The new section 140A provides that related-party transactions must be carried out based on the arm's-length principle. Simply, this means that taxpayers who transact with related parties must be able to prove that the pricing for these transactions is no different than what it would be if the transaction was with third parties. For taxpayers to prove that their related-party transactions are carried out on an arm’s-length basis, the new provision would require the taxpayer to prepare contemporaneous transfer pricing documentation based on the Malaysian transfer pricing guidelines. The burden of proof is now much greater than previously. It would appear that if taxpayers engaged in related-party transactions do not have proper documentation, the initial reaction of the Inland Revenue Board could be that the transactions are not conducted on an arm’s-length basis.

A further point to note is the contemporaneous requirement for documentation. This generally means that the documentation should be prepared at the time the related-party transactions take place or was being contemplated. Again, this will add to the taxpayers’ burden of keeping documentation. It is expected that the contemporaneous requirement may be relaxed such that taxpayers will be allowed up to the filing deadline of their tax returns to prepare the required transfer pricing documentation.

What taxpayers can do now prepare

As a start, taxpayers should review all their related-party transactions and ask themselves if they are able to prove that these transactions are conducted on an arm’s-length basis. It is uncertain at this moment whether specific thresholds will be applied in determining whether the preparation of contemporaneous transfer pricing documentation is required so that taxpayers are not burdened with additional compliance costs that are disproportionate to their circumstances. If it is considered that the documentation is insufficient to prove arm’s length, preparation of a specific transfer pricing documentation should be considered with assistance from professional advisors.

Changing transfer pricing environment

Given the significant changes in the transfer pricing scene in Malaysia, this section is viewed as a signal that the IRB is placing greater emphasis on transfer pricing compliance and will be more willing to challenge taxpayers during audits and if necessary, in court. It is also expected that the IRB will redeploy more resources into this area to tighten compliance with transfer pricing matters.

The news is not all bad for taxpayers. The government has recognised the importance of an advance pricing agreement (APA) mechanism. With effect from January 1 2009, taxpayers can apply for APAs under section 138C of the ITA.

Taxpayers who are engaged in significant related-party transactions can now consider using the APA as a strategic tool to manage their transfer pricing risks. APAs will allow taxpayers to achieve transfer pricing certainty and could also minimise penalties.

In the new section 140A, the thin-capitalisation concept is also introduced. This concept is new in Malaysia.

Thin capitalisation

Thin capitalisation aims to restrict the deduction of interest expenses on loans between associated parties. Broadly, the amount of interest to be restricted is ascertained by comparing the ratio of associated party debt to the equity of a company. Interest attributed to associated party debt over and above the prescribed ratio will not be deductible.

So what type of debt to equity ratio can be expected? Regionally, debt to equity ratio of 3:1 is common for thin-capitalisation purposes with a higher ratio being allowed for financial institutions. The IRB has on occasion indicated that a debt to equity ratio of 3:1 will apply in the Malaysian context. With the implementation deadline rapidly approaching, companies will need to critically review their debt equity ratios.

Looking ahead

The Inland Revenue Board is expected to issue rules soon for the new transfer pricing and thin capitalisation concepts to be operational, as well as provide clarity on its application. The IRB is also looking into issuing the APA guidelines in the near future to encourage more taxpayers to come forward with APA applications.

Lim Poh Chin (plim@kpmg.com.my) and Bob Kee (bkee@kpmg.com.my)

The views and opinions expressed herein are those of the author and do not necessarily represent the views and opinions of KPMG in Malaysia or KPMG's network of firms