FRS 139 and its bearing on transfer pricing

As if transfer pricing per se is not complex enough, by January 1, 2010 there will be an added factor that involves fair value accounting which is also known as the "mark-to-market" rule.

Since transfer pricing compliances are very much driven by collating data on comparable activities and products provided by competitors within the same jurisdiction - a process that is already difficult in and, of itself, fair value accounting will mean that applicants may have even higher standards of proof.

This Ernst & Young piece is instructive:

COME Jan 1, the Malaysian Accounting Standards Board’s Financial Reporting Standard 139 – Financial Instruments: Recognition and Measurement (FRS 139) will finally be implemented in Malaysia. Four years since its implementation date was set, it is still considered uncharted waters for many corporations. This is not surprising since FRS 139 is considered the “mother” of all standards by some.

Under FRS 139, many financial assets and financial liabilities are required to be carried at fair value. This will have a significant impact on loans between related parties, which generally can be interest-free or carry interest rates which are well below the market rates.

The definition of fair value under FRS 139 is “the amount for which an asset could be exchanged, or a liability settled, between knowledgeable, willing parties in an arm’s length transaction”. Paragraph 48A of FRS 139 further states that “The best evidence of fair value is quoted prices in an active market ... Valuation techniques include using recent arm’s length market transactions between knowledgeable, willing parties, if available ... ”

Interestingly, it loosely echoes the Organisation for Economic Cooperation and Development’s guide for an arm’s length interest rate:

“... an arm’s length interest rate shall be an interest rate which was charged, or would have been charged, at the time the financial assistance was granted, to uncontrolled transactions with or between independent persons under similar circumstances.”

It could well imply that the measurement of related party loans initially at their respective fair values and subsequently at amortised cost using the effective interest method, may be deemed to be in line with the arm’s length principle since market interest rate is used.

Following the introduction of Section 140A of the Income Tax Act 1967 (ITA) which basically requires taxpayers to ensure that their related party transactions are carried out at arm’s length, would this then mean that an assessment of the fair value of related party loans by the auditors under FRS 139 can serve as contemporaneous documentation for transfer pricing purposes?

The corporate taxpayers do not have an option as to whether to accept the fair value accounting treatment in their financial statements – it is a requirement of FRS 139 and also the Companies Act 1965.

Further, requiring corporations to measure related-party loans initially at their respective fair value may not only affect the income statement. However, for certain, the subsequent amortisation amounts, measured at amortised costs, will represent accounting interest income or interest expense in the income statement. Book entries are generally not the actual receipts or payments, and in tax terms are not real costs or income earned.

At this point, it would be helpful to look at what other tax jurisdictions have done under similar circumstances. Hong Kong, Singapore and New Zealand tax authorities have issued departmental interpretation and practice notes on the income tax implications arising from the adoption of IAS 39 or its local equivalent.

While in general most tax authorities require the tax treatments to follow or be consistent with the accounting treatment under FRS 139 as far as possible, they also acknowledge that the revenue versus capital consideration would need to be considered in determining the tax treatment.

As an example, in Singapore, the tax adjustment is such that the discount on the interest-free loan recognised in the income statement will not be allowed as a tax deduction and the interest income recorded will not be taxed because these are merely book entries.

The auditor’s primary role is still that of expressing an opinion as to the true and fair view of the financial statements. This means that corporations would still need to provide auditors with supporting evidence of the fair value of the related-party loans to enable auditors to express an opinion.

The fair value measurement rests on the rebuttable presumption that effective interest rates used in the amortised cost method is the market interest rate and is thus, at arm’s length. While this is generally true, loan arrangements made with unrelated parties in the current business environment should be considered as arm’s length, although they may not carry the same market interest rates due to various factors such as level of credit risks, tenure, size of collaterals, etc.

So, what would corporations provide to the auditors? Section 140A of the ITA provides that the acquisition or supply of property or services with related parties be conducted at arm’s length, failing which the Director General of Inland Revenue may adjust the transfer prices.

Since 2003, transfer pricing guidelines have been issued, setting out the extent of information required in a transfer pricing report. The guidelines also stipulate that it is a pre-requisite that a comparable analysis (benchmarking) be carried out to substantiate the arm’s length pricing.

To ensure that corporations provide auditors with the correct arm’s length and market rate interest for related-party loans in the FRS 139 measurement of fair value, it is very likely that a comparable analysis would need to be carried out. This should then provide the setting not only for the auditors but for the tax authorities in support of the argument for arm’s length. Any fair value book entries put through the financial statements should then be met with minimum queries from the tax authorities.