RM9.0 million transfer pricing exposure identified before an LHDN request: rebuilding a loss-making manufacturer’s position

A contract manufacturer had already prepared transfer pricing documentation to explain its operating loss. But the benchmarking analysis was based on an outdated range, while parts of the explanation were inconsistent with the risks allocated under the company’s own intercompany agreement. KTP reviewed the position, quantified the potential exposure and rebuilt the analysis before any LHDN notice was issued.

The result

KTP identified and quantified a potential transfer pricing adjustment of RM9.0 million, together with surcharge exposure of up to RM450,000 and documentation penalty exposure of RM20,000 to RM100,000 per year of assessment.

The company now has a complete, evidence-based transfer pricing file that can be furnished within 14 days of an LHDN request, together with a revised cost-plus pricing formula designed to address the issue prospectively rather than repeating the same problem year after year.

At a glance

Client:Johor-based component manufacturer within a regional MNE group
Revenue: RM180 million

Business model: Substantially all output sold to a single related-party principal under a cost-plus supply agreement
Issue:Operating loss, with EBIT margin of negative 1.2%.
Service: Benchmarking review, functional and risk analysis, documentation rebuild and pricing policy reset

The challenge

The company closed the year with an operating loss despite operating under a cost-plus arrangement with a related-party principal.

Transfer pricing documentation had already been prepared, but management still faced a more important question: would the position stand up if LHDN reviewed it?

The existing file explained the loss by reference to falling demand, rising raw material costs and underused fixed capacity. On the surface, the explanation appeared reasonable. But a closer review identified two issues that could materially weaken the company’s position.

What we found

The benchmarking analysis used the wrong range. Under the Transfer Pricing Rules 2023, Malaysia’s arm’s length range runs from the 37.5th to the 62.5th percentile, rather than the 25th to 75th interquartile range commonly used in earlier benchmarking studies.

The existing file had been prepared using the old range and had not been retested. On the current basis, the company fell outside the arm’s length range, exposing the result to a potential adjustment to the median.

The explanation was inconsistent with the contract. Under the company’s supply agreement, volume, market and capacity risks were allocated to the principal.

That created a problem with the existing explanation. If the manufacturer did not bear those risks, relying on falling volume or underused capacity to explain its weak return could be inconsistent with its contractual risk profile.

Instead of strengthening the company’s position, the inconsistency could have raised questions over whether the contractual allocation of risk was reflected in practice.

Our approach

We tested the range before defending the result. We rebuilt the comparable set using single-year data, screened out comparables that did not perform sufficiently similar functions and considered the preference for local comparables. This changed the arm’s length range and clarified the company’s actual position.

We reconciled the explanation against the contract. We reviewed the intercompany agreement against the company’s actual conduct, function by function and risk by risk. The commercial explanation was then rewritten so that it relied only on factors consistent with the company’s functional and risk profile.

We replaced narrative with evidence. We supported the position with segmented financial information prepared on a documented allocation basis, a quantified capacity utilisation adjustment, order and volume records, and third-party industry data showing broader margin pressure.

We quantified the exposure and the options. We set out the potential adjustment, surcharge exposure, documentation penalty exposure, the voluntary disclosure route and the option of revising the cost-plus formula prospectively so the same issue would not recur in future years.

Why this matters today

The Transfer Pricing Rules 2023 apply from year of assessment 2023. Transfer pricing documentation must be furnished within 14 days of an LHDN request, and failure to do so can attract a penalty of RM20,000 to RM100,000 for each year of assessment.

A surcharge of up to 5% may also be imposed on a transfer pricing adjustment that increases income or reduces a deduction or loss.

Companies still relying on benchmarking studies prepared under the previous interquartile range should therefore consider whether those studies remain appropriate under the current rules, rather than waiting until an LHDN request is received.

KTP's View

A well-written explanation is not enough if it is inconsistent with the company’s functional and risk profile.

The analysis has to run in the right order: first test the arm’s length range, then establish what the company’s functions and risks support, and only then build the evidence around that position.

For a loss-making entity, consistency between the contract, actual conduct, financial results and transfer pricing documentation is what makes the position defensible.