risks

(Non-exhaustive list of sources of risks)



Comparability analysis

• Recognition of Berry Ratio as a profit level indicator in determining the remuneration of

intermediary activities where taxpayers undertake intercompany purchases and on-selling of

goods, subject to fulfilling certain criteria;

• Recognition of working capital adjustments in enhancing the comparability analysis, given that

reasonable adjustments can be made and that such adjustments result in minor differences.

Chapter VIII – Intangibles

• In addition to the manufacturing and marketing of intangibles, the definition of intangibles has been

broadened to cover government licenses and contractual rights under certain circumstances, which

grant companies special privileges or exclusivity. Examples are given below:-

(a) Government concessions which grant the rights to exploit specific natural resources such as

concession for the extraction of forest produce;

(b) Production Sharing Contract which grants oil and gas companies the rights for exploration and

production of oil and gas in Malaysia (Exploration and production rights granted by PETRONAS

to oil and gas companies via Production Sharing Contract);

(c) Government licenses / agreements / contracts that grant trade restrictions to keep out

competitors or restrict the number of competitors, such as licenses for broadcasting or licenses

for Network Facilities Providers (NFP) and Network Service Providers (NSP) awarded to

telecommunication companies, or power purchase agreements (PPA) with independent power

providers.

• Other government contracts such as contract to supply pharmaceutical products to government

hospitals or contracts to provide consulting/technical services are also considered intangibles.

• Exclusive rights in intangibles are themselves intangible.

• Analyze the intercompany transactions by applying the concept of DEMPE analysis to define the

role of the respective entities in the supply chain - which member(s) perform and exercise control

over DEMPE functions, which member(s) provide necessary funding and other assets, and which

member(s) control and bear the various risks associated with the development and exploitation of

the intangibles.

• Identify the legal owner and the contributing affiliates to the intangibles, by analyzing the

contractual terms, functional analysis, control over significant functions, source of funding and

risks assumed between the owner of the intangibles and associated affiliates.



• In setting up licensing transactions between related parties, taxpayers should consider the

following:-

• Nature of intangibles involved;

• Processes where intangibles are utilized;

• Benefits obtained from the intangibles;

• Specific, economically significant risks associated with the transactions involving the

intangibles;

• Withholding taxes for royalty paid

• In analyzing intangibles and DEMPE functions, economically significant activities with respect to

intangibles include:

• Research and development activities which lead to customization/enhancement of existing

products or new products;

• Activities which lead to improvement in manufacturing processes;

• Advertising, Marketing and Promotional (“AMP”) activities by the Malaysian taxpayer which lead

to creation /enhancement of marketing intangibles such as customer lists, marketing

/distribution;

• Channel or favorable contracts;

• Managing customers’ relationship, localization of products/ advertisements or marketing survey

including collection of local data.

• Local functions undertaken which improve the value of intangibles, should be remunerated

accordingly in line with their functional profile/ contributions made. Mere reimbursement of cost

without any element of profit will not be accepted by the IRB.

• If a local entity contributes towards the enhancement of the intangibles, it will be considered as

having “economic ownership” of the associated intangible created.

• Characterization of the contract of the Research & Development (R&D) service provider to be

examined in greater detail, and a mere cost plus margin will not be accepted if it performs control

functions (i.e. economically significant functions, providing assets and necessary funding) and

bears associated risks surrounding the development of intangibles.

• Where a local entity that has been characterized as a limited risk distributor undertakes significant

functions, bears risks and costs associated with the advertising, marketing and promotion of the

Group’s products, it would be entitled to a higher return rather than a routine return for its

activities.

• Where a local entity has been characterized as a limited risk distributor and performs marketing

activities on behalf of its principal, it should be compensated a cost plus service fee for the

marketing activities in addition to the routine return of its distribution activities.

• Where a local entity engaged in contract manufacturing activities enhances the manufacturing

process while the legal ownership vests with another group entity, the local entity is entitled to a



return on enhancement of the manufacturing process if this is transferred or shared with other

group entities.

• Continued payment of royalty by local manufacturer, although it has gained necessary experience

and contributed to the improvement and efficiency of the manufacturing process, could be

challenged.

• The IRB may also disallow royalty payments if it is not shown that the royalties currently paid are

for newly developed or enhanced intangibles, as the original intangibles may have become obsolete

over the years.

• Introduction of the concept of valuation techniques to ascertain the arm’s length price of related

party transactions involving intangibles.

• Valuation techniques premised on the calculation of the discounted value of projected future

income streams or cash flows derived from the exploitation of the intangibles being valued, may be

useful.

• Taxpayers should explicitly set out each of the relevant assumptions made in creating the valuation

model, describe the basis for selecting the valuation parameters, and should be prepared to defend

the reasonableness of such assumptions and valuation parameters.

Chapter XI – Documentation

Material changes

IRB has now defined the term “material changes” and cited examples below:-

• Material changes are significant changes that would give impact to the functional analysis or

transfer pricing analysis of the tested party;

• Material changes include changes to the operational and economic conditions that will significantly

affect the controlled transactions under consideration.

Examples of changes in operational conditions include the following:-

(a) Changes in shareholding;

(b) Changes in business model and structure;

(c) Changes in business activities (e.g. changes in group business activities that give impact to local

business activities);

(d) Changes in financial/financing structure;

(e) Changes in TP policy; or

(f) Mergers and acquisitions

Examples of changes in economic conditions include foreign exchange, economic downturn or natural

disasters.



Economic analysis

• As long as the operational conditions remain unchanged, the comparable searches in databases

supporting part of the transfer pricing documentation should be updated every three years rather

than annually.

• Financial data and suitability of the existing comparable companies should be reviewed and updated

every year in order to apply the arm’s length principle reliably.

Additional guidance to the existing list of documentation

• Organizational structure - Description of the management structure of the local entity, a local

organization chart, and a description of the individuals to whom local management reports and the

country(ies) in which such individuals maintain their principal offices.

• Nature of the business / industry and market conditions - Detailed description of the business and

business strategy pursued by the local entity including an indication of whether the local entity has

been involved in or affected by business restructurings or intangibles transfers in the present or

immediate past year and an explanation of these aspects affecting the local entity.

• Pricing policies - The formula adopted, including anticipated profit margin/ mark-up and cost

component, how the formula is applied, who determines the pricing policy, how often the policy is

revised, etc.

• Application of Transfer Pricing Method – In arriving at the arm’s length price, taxpayers will have

to apply an appropriate method based on the facts and circumstances of each controlled

transaction.

• Financial Information – Supplementary financial data in the form of taxpayer’s audited financial

statements, supporting information and allocation schedules, and comparable companies’ financial

information.

Penalty will not be imposed in the following cases

(a) Transfer pricing documentation is submitted within 30 days upon request by the Director General;

and

(b) The transfer pricing documentation prepared fulfils the requirement of the Rules and the

Guidelines, wherein reliable and correct information is provided by the taxpayer.

Conclusion on updates / changes made to the Guidelines


Practical issues for taxpayers

The supplementary guidance is a much welcomed step, as it provides further clarity and guidance on the

application of the arm’s length principle in line with the OECD guidance. However, there are several

practical issues that remain unaddressed, for example:-

• The IRB has not indicated the effective date of the updated Guidelines;

• The revised IRB Guidelines suggest that the median point will still be used as a reference point for

testing the arm’s length nature of related party transactions, and making relevant adjustments;

• Challenges in applying the CUP and PSM due to limitation of data in the public domain, particularly in

establishing the arm’s length nature of transactions involving intangibles, while the valuation

techniques used can be subjective due to the assumptions made i.e. in terms of the projected

financials used, discount rates applied, etc. to arrive at the arm’s length remuneration for licensing of

intangibles;

• Burden of proof on taxpayers to maintain records, documents and intercompany transaction

workings, etc., to demonstrate that the related party transactions are commercially rational and

economically relevant;

• The updated IRB Guidelines do not provide clear guidance on the manner and method of applying

working capital adjustments.

Next steps for taxpayers

• Taxpayers that meet the Master File documentation requirements should start the process of

planning, preparing and gathering relevant group level information and documentation for Master File

compliance;

• Reassess the current operational conditions to determine if there are material changes and

accordingly prepare contemporaneous transfer pricing documentation in line with the updated

Transfer Pricing Guidelines;

• Reassess the economically relevant characteristics of current intercompany transactions to ascertain

whether the arrangements reflect the actual conduct of the parties and substantially conform to the

terms of the written contract;

• For transactions involving intangibles (based on updated definition), assessment of the relative value

of contributions by each party, comparability of contributions or DEMPE analysis is required in

determining the arm’s length price.

Conclusion on updates / changes made to the Guidelines


How EY can help

• Assist you to enhance and improve existing transfer pricing documentation and analysis in applying

the principles arising from the updated IRB Guidelines;

• Advise you on determining appropriate transfer pricing policies and pricing mechanisms, as well as

assist in verifying existing contractual arrangements in line with the updated IRB Guidelines;

• Assist with the implementation of your transfer pricing policy;

• Assist in transfer pricing audit defense and support on technical transfer pricing issues arising from

IRB’s transfer pricing adjustments;

• Assist in the application of Advance Pricing Agreements to gain certainty on the appropriate transfer

pricing method and/ or application of Mutual Agreement Procedures to resolve double taxation issues

based on the updated IRB Guidelines.

For additional information regarding this alert, please contact the following:-

Sockalingam Murugesan

Partner and Head of Transfer Pricing

Ernst & Young Tax Consultants Sdn. Bhd.

[email protected]

+603 7495 8224

Vinay Nichani

Partner – Transfer Pricing


[email protected]

+603 7495 8433

Hisham Halim

Partner – Transfer Pricing


[email protected]

+603 7495 8536

Gary Ling

Director – Transfer Pricing


[email protected]

+603 7495 8388

EY | Assurance | Tax | Transactions | Advisory About EY EY is a global leader in assurance, tax, transaction and advisory services. The insights and quality services we deliver help build trust and confidence in the capital markets and in economies the world over. We develop outstanding leaders who team to deliver on our promises to all of our stakeholders. In so doing, we play a critical role in building a better working world for our people, for our clients and for our communities. EY refers to the global organization, and may refer to one or more, of the member firms of Ernst & Young Global Limited, each of which is a separate legal entity. Ernst & Young Global Limited, a UK company limited by guarantee, does not provide services to clients. For more information about our organization, please visit ey.com. © 2017 Ernst & Young Tax Consultants Sdn. Bhd. All Rights Reserved. APAC no. 07000991 ED None.

This material has been prepared for general informational purposes only and is not intended to be relied upon as accounting, tax or other professional advice. Please refer to your advisors for specific advice.

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