In the globalised economy of the 21st Century, businesses often operate across borders, creating a web of transactions between associated entities within multinational enterprises (MNEs).
These transactions, referred to as intercompany or intragroup or controlled transactions, include the sale of goods, provision of services, transfer of intellectual property and financial arrangements.
The prices set for these transactions, which are known as transfer prices, are not just a matter of business strategy but also a significant tax compliance issue.
For countries such as Malawi, where transfer pricing laws are relatively new, the subject is not just about aligning with global standards, but also about ensuring that domestic tax revenues are protected.
This article unpacks the concept of transfer pricing, its global and domestic significance, and why it is critical for businesses to understand and comply with these rules.
Defining transfer pricing
At its core, transfer pricing refers to the pricing of goods, services, and intangible assets exchanged between related entities within an MNE or a local group. For example, if a parent company in South Africa sells machinery to its subsidiary in Malawi, the price at which the machinery is transferred is the transfer price.
Unlike transactions between independent parties, the prices for intercompany transactions may not be influenced by external market forces. However, tax authorities should not automatically assume that associated enterprises manipulate their profits as these enterprises sometimes bargain with each other as though they were independent enterprises.
In Malawi, transfer pricing rules address not only cross-border transactions, but also domestic transactions between related entities. This ensures that profits are not artificially shifted between companies operating within the same jurisdiction to lower their collective tax burden.
It should be highlighted at the outset that transfer pricing is not an exact science. As such, it does require the exercise of judgment on the part of both the tax authority and taxpayer.
The importance of transfer pricing
1. Fair tax allocation
Transfer pricing ensures that the profits of MNEs are taxed where economic activities generating the profits are performed. This is critical for fair tax allocation among countries involved in cross-border intercompany transactions.
2. Prevention of aggressive tax avoidance
Tax avoidance is generally considered as an abuse or manipulation of the law rather than a disregard for it. It is often driven by the desire to exploit structural loopholes in the law to achieve tax outcomes that were not intended by the legislation.
Transfer pricing rules aim to prevent profit shifting and base erosion. For example, without such rules, an MNE might charge its Malawian subsidiary excessive management fees, thereby reducing taxable profits in Malawi and shifting them to a low-tax jurisdiction.
3. Revenue protection
For developing countries such as Malawi, protecting tax revenues is essential for funding public services and infrastructure. Transfer pricing regulations play a vital role in safeguarding these revenues.
4. Business integrity and reputation
MNEs that adhere to transfer pricing rules enhance their reputation with tax authorities and the public. They also avoid costly disputes and penalties that can arise from non-compliance.
Key concepts in transfer pricing
1. Controlled transactions
These are transactions between related parties within the same multinational or local group. Examples include sale of goods, such as raw materials or finished products; provision of services such as management or technical support; transfer of intangible assets such as patents, trademarks and copyrights and financial arrangements such as loans, guarantees, or interest payments.
2. Related parties
The parties involved in a controlled transaction are considered related if one has control over the other, or both are controlled by a common entity. Control may be direct or indirect and is typically determined by shareholding or voting rights.
3. Arm’s length principle
The arm’s length principle is the cornerstone of transfer pricing. It requires that the conditions of a controlled transaction be consistent with those that would have been agreed upon between unrelated parties under comparable circumstances.
The arm’s length principle in practice
The arm’s length principle ensures that intercompany prices reflect market realities. For example: If a Malawian parent company sells products to its subsidiary at K5 000 per unit, but sells identical products to unrelated customers at K10 000 per unit, this would likely violate the arm’s length principle if the price paid by the subsidiary is outside the arm’s length range.
In transfer pricing it is not always possible to determine a single correct arm’s length price, rather, the correct price may have to be estimated within a range of acceptable prices, i.e., the arm’s length range.
Transfer pricing in Malawi
The transfer pricing regulations are contained in Section 127A of the Taxation Act, Cap 41:01 of the Laws of Malawi; the Taxation (Transfer Pricing) Regulations, 2017; and the Taxation (Transfer Pricing Documentation) Regulations, 2017.
These regulations provide guidelines for determining the arm’s length price for supply and transfer of goods and services; administrative rules, including the types of records and documents required by the Commissioner General of the Malawi Revenue Authority.
The transfer pricing regulations apply to both domestic and cross-border transactions between associated enterprises and are broadly aligned with the Organisation for Economic Cooperation and Development (OECD) Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations.
Non-compliance with the domestic law can result in significant penalties, including tax adjustments and fines.
Transfer pricing challenges
Despite its importance, transfer pricing compliance poses significant challenges for businesses;
(i) Complexity of transactions: Transactions involving intangibles or financial arrangements are often complex and require sophisticated analysis.
(ii) Limited local comparables: In Malawi, finding reliable local comparables for benchmarking can be difficult due to the small size of the market.
(iii) Evolving regulations: Transfer pricing laws in Malawi are still evolving, requiring businesses to stay informed and adapt quickly.
(iv) Resource constraints: Smaller businesses may lack the resources or expertise to implement robust transfer pricing policies.
Global trends and their implications for Malawi
Transfer Pricing is a global issue, with significant developments driven by the OECD’s Base Erosion and Profit Shifting (Beps) initiative. Key recommendations under Beps Action Plan 13 include:
(i) Master File
(ii) Local File
(iii) Country-by-Country Reporting (CbCR)
For Malawi, the domestic law only requires taxpayers to prepare the local file. However, it is necessary to align fully with Beps Action Plan 13.
These global standards on transfer pricing present both opportunities and challenges. While compliance with Beps recommendations enhances credibility, it also places additional demands on businesses and tax authorities.
Why businesses must take transfer pricing seriously
Ignoring transfer pricing regulations can lead to severe consequences, including: Tax adjustments and penalties; lengthy and costly disputes with tax authorities and reputational damage that can harm business relationships.
Conversely, proactive compliance can provide significant benefits such as avoiding penalties and disputes; building trust with tax authorities and enhancing business reputation in the global market.
Conclusion
Transfer Pricing is a critical issue that affects businesses, tax authorities, and economies at large. For Malawi, it represents an opportunity to safeguard tax revenues, not just from cross-border transactions but also from domestic arrangements.
However, it also poses challenges, particularly for businesses that are new to the concept. In Malawi, where both international and domestic transactions are subject to scrutiny, businesses must understand and comply with transfer pricing rules.
This article serves as a starting point for unpacking transfer pricing. In the coming articles, we will delve deeper into various aspects of transfer pricing, from functional analysis and Transfer Pricing methods to documentation requirements and dispute resolution.
Our goal is to demystify this complex topic and provide practical insights for businesses operating in Malawi. By the end of this series, readers will have a comprehensive understanding of this critical topic.
Join us for the next article, where we will explore the arm’s length principle in detail. We will discuss its origins, application, and why it is the foundation of transfer pricing compliance. n
*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.
