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Transfer Pricing Adjustment in South Africa
Transfer prices between associated enterprises must be set at arm’s length for tax purposes. Where the prices are not at arm’s length, such prices must be adjusted to reflect the arm’s length.410 Section 31(1)(b) requires that the terms and conditions of all cross-border transactions between connected persons must be concluded as though those terms are between independent persons dealing at arm’s length level. Section 31(1)(b) provides that:411
Any term or condition of that transaction, operation, scheme, agreement or understanding is different from any term or condition that would have existed had those persons been independent persons dealing at arm’s length.
Where the terms and conditions of the affected transaction differ from those that would have existed at arm’s length, the taxpayer is required, in terms of section 31(2) to calculate its taxable income as if the terms and conditions of the affected transaction had been at arm’s length. If the calculation results in a difference in the taxable income, this amount is referred to as the primary adjustment in tax law parlance. An adjustment is only required if one of the parties derives a tax benefit from the transaction. Section 31(2) subtly introduces the self-assessment principle in transfer pricing as it requires the taxpayer to make the adjustment. This is contrary to the previous dispensation where the Commissioner of SARS was the one obliged to make the primary adjustment. A primary transfer pricing adjustment is a precursor to a secondary adjustment.
In terms of section 31(3) of the Income Tax Act, if the taxpayer is a company, and subject to certain exceptions, the amount of the primary adjustment can be recharacterised by being deemed to be a distribution of a dividend in specie declared and paid by the taxpayer. Although this research is confined to transfer pricing practice by companies, section 31(3)(b)(ii) further provides that where the taxpayer is a person other than a company, the amount of the primary adjustment is deemed to be a donation. This re-characterisation is referred to as the secondary adjustment. The rationale behind section 31(3)’s recharacterisation of the primary adjustment is that due to the non-arm’s length prices charged between the related parties to the affected transaction, the recipient of the payment would have increased profits, which it would likely have repatriated to the non-resident related payee in the form of a dividend, it is for this reason that the hidden profits that were transferred under the non-arm’s length affected transaction should accordingly be re-characterised as a dividend. The deemed dividend imposed under the secondary adjustment should be treated as any other distribution of an asset in specie paid by a resident company to a non-resident person. The dividend would be subject to South African dividends tax at a rate of 20% in terms of section 64E of the Income Tax Act. It is important to note that section 31 does not directly refer to recharacterisation but the deeming nature of section 31(3) has some recharacterisation aspects to it as it deems a primary adjustment to be a distribution of a dividend in specie. The OECD BEPS Action Plan 10 proposes to develop rules to prevent BEPS by engaging in transactions which would not or would only very rarely occur between third parties. This will involve adopting transfer pricing rules which will clarify the circumstances in which transactions can be recharacterised. Given the fact that section 31 does not directly refer to recharacterisation, it is hoped that this provision will in future be amended to take into account this proposal.
The main concern with transfer pricing adjustments in South Africa is that there are no specific penalties imposed in addition to adjustments which has been made by SARS where a taxpayer has failed to make an adjustment because section 31 seem to suggest that a taxpayer will voluntary comply with the law and make an adjustment at all times. The adjustments are not punitive in nature because a taxpayer is put in the same position they would have been had the adjustment took place. This adjustment has no deterrence effect to an errand taxpayer from repeating the same conduct. Adjustment made under the transfer pricing rules could attract penalties for understatement of tax and penalties for underpayment of tax if there was no differentiation between specific and general anti avoidance rules. The problem is that these are general penalties imposed under the Tax Administration Act 2011. Legislative amendments in 2016 have changed the definition of an understatement to encompass any additional tax arising from an adjustment made by the Commissioner under any general anti-avoidance provision. It has been argued elsewhere in this thesis that general anti-avoidance provisions cannot be used to analyse transfer pricing practice. Logically, this makes it difficult to conclude or suggest that penalties under general anti-avoidance rules should be applied to sanction a failure to make transfer pricing adjustment. If it could hypothetically be argued that the transfer pricing rules are an anti-avoidance provision, a penalty equivalent to 75% of the additional tax due would be imposed on a transfer pricing adjustment. Since there are no transfer pricing penalties to deal specifically with the failure to act according to the arm’s length principle, it will help a great deal if section 31 can be amended to cover this aspect since it cannot be covered under section 80A-80L.
The discussion of the transfer pricing adjustment will not be complete without analysing the recent and first ever transfer pricing case in South Africa. The case is Crookes Brothers Limited v Commissioner for the South African Revenue Service.412 This case involves a South African company that advanced loans to its Mozambican subsidiary (“MML”). In its 2015 tax and pursuant to the terms of the loan agreement with its subsidiary, the taxpayer made transfer pricing adjustments to its taxable income. Upon filing their returns the taxpayer requested SARS to issue reduced assessments, claiming that the adjustments were made in error. The basis for the taxpayer’s claim was that the terms of the loan are aligned to the requirements of section 31(7) of the Income Tax Act which would exempt the loan from the application of transfer pricing rules. In terms of section 31(7), an interest-free loan advanced by a resident company to a non-resident connected company will not be subject to the arm’s length transfer pricing provisions of section 31 where:
(i) The resident company directly or indirectly holds in aggregate at least 10% of the equity shares and voting rights in the non-resident company;
(ii) The non-resident company is not obliged to redeem the debt in full within 30 years from the date the debt is incurred; and
(iii) The redemption of the debt in full by the non-resident company is conditional upon the market value of the assets of the non-resident company not being less than the market value of the liabilities of the non-resident company.
The taxpayer supported their claim by furnishing SARS with the loan agreements. Upon SARS’ interpretation of the loan agreements, it concluded that the terms of the loan agreement are contrary to section 31(7) of the Act because there was a clause in the agreement which accelerated the redemption of the loan in the event of bankruptcy, liquidation, business rescue or judgment against MML. Based on that clause, the request for reduced assessments was rejected. The taxpayer made application to the High Court to review and set aside SARS’ decision. The court ruled that the inclusion of this clause in the agreement jeopardised the application of the exemption and the taxpayer’s application was dismissed with costs and the transfer pricing adjustments were confirmed. Despite the parties’ intention, the court gave effect to the wording of the agreements. It remains to be seen if the taxpayer is not going to appeal. The correctness of this judgment is questionable because section 31(7)(b) states that a “foreign company is not obliged to redeem that debt in full within 30 years from the date the debt is incurred“. This in my view means that the foreign company is not required to redeem the debt at the time that the debt is incurred, it would have been correct if the court ruled that a foreign company should not be required to redeem the debt within the 30 year period, or that the resident company should not have the right, or be able to obtain the right, to require the foreign company to redeem within 30 years at any time.
Integration of Transfer Pricing with Thin Capitalisation
As already mentioned, in South Africa, thin capitalisation and transfer pricing are regulated by the same provision.413 The arm’s length principle is also applied to prevent thin capitalisation where financial assistance between connected parties does not meet the arm’s length standard. Financial assistance is described in section 31(1) to include the provision of any loans, advance, debt, security or guarantee.414 In applying the arm’s length principle to thin capitalisation, the taxpayer is expected to use the self-assessment method to determine the amount they would have been able to borrow had the transaction been concluded between independent enterprises.415
South Africa introduced thin capitalisation rules in 1995 as a result of the recommendations of the First Interim Report of the Katz Commission.416 Before the amendment, thin capitalisation was combated by using the arm’s length principle and the fixed ratio approach. In terms of section 31(3) of the Income Tax Act,417 the Commissioner of SARS was empowered to have regard to the international financial assistance rendered by the non-resident (investor) to the resident who is a connected person as defined.418 If the financial assistance was considered excessive in proportion to the particular lender’s fixed capital in the borrower, the interest and finance charges relating to the excessive financial assistance could be disallowed as a deduction.419 In other words, where the transaction did not reflect the arm’s length price, the excessive portion of the consideration was not deductible for income tax purposes.420 The old rules allowed the Commissioner of SARS to adjust the consideration paid in respect of the transaction according to his discretion.421 These rules allowed the Commissioner of SARS to adjust the price of goods or services but not to re-characterise the nature of the goods or services.422 The excessive amount was therefore taxed as a dividend in terms of section 64C (2)(e) of the Income Tax Act and subjected to 20 per cent of the Secondary Tax on Companies (STC).423
It should however be noted that the repealed section 31(3) did not directly prescribe how excessive financial assistance was determined.424 This was determined in terms of SARS ‘Practice Note 2’.425 The SARS ‘Practice Note No 2’ provided that where the debt to equity ratio was less than 3:1,426 the Commissioner of SARS could decide not to adjust the amount in the transaction. Interest falling below the 3:1 ratio was not considered to be excessive.428 Where the debt to equity ratio exceeded 3:1, the Commissioner of SARS had the discretion to disallow any interest relating to the portion of the financial assistance as a deduction in the hands of the resident recipient.
In terms of the current provisions, the 3:1 debt to equity ratio is no longer applicable and SARS ‘Practice Note 2’ has been withdrawn. The deletion of the 3:1 debt to equity ratio as a safe harbour has made the test for thin capitalisation more strenuous and wide. The interrogation of financial assistance has been widened since there are no set parameters built into the charging section as to exactly how excessive financial assistance has to be determined. The Commissioner of SARS’s powers are unlimited in this regard.
The current section 31 requires that the arm’s length principle has to be applied to financial assistance in the same way it applies to any other transfer pricing transaction.The practical effect of the provision is that the taxpayer must determine what amount they would have been able to borrow had the transaction been concluded between independent parties. The taxpayer has to determine their lending capacity by taking into account the terms and conditions which would have been applicable between independent parties on arm’s length terms. Any difference between the tax liability calculated on non-arm’s length terms and the tax liability calculated on arm’s length terms will be treated as a non-arm’s length loan.
CHAPTER 1 INTRODUCTORY CHAPTER
1.1 Background: The Transfer Pricing Concept
1.2 Historical Overview of Transfer Pricing Regulation
1.3 Transfer Pricing Manipulation
1.4 Thin Capitalisation
1.5 Problem Statement
1.6 Research Questions
1.7 Methodology
1.8 Scope of the Study
1.9 Outline of the Chapters
CHAPTER 2 THE ARM’S LENGTH PRINCIPLE AND TAX PLANNING CONCEPTS
2.1 Introduction
2.2 The Arm’s Length Principle
2.3 The Features of the Arm’s Length Principle
2.4 The Advantages of the Arm’s Length Principle
2.5 Problems Associated with the Application of the Arm’s Length Principle
2.6 Tax Avoidance
2.7 Tax Evasion
2.8 Classification of Transfer Pricing Manipulation
2.9 Conclusion
CHAPTER 3 TRANSFER PRICING METHODS
3.1 Introduction
3.2 Overview of the Transfer Pricing Methods
3.3 The Comparable Uncontrolled Price Method
3.4 The Resale Price Method
3.5 The Cost Plus Method (CPM)
3.6 The Transactional Net Margin Method
3.7 The Profit Split Method
3.8 Conclusion
CHAPTER 4 MNES’ REASONS FOR TRANSFER PRICING
4.1 Introduction
4.2 Transfer Pricing as a Neutral Concept
4.3 Reasons for Transfer Pricing
4.4 Conclusion
CHAPTER 5 GENERAL CHALLENGES CONTRIBUTING TO TRANSFER PRICING MANIPULATION
5.1 Introduction
5.2 Lack of Comparable Transactions
5.3 Use of Secret Comparables
5.4 Challenges Posed by E-Commerce on Transfer Pricing
5.6 Conclusion
CHAPTER 6 TRANSFER PRICING IN SOUTH AFRICA
6.1 Introduction
6.2 History of Transfer Pricing in South Africa
6.3 The Arm’s Length Principle in South Africa
6.4 Features of the South African Transfer Pricing Regime
6.5 Other Causes of Transfer Pricing Manipulation in South Africa
6.6 Transfer Pricing Document Requirements in South Africa
6.7 Conclusion .
CHAPTER 7 REGULATION OF TRANSFER PRICING IN THE UNITED STATES (US)
7.1 Introduction
7.2 Historical Background of the US Transfer Pricing System
7.3 Section 482 of the Internal Revenue Code (IRC)
7.4 The Arm’s Length Principle in the US
7.5 The Best Method Rule
7.6 Global Formulary Apportionment Method (GFA) in the US
7.7 Selected Weaknesses of Section 482
7.8 Domestic Transfer Pricing in the US
7.9 Transfer Pricing Documentation in the US
7.10 Advance Pricing Agreements in the US
7.11 The Use of Regulations to Provide Transfer Pricing Certainty
7.12 E-commerce and Transfer Pricing in the US
7.13 Lessons Learnt from the Us Transfer Pricing Regime
7.14 Conclusion
CHAPTER 8 TRANSFER PRICING IN INDIA
8.1 Introduction
8.2 Historical Background to Transfer Pricing in India
8.3 The Legal Framework of Transfer Pricing in India
8.4 The Arm’s Length Principle in India
8.5 Wide Audit Powers Held by the Transfer Pricing Officers
8.6 Transfer Pricing Methods in India
8.7 Supplementary Transfer Pricing Regulations in India
8.8 Dealing with E-Commerce in India
8.9 Thin Capitalisation in India
8.10 Comparability Analysis within the Indian Context
8.11 Transfer Pricing Documentation Requirements in India
8.12 Advance Pricing Agreements in India
8.13 Lessons Learnt from the Indian Transfer Pricing System
8.14 Conclusion
CHAPTER 9 FINDINGS, RECOMMENDATIONS AND CONCLUSION
9.1 Summary of Findings
9.2 Recommendations
9.9 Concluding Remarks
BIBLIOGRAPHY
