The first point in any strong defense for transfer pricing is a well assessed functional analysis (i.e. Functions, Assets and Risks (“FAR”) analysis).

• Functions: The service provider and the service recipient should identify their roles and responsibilities. The activities performed by the service provider will assist in identifying the nature of the service.
• Assets: An evaluation of the usage of assets, particularly intangible assets, will further enhance the assessment. Service providers should assess whether their services require the use of unique and valuable intangibles or lead to the creation of such intangibles and what is the impact for the usage or the creation of these intangibles.
• Risks: Finally, the service provider and the recipient should evaluate the level of risk involved in the services, in general, the level of risk should be commensurate with the level of mark-up / margin earned by the service provider.

Once the FAR is complete, the next step would be to identify the nature of the services and where more than one service is provided by a service provider, the service provider should segregate the low value adding and high value adding services (i.e. those services that would likely meet the definition of LVAS or activities that would not qualify for the simplified approach).

Oftentimes, MNE groups fail to assess and record the commerciality of an intra-group transaction, this is to answer, “why would a third party pay for the services?”. By evaluating and documenting the commercial rationale, companies ensure that the transaction is economically rational. The goal is to demonstrate that the services are not artificially created or motivated only by a tax advantage.

Service providers would be required to determine whether the service activities conducted are in fact chargeable and do not contain non-chargeable activities (i.e. shareholder activities, duplicative services, on call services, incidental/passive services). Furthermore, whether the service activities provide an economic benefit to the service recipient.

The determination of an arm’s length charge consists of three key points:

• Cost Identification: It is important that detailed calculations are prepared and maintained showing the determination of the cost pool, including a justification of why the costs are attributable to the service, this can be particularly important to service providers of more than one type of service, such as BPOs. It is important that costs are segregated into staff costs (i.e. costs of staff performing the service), direct costs (i.e. day-to-day running costs), indirect costs (i.e. residual day-to-day running costs) and third-party costs (i.e. license fee paid for third party software).
• Cost allocation: Services that are provided to multiple recipients should have an explanation and justification for the selected allocation keys (i.e. whether it is headcounts for HR services, number of computers for IT services or revenue) including how direct and indirect costs are allocated.
• Mark-up: Should services fall within the definition of LVAS, the simplified approach can be used and the service provider can apply a mark-up of 5%. However, for those services that do not fall within the definition of LVAS should perform a local benchmarking study.

A formal agreement is critical in Malaysia for taxpayers to show that the services activities are chargeable as opposed to just adhoc services that may be considered not chargeable. Agreements are hardly mentioned in the transfer pricing guidelines, nevertheless they are always requested by the tax authority. Therefore, we always recommend to formalise all intra group services with agreements as it reduces significantly the likelihood of the services being characterised as non-chargeable.