Managing transfer pricing risks

Written by Avik Bose, Lee Siew Ying and Foong Chee Hong

Fund managers are facing new challenges as tax authorities seek to establish increasingly stringent transfer pricing compliance requirements.

In recent years, transfer pricing has become increasingly relevant to the fund management industry as it is not uncommon for fund managers to sub-contract part of the value chain to associated enterprises located in other jurisdictions. As tax authorities seek to establish increasingly stringent transfer pricing compliance requirements to promote greater transparency and a more equitable share of the global tax pie, corporate citizens with an international footprint - including fund managers - find themselves facing a new set of challenges.

By definition, transfer pricing refers to the pricing of goods, services and intangibles transferred between entities belonging to the same business group (related parties) with a mandate that the pricing be at arm's length. 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 to that transaction. As an international business and financial hub for multinational corporations, Singapore prescribes to the international standard of this principle to guide transfer pricing.

Singapore is regarded as one of the most appealing jurisdictions for fund managers to operate, owing to its conducive business environment as well as regulatory and tax regimes. In addition to the bevy of tax incentives available to fund managers, the Singapore government recently launched the Variable Capital Company (VCC) that offers increased operational flexibility compared to the existing investment fund structures. This being said, fund managers intending to set up office in Singapore should first establish a proper transfer pricing framework ensuring that all related-party arrangements conform to the arm's length principle.

Transfer pricing considerations for fund managers

When a fund manager sub-contracts part of the value chain to an associated enterprise, the latter should be remunerated at arm's length. The first step in establishing a proper transfer pricing framework involves a comprehensive value chain assessment that maps out the group's core activities. Typically, core functions consist of portfolio management, trade execution, research, marketing and distribution activities while non-core functions consist of accounting, fund administration as well as other back-end reporting activities. More often than not, core and non-core functions are highly integrated, and the challenge of value chain analysis is how to accurately isolate each function.

To further complicate matters, fund managers may outsource only a part of the fund management function to sub-advisers abroad; they are required to retain the discretionary control over broader investment decisions.

While the overall operational structure of the fund management industry is broadly similar, the choice of an appropriate transfer pricing method to remunerate each activity can be complex and diverse in practice. The most common transfer pricing methods for the fund management industry are the comparable uncontrolled price (CUP) method, the cost-plus method and the profit-split method.

The CUP method compares the price charged for services transferred in a related-party transaction with the price charged for similar services transferred between independent parties in comparable circumstances. This method allows fund managers to establish an appropriate arm's length price based on prevailing independent market rates.

The fund management industry is one of the few industries where the CUP method is broadly applied - this is attributed to the fact that various subsets of fund management services are remunerated based on a fee, often calculated as a percentage of assets under management. This method is generally preferred by tax authorities as it is the most direct way to determine the arm's length price, and is usually adopted where the fund manager has full discretionary authority to undertake investment decisions.

In cases where the manager sub-contracts a part of portfolio management to a sub-adviser and retains all key decisions and investment authority inhouse, the sub-adviser could, in theory, be remunerated on a cost-plus mark-up basis. In this scenario, the sub-adviser usually provides advisory services to the primary fund manager and does not have any discretionary powers to undertake investment calls.

The cost-plus method seeks to remunerate the outsourced function by adding a mark-up on the costs incurred in the production of the services to arrive at the arm's length price of that transaction. While the application of this transfer pricing method is relatively straightforward, tracking and allocation of costs incurred during the production of these services become operationally challenging especially when the sub-adviser is also involved in discretionary fund management activities of its directly managed funds, in addition to the provision of advisory services to its group entities.

For more complex cases where the value contributing to the business is harder to pinpoint, the profit-split method may be more appropriate where profits are divided based on the parties' relative contribution to the business. A key aspect of this method is that one needs to assess whether the sub-advisers have discretionary investment decision-making capabilities. If so, considering that the sub-adviser is responsible for making investment decisions and assuming higher risks in relation to their investment calls, often participating in the investment committees, a larger portion of profits (or losses) should be assigned to the sub-adviser.

The application of the profit-split method is more nuanced compared to the earlier two methods. The challenge in applying this method is to devise a consistent approach that can accurately quantify the relative contribution of each involved party.

While the delineation of functional characteristics within a related-party transaction is key to establishing the appropriate transfer pricing framework, it is pertinent to take into consideration the assets and risks that contribute to the overall value creation process. With such complexity involved, it is not uncommon for fund managers to adopt a combination of transfer pricing methods to account for the various considerations.

Way forward

Transfer pricing remains one of the key areas of scrutiny by tax authorities globally as they increase their efforts to clamp down on cross-border tax evasion and avoidance, and Singapore is no exception.

Amid the increased compliance requirements from tax authorities, it is now even more pertinent for corporate taxpayers and, in particular, fund managers to re-assess the appropriateness of the transfer pricing framework and to prepare adequate documentation with robust supporting economic analyses to meet such requirements.

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