TP adjustments: What are the consequences?
24 January 2014
Posted by: Author: Billy Joubert
Author: Billy Joubert (Deloitte)
South Africa’s transfer pricing rules changed radically for years of assessment starting on or after 1 April 2012. This means that the consequences of such an adjustment being made now are very different, depending on whether the adjustment relates to a year of assessment commencing before – or after - 1 April 2012. Perhaps the most fundamental change was in relation to the mechanics for making transfer pricing adjustments. As regards the consequences of TP adjustments, these are also now very different. Many of the TP adjustments currently being made or contemplated relate to years of assessment commencing before 1 April 2012. For ease of reference we shall refer to such years as old years. Whereas previously such adjustments were made by SARS (by exercising a discretion), under the new rules it is the taxpayer itself which is required to make any adjustments which may be necessary.
Such adjustments must be made when determining the taxable income of the taxpayer. In effect this means that they are made at year-end. The consequences of TP adjustments are also now radically different. Previously a TP adjustment triggered STC. Now a TP adjustment gives rise to a deemed loan by the SA taxpayer to the foreign related party. This deemed loan is referred to by SARS as a secondary adjustment (whereas the TP adjustment itself is referred to as a primary adjustment). The way the secondary adjustment works is that the taxpayer is required to calculate deemed interest on this deemed loan (at an arm’s length rate) and pay tax on that deemed interest each year. The only way of making that deemed loan go away is for the taxpayer physically to be refunded the adjusted amount by the foreign related party.
The timing of the arising of this deemed loan is not exactly clear. For taxpayers, the less favorable possible interpretation is that it arises simultaneously with the non arm’s length transaction. Based on this interpretation, even in the year when the transfer pricing adjustment is made, it is also necessary to calculate deemed interest – from the date of the relevant transaction(s) – and pay tax on this deemed amount. However, we are more inclined to the view that, based on the wording of section 31(3), the deemed loan arises when the taxpayer’s taxable income for the relevant year is calculated (and the transfer pricing adjustment made). This is done at year-end. Based on this interpretation (which we think is the more likely one) the deemed loan only gives rise to additional taxable income with effect from the year after the primary transfer pricing adjustment is made.
This secondary adjustment by means of a deemed loan is an unwieldy mechanism which is going to cause significant difficulty for taxpayers. Imagine a fairly simple scenario involving a South African company which, over a three year period, fails to charge for certain management services rendered to a foreign subsidiary. This exposure is picked up midway through the 4th year. By the time this exposure is identified, the company will be liable for the following:
- Tax on the adjustments that should have been made for each of the years
- Penalties and interest arising from the under-payment of tax for each of the years (because of the fact that no transfer pricing adjustment was made at year-end)
Tax on the deemed interest on each of the 3 deemed loans resulting from the amount that
should have been adjusted at year-end.
Penalties and interest on the underpayment of tax associated with these loans (commencing
from year 2 – if we are correct that the deemed loan arises at year-end)
It can be appreciated that, for a recurring transaction, these exposures just carry on compounding as the years go by as a result of the new deemed loan that arises every year. The alternative to this nightmarish scenario would have been simply to treat the adjusted amount as a deemed dividend subject to something similar to dividend withholding tax. It is suggested that this would have been a much cleaner option. The legislation does not deal explicitly with the consequences of a "repayment” being made to the SA company by the foreign related party. Using the above example, assume that in year 4, the foreign subsidiary pays the SA company the amount that it should have originally paid for the management services. It seems logical that the three deemed loans will disappear.However, what are the tax consequences of the receipt of the amounts?
The SA company’s taxable income will already have been calculated including these amounts. Therefore it seems clear that the subsequent receipt of these amounts cannot comprise a further taxable accrual. The accounting treatment of this receipt is by no means clear. It is a non-taxable receipt for tax purposes but how should it be reflected for accounting? Also, does it make a difference whether the amount is paid by a shareholder in the SA company or by another group company? Most of the TP adjustments being made at the moment still relate to "old” years before these new rules came into effect (in other words, years of assessment commencing before 1 April 2012). Therefore TP adjustments in respect of those years are still required to be made by SARS. Such adjustments only arise if and when SARS exercises its discretion. Therefore the penalty and interest treatment does not apply.
The punitive consequence of a TP adjustment (ie the secondary adjustment) under the old rules was secondary tax on companies (STC). More specifically, the adjustment was deemed to be a dividend (in terms of section 64C(2)(e)) and was accordingly subject to STC. However, STC has been abolished and TP adjustments made by SARS in respect of "old” years are accordingly not subject to STC. The deemed loan described above also does not apply to old years. Therefore the only consequence for the taxpayer of such an adjustment is additional taxable income in the year when the adjustment is made. We have recently seen SARS attempting to circumvent this lack of a punitive consequence by seeking to treat the disputed amount as a distribution made by the SA company to the foreign shareholder. The amount in question comprised a payment made by the SA company. SARS argued that the SA company had derived no benefit at all from the underlying transaction. Rather than making a TP adjustment, SARS argued that the amount constituted "cash distributed or transferred by that company to or for the benefit of that shareholder” as contemplated in section 64C(2)(a).
This ingenious argument, if successful, would have much more serious consequences than the ones described in relation to a TP adjustment for an old year. More specifically:
- The taxpayer would be denied an income tax deduction in respect of the payment (on the basis that it was not incurred in the production of income).
- The taxpayer would be subject to penalties and interest calculated from the relevant year of assessment (for understating its taxable income as a result of claiming the unjustified deduction).
- It would also be liable for STC on the basis that STC should have been paid during the relevant year.
- It would also be liable for penalties and interest in respect of the late payment of STC.
This argument is probably only feasible – if at all – when the underlying transaction has absolutely no substance. In circumstances where there is a genuine transaction, but where the pricing is in dispute, section 31 is probably the appropriate remedy and an attempt by SARS to re-characterise the transaction as described above would probably be unjustified. Therefore, the consequences of TP adjustments are very much in a state of flux. For old years there is no remaining secondary adjustment mechanism, whereas for years starting on or after 1 April 2012, the secondary adjustment mechanism is very uncomfortable. Also, quite significant uncertainty exists as regards the practical application of this mechanism – as outlined above. All of this has the effect of significantly increasing the risks associated with transfer pricing exposures or potential exposures.
This article first appeared on the Jan/Feb edition of TaxTalk.