The diversity of controlled transactions within both local and multinational enterprise (MNE) groups necessitate a structured approach to ensure compliance with the arm’s length principle and international transfer pricing best practices.
Therefore, understanding controlled transactions is crucial for businesses to ensure proper allocation of profits, maintaining compliance with tax rules, and minimising risks of disputes and double taxation.
This article explores what controlled transactions are, their various forms, and why they matter in transfer pricing. We will also highlight practical considerations for the local businesses to ensure compliance with both local and international standards.
What are controlled transactions?
Controlled transactions are business transactions that are undertaken between two or more associated enterprises within both local and MNE groups. These transactions, which are also known as “intercompany” or “intragroup” transactions, are subject to transfer pricing regulations to ensure they are conducted at arm’s length.
The main objective of transfer pricing legislation is to prevent multinational enterprises from shifting profits between entities operating in the same or different jurisdictions that result in the erosion of the tax base.
Such a practice is only possible when there is a level of control that can be exercised within a local or multinational group and across different jurisdictions. This level of control can only exist when the enterprises are associated.
Associated enterprises
Associated enterprises are defined based on domestic circumstances and hence varies, to some extent, amongst different countries. The domestic law in Malawi employs a hybrid qualification with a mixture of minimum shareholding, effective management or control, and other factors.
According to the Taxation Act, enterprises are considered to be associated if:
• one enterprise owns more than 50% of the share capital of the other enterprise;
• an enterprise has the practical ability to manage or control the business decisions of the other enterprise;
• an enterprise liable to tax in Malawi transacts with a resident of a tax haven whether or not they are related; and
• a resident of a tax haven transacts with a permanent establishment of a non-resident enterprise in Malawi, whether or not they are related.
The “de minimis” rule
The domestic law also has a “de minimis” rule that exempts taxpayers from maintaining detailed transfer pricing documentation if the aggregate value of their domestic controlled transactions is less than the Malawi Kwacha equivalent of $135 000 (about K236 million) during a tax year.
The objective of the rule is to reduce the administrative burden on small and medium-sized enterprises (SMEs) and taxpayers engaged in low value domestic controlled transactions thereby allowing the Malawi Revenue Authority (MRA) to focus on high-risk and high-value cases. However, the rule does not allow taxpayers to split what in reality are larger transactions into apparently smaller transactions to avoid the operation of the law.
Taxpayers falling under the “de minimis” threshold must still ensure that their controlled transactions are conducted at arm’s length (and therefore must have transfer pricing policies in place) as this rule only relieves them from maintaining detailed transfer pricing documentation.
Types of controlled transactions
Controlled transactions can take various forms such as transfer of goods, provision of services, licensing of intellectual property, or financial arrangements such as loans, each requiring specific analysis and documentation.
Sale of goods
This is one of the most common forms of controlled transactions that involve the transfer of tangible goods such as raw materials, semi-finished and finished products between associated enterprises. For instance, a local subsidiary importing machinery from its Chinese parent company would be considered a controlled transaction.
Provision of services
Services provided between associated enterprises can range from routine administrative support to highly specialised technical assistance. Such services include management, technical, administrative and shared services provided between associated enterprises. For example, a parent company offering strategic advisory services to its subsidiaries.
However, there are two key issues that must be considered in the analysis of controlled transactions regarding the provision of intragroup services:
Determination of whether intragroup services have been rendered.
An intragroup service is considered to have been rendered if the activity performed provides the service recipient with an economic or commercial benefit. However, if the activity is not one for which an independent enterprise would have been willing to pay or perform for itself; or provides an incidental benefit; or duplicates a service already being performed or if it is for the benefit of its shareholder, the activity is not be considered as an intra-group service under the arm’s length principle.
Determination of whether the pricing for the intragroup services is at arm’s length.
The arm’s length price of the controlled transaction is determined by conducting functional and comparability analyses and applying the most appropriate transfer pricing method to the circumstances of the case.
The major challenges with services include demonstrating the benefit test; allocating costs appropriately and determining a reasonable mark-up on costs to align with the arm’s length principle.
Transfer of intellectual property (IP)
This involves the licensing or transfer of patents, trademarks, copyrights, or know-how between associated enterprises. Proper valuation of IP transactions is complex but essential to avoid tax disputes.
The challenges include valuation of unique and hard-to-value intangibles, allocation of profits, and determining appropriate royalty rates.
Financial arrangements
Controlled financial transactions include intercompany loans, guarantees and cash pooling. These transactions involve the movement of funds within an MNE group which is crucial for financing operations and managing group-wide risks.
These arrangements must reflect arm’s length interest rates and terms. However, the major challenges include determining arm’s length interest rates and fees; ensuring compliance with thin capitalisation rules; and assessing the creditworthiness of the borrowing entity.
Why controlled transactions matter in transfer pricing
Controlled transactions are a primary focus of transfer pricing regulations because they present opportunities for profit shifting by MNEs which might be tempted to allocate profits to low tax jurisdictions by manipulating transfer prices for the controlled transactions. This practice, known as base erosion and profit shifting (BEPS), erodes the tax base of jurisdictions with higher tax rates.
For Malawi, ensuring that controlled transactions are conducted at arm’s length is vital to maintaining tax revenues and economic integrity. The Malawi Revenue Authority requires robust documentation to prove that controlled transactions are priced fairly and consistently with market conditions.
Conclusion
It is essential for local businesses that are part of local or multinational groups to understand and properly manage controlled transactions to avoid tax penalties and ensure fair profit allocation.
By identifying all such transactions, conducting thorough functional and comparability analyses, and maintaining comprehensive documentation, companies can align their transfer pricing policies with both local and international standards.
In our next articles, we will delve deeper into the different types of controlled transactions. We will explore how to apply the arm’s length principle and ensure compliance in specific scenarios.
*Vilipo Muchina Munthali is managing consultant at Swift Resources, an international tax and transfer pricing consulting firm that specialises in developing, implementing and defending transfer pricing policies for both local groups and multinational enterprises.
