Transfer pricing and customs valuation considerations in Sri Lanka

Transfer pricing is a concept that is of increasing importance to businesses, especially those with cross-border intercompany transactions. 
As international tax and transfer pricing landscapes, both globally and in Sri Lanka, are developing rapidly, the multinational enterprises (MNEs) should stay ahead of the intricacies of transfer pricing compliance and ensure that their transfer pricing practices align with the evolving regulatory landscape. It is therefore an opportune time for businesses to review their transfer pricing arrangements, both from an operational effectiveness and compliance perspective.

A recent webinar hosted by KPMG Sri Lanka shed light on the key concepts of transfer pricing and importance of achieving full compliance with regulations to mitigate transfer pricing risk exposure.

Setting the stage for the topic, KPMG Sri Lanka Director Tax and Regulatory Hasitha Radella said, “Governments are now dedicating substantial resources to transfer pricing enforcement, aiming to foster growth in tax revenue. This underscores the significance for taxpayers to proactively align their supply chains and pricing policies with the evolving expectations of tax authorities, thereby minimising the risk of prolonged disputes.” 

What is transfer pricing? 

Transfer pricing deals with the determination of prices charged in transactions performed between related companies. Transactions between related parties should observe the arm’s length principle. This means the prices charged in related party transactions should not differ from the prices charged in third party transactions, under comparable circumstances. 
It is a concept applicable to cross-border transactions of tangible goods between related parties. It is important to note that the price is determined by the group management and is not subject to normal market forces of supply and demand. 

Take an example of ABC UK, a company conducting operations across multiple countries, with branches worldwide. ABC UK manufactures and sells its products to ABC SL for sale in the Sri Lankan market. If the transfer price of products sold to Sri Lanka is low, there would be higher profits parked in ABC SL. 

However, if ABC UK decides to increase its selling price to ABC SL, SL profits will reduce. By simply changing the transfer price, the group can shift profits from one country to another. Transfer pricing provisions help regulate the pricing of transactions between related parties to avoid such a situation. 
As such, if ABC UK is selling to ABC SL, it should transact at a price that ABC UK would adopt when it transacts with a third party in a similar circumstance. This will ensure that each country receives a fair price on which it would receive its revenue from taxes. 

A global issue

The issue of profit shifting among the MNEs is a matter of global concern, which has been addressed by international organisations such as the Organisation for Economic Cooperation and Development (OECD), United Nations and World Bank. The OECD was assigned the responsibility of identifying loopholes within the international tax system, quantifying the impact of profit shifting on tax revenue and proposing suitable solutions. 

The OECD findings have estimated that the annual revenue loss from tax planning and profit shifting strategies used by the MNEs is around US $ 100-240 billion, representing around 04-10 percent of the global corporate income tax revenue. The OECD presented a set of 15 action items to address the loopholes identified. Initially, they held the belief that the expected outcome could be achieved if only the OECD member countries implemented these action items. 

However, they later recognised that this approach is insufficient and it was imperative that all countries collaborate to achieve the targets. An Inclusive Framework was established in 2016, with four minimum standards, to which the member nations are expected to conform. Currently, over 140 countries, including Sri Lanka, have implemented these standards, to tackle tax avoidance, improve the coherence of international tax rules and ensure a transparent tax environment. 
It was recently revealed by advocacy group Tax Justice Network that over US $ 407 million was lost during the year, due to profit shifting/global tax abuse by the MNEs in Sri Lanka, representing 3.6 percent of total tax revenue – higher than both the regional and global average. The MNEs attempt to shift profits away from Sri Lanka, due to the relatively higher tax rates.

‘‘Governments are now dedicating substantial resources to transfer pricing enforcement, aiming to foster growth in tax revenue. This underscores the significance for taxpayers to proactively align their supply chains and pricing policies with the evolving expectations of tax authorities, thereby minimising the risk of prolonged disputes”

KPMG Sri Lanka Director Tax and Regulatory 
Hasitha Radella 

Steps involved in a transfer pricing exercise 

The transfer pricing regime in Sri Lanka is primarily governed by Inland Revenue Act No 24 of 2017 and Transfer Pricing Regulations No 2 of 2020 as well as various other notices, gazettes and guidelines.
The companies need to first identify whether an ‘associated enterprise’ relationship exists between the related parties. The definition of who is an associated enterprise is very wide and is prescribed in detail in Inland Revenue Act No 24 of 2017. Broadly speaking, it is where there is a degree of direct or indirect control between parties. 
Once associated enterprises have been identified, the transactions carried out with such parties would fall under the domain of transfer pricing regulations. The transactions between two associated enterprises should be carried out in accordance with the arm’s length principle. The arm’s length price will be determined by the application of the most appropriate pricing method, namely:

• comparable uncontrolled price method;
• resale price method;
• cost plus method;
• transactional net margin method or 
• profit split method.

Controlled and uncontrolled transactions 

Under the arm’s length principle, the transactions within a group are compared to transactions between unrelated entities, under comparable circumstances. There can be internal comparables and external comparables. The internal comparables refer to transactions conducted with third parties by the company itself. Adjustments may be necessary to address disparities between the transaction and internal comparable. If an internal comparable cannot be identified, the external comparables can be sourced from different third party databases.

Compliance requirements and penalties

Local file (detailed information and overview of the local entity and transactions involving the local taxpayer) – required if aggregate value of associated enterprise transactions exceed Rs.200 million annually.
Master file – (if the taxpayer is a member of an MNE group, an overview of the group and standardised information about its business should be provided) – required if the aggregate group revenue exceeds EUR 50 million or the rupee equivalent.
Country by country reporting (CbCR) – (information about the allocation of global income, income taxes paid and business activities of the MNE by tax jurisdiction) – required if the total consolidated group revenue exceeds EUR 750 million or the rupee equivalent.
Transfer Pricing Disclosure Form – required to be filed with the Return of Income if the aggregate value of the associated enterprise transactions exceed Rs.200 million annually.
Schedule 9B of the Return of Income – applicable to all taxpayers with associated enterprise transactions.
If the taxpayers fail to maintain and submit documentation, various non-compliance penalties and fines will be imposed. 

Active enforcement of transfer pricing regulations

It is essential for the MNEs to ensure proper preparation of current, valid intercompany agreements, representing the nature and risk responsibilities involved in transactions as well as be prepared to provide supporting documentation to substantiate financial statements and information provided to the Inland Revenue Department. 
The taxpayers need to recognise the importance of having the relevant documentation in place and revisit the intercompany transactions to see if reasonable transfer pricing has been applied well in time, before the Inland Revenue Department commences transfer pricing audits. 
During the pandemic, there was a slow-down in tax investigations – however, they are on the rise currently, for a number of reasons:

• Sri Lanka needs to increase tax collection to reduce borrowing and face the ongoing financial crisis.
• Tax authorities are privy to more information than ever before, due to increased reporting requirements and tax transparency.
• The Inland Revenue Department is making better use of technology to analyse data and make well-informed decisions.
• Audits are being approached more aggressively, with increased focus on detailed fact finding and evidence testing.

Since Sri Lanka is a relatively high tax environment, the tax authorities are aware that the companies are looking to shift profits out of Sri Lanka, hence the heightened focus transfer pricing monitoring.

Additionally, the webinar delved into an overview of customs valuation rules, opposing interests of the Commissioner General of Inland Revenue (CGIR) and Director General of Customs (DGC) and the balancing thereof and practical applications. A noteworthy point of interest raised was the conflicting interests between the two governing authorities in relation to import and export of tangible goods – the DGC aims to achieve the highest transaction value (which would lead to increased customs duties) whereas the CGIR focuses on ensuring that the profits reflected in the financial statements are accurate and in line with the transfer pricing regulations – that is no overstatement of expenses through cost of imports, royalties payable, patent costs or supporting services. 

As such, it was emphasised that the entities should focus on the total tax liability as well as the impact from the perspective of both transfer pricing and customs valuation, in relation to intercompany cross-border transactions for tangible goods.