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Revenue’s Power To Make Transfer Pricing Adjustments

Section 140A of the Income Tax Act 1967 (ITA) provides that transactions with an associated person must be determined and applied at arm’s length price. This provision allows the Director General of Inland Revenue (DGIR) to substitute prices on transactions between associated persons if the price is less than or greater than the price which might have been fetched if the parties to the transaction had been independent persons dealing at arm’s length.


Legal Position


The DGIR may adjust any price which he has reason to believe is not at arm’s length under Rule 13(1) of the Income Tax (Transfer Pricing) Rules 2012 (the 2012 Rules). In determining the arm’s length price, rule 6 of the 2012 Rules provides that one of the crucial steps includes a comparability or benchmarking analysis to identify independent companies with sufficiently similar characteristics based on the findings in the functional analysis. However, the 2012 Rules are silent on when adjustment would be necessary, as the requirement to make adjustment is merely when the DGIR “has reason to believe” that a price is not at arm’s length.


Subsequently, the Income Tax (Transfer Pricing) Rules 2023 (the 2023 Rules) were introduced, which provide some clarity on determining whether an adjustment needs to be made to the price of a transaction between associated persons. Amongst others, rule 13(3) of the 2023 Rules provides that the DGIR is allowed to make transfer pricing adjustment on margins falling outside the arm’s length range to the mid-point of the arm’s length range, i.e. the median. The need for a comparability analysis remains unchanged and is provided under rule 7 of the 2023 Rules.


Case Law On The Need For Comparability Analysis


(1)            Ensco Gerudi (M) Sdn Bhd v Ketua Pengarah Hasil Dalam Negeri [2021] MLJU 1229


The importance of a comparability analysis is illustrated in Ensco Gerudi, where one of the issues for determination before the High Court was whether the DGIR has a duty to give reasons for its decision to adjust the taxpayer’s transaction with its related party and if so, whether the DGIR had breached such a duty.


In Ensco Gerudi, the taxpayer was principally engaged in the business of providing offshore drilling services and leasing drilling rigs to oil and gas operators in Malaysia. In the course of business, the taxpayer entered into a Master Charter Agreement to lease the drilling rigs from a third-party contractor, Ensco Labuan Limited (ELL). The taxpayer then rented out the drilling rigs to its own customers. As part of the Master Charter Agreement, the taxpayer agreed to pay ELL a percentage of the applicable day rate that the taxpayer earned from its drilling contracts with its customers for the drilling rigs.


The DGIR sought to make adjustments to the arm’s length price of the taxpayer’s transaction with ELL. In doing so, the DGIR dismissed the taxpayer’s use of the transactional net margin method (TNMM) as the appropriate transfer pricing methodology and insisted on the application of the profit split method. Meanwhile, the taxpayer maintained that TNMM was the most appropriate transfer pricing methodology and applying TNMM, the taxpayer fell within the arm’s length range of the comparable companies. Accordingly, the taxpayer claimed that its transaction with ELL adhered to the arm’s length principle and no adjustment was necessary. However, the DGIR maintained its decision and issued additional tax assessments for RM106,766,976.02.


Aggrieved by the DGIR’s decision, the taxpayer filed a judicial review application and succeeded before by the High Court.


The High Court held that the DGIR had acted arbitrarily as there was no transfer pricing report or any functional or economic analysis prepared by the DGIR, leaving the taxpayer in the dark as to how the DGIR arrived at the transfer pricing adjustments. The High Court also found that the DGIR had not proffered any justification on how the taxpayer and ELL were associated persons under Section 140A of the ITA. According to the High Court, the DGIR had only explained that the transactions were carried out between the parties within the same group- however, this was not the requirement under Section 140A. There was also no justification as to why the transaction between the taxpayer and ELL was not at arm’s length especially when the DGIR did not produce its own transfer pricing report.


On appeal, the Court of Appeal reversed the High Court’s decision and held that the DGIR has no obligation to prepare transfer pricing report on matters which were well within the taxpayer’s knowledge. In any event, the court held that the DGIR had provided his reasons for the adjustments in his letters to the taxpayer during the course of the tax audit. Additionally, the Court of Appeal also held that the central issues of the judicial review proceedings in this matter were essentially factual issues that should be decided by the Special Commissioners of Income Tax (SCIT).


(2)            Ketua Pengarah Hasil Dalam Negeri v Procter & Gamble (Malaysia) Sdn Bhd [2022] MLJU 743


In Procter & Gamble, pursuant to a distribution agreement dated 1.7.2001, the taxpayer was appointed as the distributor of Proctor & Gamble International Operations Pte Ltd (PGIOPL) to oversee the distribution of a range of Procter & Gamble consumer goods to Malaysian customers. Article 4.3 of the distribution agreement states that PGIOPL will set the prices of the goods sold to the taxpayer in a manner which guaranteed a margin that adhered to arm’s length principles. The margin between the taxpayer and PGIOPL was agreed at 2.25%.


The DGIR alleged that the margin earned by the taxpayer was not at arm’s length and adjusted the purchasing transaction or other transactions between the taxpayer and PGIOPL to the median of the taxpayer’s set of comparables on the basis that arm’s length price must always be adjusted to median. Thereafter, the DGIR proceeded to issue additional tax assessments against the taxpayer and the taxpayer appealed to the SCIT. The SCIT allowed the taxpayer’s tax appeal and subsequently, the High Court upheld the SCIT’s decision.


Amongst others, the High Court found that the DGIR’s comparability analysis was insufficient as there was no explanation for the rejection criteria, adjustments made to the comparable companies and the search criteria used to look for comparables. In the absence of the DGIR’s own transfer pricing analysis, the taxpayer’s transfer pricing documentation prevailed. As a result, the High Court held that the transfer pricing adjustments made by the DGIR cannot be sustained since the taxpayer established that the margin of 2.25% fell within the arm’s length range.


(3)            Ketua Pengarah Hasil Dalam Negeri v Sandakan Edible Oils Sdn Bhd [2023] 1 LNS 616


In Sandakan Edible Oils, the DGIR invoked Section 140A(3) of the ITA and rule 13(1) of the 2012 Rules in adjusting the taxpayer’s profit margin to the median point, notwithstanding that the DGIR’s own benchmarking analysis was that the taxpayer’s financial results fell within the arm’s length range.


The taxpayer was a company whose principal activity is to carry out the refining and sale of edible oils and related products, and the packaging and sale of cooking oil. The taxpayer was requested to prepare a benchmarking analysis against other refining companies in Malaysia to compare its transaction against the transactions of other comparable entities in the same field. After an exchange of several letters, a final list of comparable companies was agreed upon between the taxpayer and the DGIR. The DGIR then proceeded to prepare a benchmarking analysis based on the final list of comparable companies. Based on the DGIR’s benchmarking analysis, the taxpayer’s financial results fell within the interquartile range. However, the DGIR later alleged that there were 4 comparability defects which required adjustments to be made to the median and raised additional tax assessments. The taxpayer appealed to the SCIT. The SCIT allowed the taxpayer’s appeal on the basis that the DGIR failed to justify that the median price as adjusted by the DGIR was the arm’s length price.


The DGIR appealed to the High Court, which dismissed the DGIR's appeal. The central issue in the DGIR’s appeal was whether the DGIR’s adjustment of the taxpayer’s profit to the median point in determining the arm’s length price was in accordance with Section 140A and the 2012 Rules.


In determining the issue, the High Court found that the DGIR’s adjustment was inconsistent with its action in accepting the taxpayer’s list of comparable companies. The DGIR had on one hand accepted the comparable companies proposed by the taxpayer and on the other hand, was contending that there were comparability defects pertaining to the huge differences in turnover between the taxpayer and the comparable companies. Accordingly, the High Court held that there was no basis in law or fact for the DGIR to adjust the taxpayer’s margin to the median when it fell within the arm’s length range of the agreed comparable companies.




Following the cases of Procter & Gamble and Sandakan Edible Oils as well as the introduction of the 2023 Rules, the position is now clear that the DGIR is only allowed to make transfer pricing adjustment to the median when the profit margin of a transaction falls outside the arm’s length range. If the profit margin falls within the arm’s length range, the price may be regarded as the arm’s length price and therefore, no adjustment is needed.


This position can also be seen in the Indian cases of Global Logic India Pvt Ltd, New Delhi vs Assessee ITA No. 5110/Del/2010 and Agilent Technologies (International) vs Dcit, Gurgaon ITAs No. 1620/Del/2015, 477 & 6429/Del/2016 where the Income Tax Appellate Tribunal held that no adjustment should be made if the profit margins were within the arm’s length range of the comparable companies.


It is clear that the DGIR’s power to make transfer pricing adjustments is not to be exercised arbitrarily. Although the DGIR is conferred the power to make transfer pricing adjustments, such a power is not unfettered. A robust comparability analysis is essential in determining an arm’s length price as it provides clarity as to how the taxpayer arrived at the arm’s length price. This is especially when the DGIR review the related party transactions during the course of a tax audit.


21 March 2024


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