Arm’s Length Principle
A new section 34D of the Singapore Income Tax Act clearly stipulates the arm’s length principle. Previously, there was no explicit statutory provision, although the Inland Revenue Authority of Singapore (IRAS) published transfer pricing guidelines concerning the application of the arm’s length principle.
Section 34D provides that if two persons are related parties and conditions are made or imposed between the two persons in their commercial or financial relations that differ from those that would be made if they were not related parties, then any profits that would, but for those conditions, have accrued to one of the persons, and, by reason of those conditions, have not so accrued, may be included in the profits of that person for income tax purposes. Section 34D also provides that if a person carries on business through a permanent establishment, the section shall apply as if the person and the permanent establishment are two separate and distinct persons.
For purposes of section 34D, the term “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 if he and that other person, directly or indirectly, are under the control of a common person.
The IRAS on February 23, 2009 published a supplementary tax guide that provides transfer pricing guidelines for related-party loans and related-party services.
A related-party loan can arise in the following situations:
- A domestic entity lends to, or borrows from, a related domestic entity (a related domestic loan). For that purpose, a domestic entity means any business entity that is incorporated or registered in Singapore and is carrying on a business in Singapore.
- A domestic entity lends to, or borrows from, a related foreign entity (a related cross-border loan).
Under the arm’s length principle, an entity that makes a loan to, or otherwise becomes a creditor (e.g., through intercompany credit balances arising from sales or the provision of services) of, another related entity should charge the related entity an arm’s length rate of interest for the use of the funds.
In the case of related domestic loans, however, IRAS will allow taxpayers to continue the common practice of extending or receiving interest-free loans or interest bearing-loans at rates that are not supported by a transfer pricing analysis to or from other related entities, provided that the lender is not in the business of borrowing and lending funds (such as banks or other financial institutions, finance and treasury centers). The IRAS will restrict the amount of any interest expense claimed by the lender on such loans, if applicable.
In the case of related cross-border loans, taxpayers should adopt the arm’s length methodology. To give domestic lenders time to restructure their loans, IRAS will continue applying interest adjustments to them on such loans for a transition period of two years starting from January 1, 2009. From January 1, 2011, all cross-border loan arrangements should be arm’s length. Guidance on the determination of an arm’s length interest rate can be found in the supplementary tax guide.
The supplementary tax guide also provides transfer pricing guidelines for related-party services (also commonly known as intra-group services). Examples are administrative, technical, financial, commercial, management, coordination and control functions.
Service providers can adopt a direct charge method or an indirect charge method. They should adopt the direct charge method in charging for related-party services, whenever possible. The direct charge method is appropriate for specific services (such as conducting a market survey for a particular new product developed by a related party) rendered to related parties, where the beneficiary of the services and the costs incurred for the performance of the services are usually clearly identifiable.
Indirect charge methods involve the use of an appropriate apportionment basis or allocation keys to charge/bill for the service provided, such as gross sales, income or receipts, loans and deposits, staff numbers, floor area and asset size. Generally, the most appropriate allocation key is one that most accurately reflects the share of benefits received or is expected to be received by the beneficiaries. IRAS will accept the allocation key adopted by the taxpayer as long as it is reasonable, founded on sound accounting principles and has been consistently applied year-to-year throughout the group, unless there are very good reasons for failing to do so.
The remuneration for related-party services should be in accordance with the arm’s length principle. According to the IRAS’s transfer pricing guidelines, the Comparable Uncontrolled Price Method and the Cost-Plus Method are often the most appropriate choices for determining the arm’s length fee for related-party services.
IRAS will accept a five percent mark-up on costs for certain routine support activities as a reasonable arm’s length charge for such services, provided that the routine support activities that the service provider offers to its related party are not also provided to an unrelated party. The supplementary tax guide provides a list of services that IRAS will accept as routine support services, such as accounting, payroll and certain other management or administrative functions. However, if a service provider has performed a detailed transfer pricing analysis that supports charging for services at a mark-up different from five percent, the mark-up should be adopted. Once an arm’s length mark-up has been adopted, it should be applied consistently year after year throughout the group, until there are any material changes to the circumstances or services provided.
The supplementary tax guide also provides transfer pricing guidelines for services provided on a cost-pooling basis and for strict pass-through costs.