World: Transfer pricing trends and challenges
05 September 2011
Posted by: SAIT Technical
In an ongoing effort to modernise South Africa's transfer pricing regulations and tackle potential tax collection deficits, the South African Revenue Service (Sars) is focusing on those problematic areas where it believes there is non-compliance by taxpayers and significant potential for increased collections for the fiscal year. Minister of Finance, Pravin Gordhan, singled out transfer pricing as a key focus area for Sars in his 2010 Budget Speech, specifically where it involves shifting profits to jurisdictions outside South Africa.
This led to proposed changes to the South African transfer pricing rules, namely section 31 of the Income Tax Act No. 58 of 1962 (the Act), which were set out in the Draft Taxation Laws Amendment Bill of 2010. As noted in the Explanatory Memorandum, the 2010 legislative amendments introduced certain modernisation changes to transfer pricing rules in accordance with the Organization for Economic Co-operation and Development's ‘Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations' (OECD Guidelines) on which these regulations are based.
The new wording of the section also removes certain previous uncertainties. We expect Sars to issue a Practice Note in this regard. Whether it will amend or replace the existing Practice Note 7 on transfer pricing in the Act is unclear.
In light of this heightened focus, it is prudent that taxpayers update their transfer pricing reports. This is especially important in the industry and benchmarking analyses, as these are the foundation of a transfer pricing framework. Updated reports will explain any deviations companies experienced from their particular industry's historical trends because of the recession. These explanations would typically include general commercial and industry conditions affecting the members of the multinational, including the current business environment and its predicted changes.
Regarding updated benchmarking analyses, it is important to put the issue of comparability into perspective. A balanced approach in terms of reliability and the burden it creates for taxpayers and tax administrations is needed.
In determining whether certain transactions are comparable, both Section 31 and Practice Note 7 of the Act and the OECD Guidelines include provisions taxpayers must make to determine the relevant risks that would affect the prices or profits attributable to such transactions.
The relevant risks set out by the regulations include financial risks, such as those caused by foreign exchange rate variability.
Paragraph 8.1.2 of the Practice Note issued on 6 August 1999 states that:
"To be comparable means that none of the differences (if any) between the situations being compared could materially affect the condition being examined in the method (eg. price or margin), or that reasonably accurate adjustments can be made to eliminate the effect of any such differences. If suitable adjustments cannot be made, then the dealings cannot be considered comparable."
Section 31 of the Act and the Practice Note do not provide specific guidance on the non-recurring and exceptional items of income/expenses for which the taxpayer can make adjustments to improve comparability.
Paragraph 1 of Article 9 of the OECD Model Tax Convention is the foundation for comparability analyses because it introduces the need for:
- A comparison between conditions (including but not limited to prices) made or imposed between associated enterprises, and those made between independent enterprises to determine whether re-writing the accounts for the purposes of calculating tax liabilities of associated enterprises is authorised under Article 9 of the OECD Model Tax Convention (see paragraph 2 of the Commentary on Article 9)
- A determination of the profits, which would have accrued at arm's length, in order to determine the quantum of any re-writing of accounts.
The South African transfer pricing regulations, in paragraph 8 of the Practice Note, specify factors for evaluating comparability and provide the framework for making comparability adjustments. However, there is no guidance on what kind of quantitative and qualitative adjustments the taxpayer can make. This challenge becomes more difficult because of a lack of quality comparable data in the public domain, leaving room for subjectivity in any transfer pricing analysis.
The UK case of DSG Retail Ltd vs HMRC (2009) UK FTT 31 (TC) 1 reveals that the OECD Guidelines did not require that the only comparables that might be considered were those in identical circumstances to the taxpayer. Rather, it required that only material differences be taken into account through a process of adjustment.
The following is an analysis of certain comparability adjustments that taxpayers may claim to ensure conformity with the arm's length principle.
Adjustment for fixed overheads and start up inefficiencies
It is a common phenomenon for an entity to earn lower profits or even incur substantial losses in the start-up phase because of high fixed overheads, start up inefficiencies and inadequate revenue. At the initial stage, an entity focuses its efforts on setting up operations, recruiting and training staff, building a sales and distribution network and implementing market penetration strategies.
An entity may also have to give additional incentives, offer discounts, float promotional schemes and incur heavy marketing and advertising expenditure to attract customers.
Adjustment for non-recurring and exceptional items of income and expenses
Another adjustment, which is typically at the forefront of benchmarking analyses, is the adjustment for non-recurring and exceptional items. The Practice Note requires that the material effects of differences in comparables concerning the taxpayer should be eliminated by making adjustments in a reasonably accurate manner. The taxpayer may earn lower profit because of exceptional/non-recurring expenses (eg. an increase in a provision for doubtful debts due to a change in accounting policy). Similarly, comparable companies may earn higher profit because of exceptional income.
Adjustment for difference in risk profile
In a South African context, this is arguably the most debated adjustment with regard to transfer pricing. It is a well-established economic principle that there is a strong positive correlation between risk and reward, ie. higher risk is assumed with the expectation of increased returns. Therefore, an enterprise's profit links directly to the risk it undertakes.
Comparable companies typically bear the full range of entrepreneurial risks. Accordingly, an appropriate adjustment should be made to the margins earned by comparable companies to make an equitable comparison. In the absence of any guidance available in the South African transfer pricing regulations, taxpayers resort to varying methodologies to compute risk adjustments.
The Delhi Bench of the Tribunal in the case of Mentor Graphics (Noida) (P.) Ltd. Vs Dy. CIT  109 ITD 101held that adjustments should be made for risk factors, and other factors such as working capital and R&D costs.
South African regulations, through the revised Section 31 or an explanatory Practice Note, should provide guidance on the methodology to perform quantitative adjustments along with practical examples. Adequate guidance on this front will go a long way to reduce disputes and protracted litigations between taxpayers and Sars.