Transfer pricing has been a growing concern for fiscal authorities over the years, because the transfer price between two related enterprises in different jurisdictions can be artificially set to shift the profit to the country with the lowest tax rate.
South African Revenue Service (Sars) Commissioner Edward Kieswetter has often referred to transfer pricing audits, transfer pricing risks that have been identified, as well as revenue arising out of successful transfer pricing audits.
South Africa first introduced transfer pricing legislation in 1995. Since then, the legislation and guidelines have evolved, with transfer pricing legislation and regulations becoming more and more complex.
The objective of transfer pricing legislation is to protect the fiscus from profit shifting, and the test is that the overall profit arising from a transaction entered into between two associated enterprises should meet the arm’s length test.
Transfer pricing has become a sophisticated ‘industry’, involving extensive databases of pricing information and experts from many professions such as accountants, lawyers, economists, intellectual property specialists and, not least, the revenue authorities.
First transfer pricing guide published in SA
Experienced tax practitioners Nishana Gosai (group tax executive at Adcorp) and Christian Wiesener (associate director at KPMG) have authored an extensive practical guideline from South Africa’s perspective – the Africa Transfer Pricing Practice Guide, published by LexisNexis South Africa.
The guide discusses the applicable legislation, practice notes, the transfer pricing guidelines issued by the Organisation for Economic Cooperation and Development (OECD), and the United Nations practice manual on transfer pricing. It also includes the public notices issued by Sars relating to transfer pricing documentation.
The complexity of transfer pricing can itself be a barrier to entry for the uninitiated. For those new to tax, the guide includes an interesting history of transfer pricing, and defines relevant concepts, such as the arm’s length principle.
A detailed tabulation of the legislative amendments to Section 31 of the Income Tax Act, the transfer pricing provision, from 1995 to 2020, is set out in Appendix B. The relevant legislation and regulations are contained in Appendix C.
Transfer pricing documentation
The onus is on the taxpayer to demonstrate to Sars that it has complied with the arm’s length principle. Taxpayers are therefore required to keep relevant documentation to support their transfer pricing policies.
The guide sets out the documentation requirements, including those needed for the preparation of the master file to be compiled by the multinational entity (MNE group) and/or the local entity.
The MNE group is required to describe its business, including the main drivers of its profit, any intangibles, financial activities, as well as financial and tax positions.
Sars has adopted the country-by-country (CbC) reporting standard, which applies to a taxpayer that is part of a multinational enterprise that has a tax presence in more than one country, and a South African entity may be required to file a CbC report.
The guide sets out all the documentation retention rules, explains the interaction between Practice note 7 and the retention rules, spells out how to submit the country-by-country information, and details the information required to be disclosed on the annual corporate income tax return (ITR14).
Function, risk and asset analysis
In ascertaining whether the arm’s length principle has been applied in achieving the overall profitability of an enterprise relating to its cross-border transactions with an associated enterprise, the OECD guidelines recommend that a functions- (such as the value drivers), risk- and asset analysis is carried out.
The authors discuss the typical functions that would be performed in specific transactions, the relevance of intangible assets, and the relationship between the risk and the return.
“In simple terms, the compensation earned must be commensurate to the functions performed, assets utilised and the risks borne by the respective parties.”
Comparability of transactions
The OECD has recommended various methodologies that can be used to simulate a similar transaction between two independent or unrelated parties (an uncontrolled transaction) – to use as a comparison against a transaction between the associated enterprises (controlled transaction), to assess whether any profit shifting has taken place.
The authors discuss these methodologies, the appropriateness of the method, and the availability of reliable information, the degree of comparability, and the reliability of the adjustments that may have to be made to eliminate material differences.
This is the crux of any transfer pricing evaluation, and technical readers will find this discussion very useful.
The guide includes discussions on further complex topics:
- The attribution of profits to a permanent establishment, which is relevant in South Africa exercising its taxing right over a non-resident doing business in SA, taking into consideration whether there is a double taxation agreement in place between SA and the non-resident’s place of residence. The authors also set out Sars’s approach.
- The identification and valuation of intangibles for transfer pricing purposes.
- Financing transactions, intra-group loans, financial guarantees, debt finance limitation rules, exchange controls, services, reportable arrangements, and cost contribution arrangements.
- The consequences of non-compliance: additional taxes, secondary transfer pricing adjustment, and penalties.
- The only two transfer pricing judgments handed down to date.
- Statutory accounting considerations.
Transfer pricing audits
This is an invaluable section as transfer pricing audits can be very costly, and are resource- and time-intensive.
The authors caution that transfer pricing audits can “span months, even years, and are invasive and disruptive to business”.
They provide examples of the specific risk factors that may spark a transfer pricing audit, as well as what to expect during an audit.
An overview is given in managing the dispute process, including the objection and appeal process and alternative dispute resolution.
The authors should be commended for tackling this mammoth task, and making all the information available in one publication.
This guide, available in both a print version (loose leaf format) and online, is an essential addition to the libraries of universities, tax practitioners, taxpayers involved in cross-border connected person transactions, and Sars.