Commodity transfer pricing under extra scrutiny

As published in The Business Times on 25 May 2021.

Written by Avik Bose and Hamish Clark, transfer pricing partner and director respectively at Deloitte Singapore. The below are their personal views and may not represent the views of Deloitte.

Recent developments in the world of commodity trading and supply chains could lead to extra scrutiny on commodity transfer pricing from tax authorities around the world, with potential knock-on effects on the commodity trading industry in Singapore.

Transfer pricing refers to the price of goods, services and intangibles sold between entities within or belonging to the same business group (related parties) with a requirement that pricing must be at arm's length. It is estimated that some 60 per cent of global trade involves such transactions. The arm's length principle posits that transactions with a related party should reflect the true economic value of the contributions made by each party.

The commodity supply chain tends to involve a high proportion of transactions occurring between related parties, necessitating a focus on transfer pricing. This is because oil and metals, for example, are rarely produced and consumed in the same country, resulting in a complex international supply chain.

The company extracting the commodity from the ground in one country typically sells to a trading and supply hub in another country. In turn, the trading and supply hub optimises the transaction and ships to the refinery, smelter or power station, often in a third country. This supply chain can involve independent parties (whereby transfer prices are not regulated by tax authorities) but most often, such transactions are between subsidiaries of the same global business group.

Singapore has held its status as a leading hub within the international commodity trade community for many decades, even centuries, due to the fact that the country is at the crossroads of major shipping routes and is relatively near to producers, suppliers, global trading entities and growing markets.

Singapore operates primarily as a trading and supply hub (with some notable refining capability), meaning that its role in the supply chain is to link the other elements together. Its job as a trader is to ensure that the right commodity is supplied to the right location, at the right time and at the most competitive cost. The trader can manage a complex value chain, often covering origination, sourcing, refining, processing, storage and transport - all the steps required to get the commodities to the customers.

The first step towards ensuring compliance with transfer pricing tax rules is to have a clear understanding and explanation of the functions performed, assets employed and risks borne by the group's trading and supply company. This feeds into the economic analysis, ensuring that the correct arm's length price is applied, and forms the backbone of the required documentation.

Trading and supply companies in Singapore range from simple selling agents to full-fledged operations bearing complex risks. The industry trend shows that such companies are playing an increasingly important role in the global value chain, as portfolio trading and hedging creates more profit potential, rather than traditional "tramline" supply. It is important that the taxpayer can clearly explain the commercial purpose of the company and ensure that it has the capacity to manage the risks.

The updated Transfer Pricing Guidelines, published by the Organisation for Economic Cooperation and Development and followed by most countries including Singapore, allow tax authorities to assess transfer prices in the context of the entire supply chain. If group synergies exist, then the benefits of such synergies should generally be shared by the relevant entities, subject to important conditions and circumstances.

The commodities markets - such as oil, gas and metals - are subject to volatile prices, which can result in losses and write-downs. This has been particularly acute during the Covid-19 pandemic. Such losses in the commodity producing countries mean a reduced tax take for the government, during a time when tax authorities are under pressure to raise extra revenues.

Some tax authorities show a lack of knowledge and understanding about the role of commodity traders. They may interpret the profit margin earned by a trader as simply a result of synergies with the rest of the business group rather than understanding the extra value created by managing storage, transport and logistics, among other possible trading activities.

This issue becomes particularly acute if there are losses in the commodity-producing country for which one tax authority is responsible, while further along the supply chain, the trading company in the same business group but in a different country, earns a healthy profit.

Commodity traders often benefit from volatile prices, thus the same market conditions which result in losses in the producing country can lead to extra profit in the trading company. Commodity multinationals could come under pressure from other tax authorities to explain profits in their Singapore-based trading company, particularly if producing countries are suffering losses.

The Inland Revenue Authority of Singapore has a strong understanding of commodity trading, given the successful history of the industry in the country. They provide insightful guidelines on the best approach to setting transfer prices for transactions involving commodity traders.

The transfer price is often based on the commodity market price (known as the comparable uncontrolled price method). However, the correct approach depends on the functions, assets and risks of the trading company. For example, the transfer prices and resulting profit margin in the trading company must reflect the level of risk that it manages, and its local substance.

It is possible to defend a fair transfer price and fair margin with all relevant tax authorities. However, this only holds true if the trading company is set up and operates in a way that aligns with its pricing policies.

Various risk mitigation methods are available, such as upfront pricing agreements with the tax authorities in both countries involved in the transaction, known as advanced pricing agreements. Adequate transfer pricing documentation will always act as the primary line of defence against challenges from tax authorities. It is also recommended for companies to get external advisory services to ensure that a proper analysis of the related party transactions is undertaken, consultation with the relevant authorities takes place and that the necessary documentation is correctly maintained.

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