Author: Jonathan Sweidan (KPMG)
Jonathan Sweidan argues that bilateral or multilateral safe harbours should be considered by SARS seeing as they can mitigate the major problem of double taxation.
The South African Revenue Service (“SARS”) has declared that transfer pricing is one of the highest priorities in terms of revenue and enforcement. Transfer pricing has attracted front page attention for many years, including former president Thabo Mbeki’s famous declaration at the 2011 launch of the United Nations Economic Commission for Africa (“UNECA”) that multinational enterprise (“MNEs”) illegally export about US$50 billion from Africa every year. Though not mentioning transfer pricing, he was clearly referring to the outflow of funds through over-invoicing and under-pricing of exports, which should be regulated by transfer pricing legislation.
Globalisation and the growth of MNEs have added a new dynamic to the tax regimes of states; as states now seek to find new equitable and just ways to apportion tax revenues. As tax authorities fight to maintain their tax bases, while preserving comity, they are continually looking for better and more efficient ways to deal with international and bilateral tax matters.
This has, in recent years, raised the question as to the feasibility of safe harbours, particularly in the Republic of South Africa. Safe harbours can be understood as thresholds provided by a tax authority for select taxpayers covered by transfer pricing regulations. Therefore, if the transfer price for the prescribed intra-group transactions is within the prescribed thresholds, then the tax authority is bound to accept the same without detailed scrutiny. A safe harbour can take various forms. At one extreme, satisfaction of specified requirements can lead to complete exemption from certain substantive or procedural requirements. More typically, a safe harbour applies a simplified set of rules to achieve compliance, if the taxpayer meets the threshold qualifications.
Safe harbours thus are not necessarily the arm’s length price for transactions, but rather represent an ‘election’ by which the taxpayer could reduce its transfer pricing litigation exposure. The thresholds provided are typically higher than the margins that would otherwise be arrived at through a traditional benchmarking study.
Historically, the Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations (“OECD Transfer Pricing Guidelines”) has taken a negative stance on safe harbours. In this regard, the 1995 version of the OECD Transfer Pricing Guidelines considered the use of safe harbours and ultimately recommended against the adoption of safe harbours, concluding that the problems of safe harbour approaches outweighed their potential benefits.
The negative considerations included:
- The safe harbour may displace a more appropriate method in specific cases, such as a CUP or other transactional method, or sacrifice accuracy — and thus be inconsistent with the arm’s-length method;
- Safe harbours are likely to be arbitrary, and sufficient refinement to satisfy the arm’s-length standard would impose burdens on the tax authority;
- Shifting income to the safe harbour jurisdiction to satisfy the safe harbour could undermine compliance in the foreign jurisdiction, and also lead to the prospect of double taxation;
- Competent authority support from the safe harbour jurisdiction should be made unavailable as a consequence of the election, so that relief could be obtained only by the taxpayer convincing the other country that its results were at arm’s-length;
- Foreign tax authorities may find it necessary to audit more extensively situations where a safe harbour was elected abroad to avoid revenue loss, thus shifting the administrative burden to such countries;
- Tax planning opportunities might be created — for example, for relatively profitable companies — including shifts to low-tax countries or tax havens;
- Equity and uniformity concerns.
Although South Africa is not a member country of the OECD, the OECD Guidelines are acknowledged as an important, influential document that reflects unanimous agreement amongst the member countries, reached after an extensive process of consultation with industry and tax practitioners in many countries. The OECD Guidelines are also followed by many countries that are not OECD members and are therefore becoming a globally accepted standard. In order to determine whether the purchase price of the relevant product is at arm’s length, it is necessary to examine OECD Guidelines.
In this regard, paragraph 3.2.1 of Practice Note 7 of the Act states that, because of the international importance of the OECD Guidelines, the PN7 is based on, inter alia, those guidelines. Furthermore, paragraph 3.2.3 of PN7 requires that the OECD Guidelines should be followed in the absence of specific guidance in terms of PN7, the provisions of section 31 or the tax treaties entered into by South Africa.
On a practical level, however, a number of countries have adopted safe harbour rules. What one finds is that safe harbour rules tend to be applied to the smaller taxpayers and to less complex transactions: where the size of the deal does not validate the cost of administration. Some of the existing global safe harbours include:
- Australia allows a mark-up of 7.5 percent on inter-company services;
- New Zealand accepts recharge of cost plus 7.5 percent for intra-group core services;
- Switzerland has a safe harbour for interest charged on intercompany loans, with different rates for loans financed through equity and loans financed through debt;
- The US has a safe harbour for intercompany financing. A company can apply the US Government Applicable Federal Rate (“AFR”), published by the Internal Revenue Service (“IRS”) every month;
- In the final US services regulations, there is a cost-only safe harbour allowing for the charge of routine services without a mark-up.
An interesting case study is that of India, a fellow member of the so-called BRICS nations. India very recently finalised their safe harbour rules that spell out the expenses a taxpayer is expected to earn for certain categories of international transactions. The safe harbour rules cover transactions relating to the provision of software development services, information technology enabled services, (“ITES”), knowledge process outsourcing (“KPO”) services, contract research and development (“R&D”) services, manufacture and export of automotive components, etc.
Another BRICS member, Brazil, is a challenging jurisdiction when establishing and supporting transfer pricing policies due to the fact that Brazilian local requirements are not aligned with the global arm’s length principle. This difference in alignment often creates double taxation when taxpayers do not proactively manage their transfer pricing policies.
However, despite the complexity due to this different criterion in Brazil, Brazilian rules also provide for fixed profit margins which may be applied as safe harbours that taxpayers may use to their own benefit. Under Brazilian rules, taxpayers have flexibility when choosing the method applied. Moreover, taxpayers may change the method applied on a yearly basis without requiring any justification or approval.
In the UK, there is an exemption that will apply for most small and medium sized enterprises. The conditions attached to this exemption can be found in HMRC’s International Manual. In this regard, a business is a ‘small’ enterprise if it has no more than 50 employees (and either an annual turnover or balance sheet total of less than €10 million) whilst a ‘medium-sized’ enterprise is defined as having no more than 250 employees (and either an annual turnover of less than €50 million or a balance sheet total of less than €43 million).
As it stands in South Africa, the burden on taxpayers to comply with the varying transfer pricing rules of the many jurisdictions in which they operate is immense, ranging from documentation required as part of tax returns or to minimise tax penalty exposure, to cooperation with lengthy and deep tax examinations. This is something small that firms that do not enjoy the economies of scale that huge MNEs do, find to be very financially constraining.
Safe harbour concepts are not new to transfer pricing in South Africa. The South African thin capitalisation provisions contained in section 31(3) of the Act as at 31 December 2011, read together with Practice Note 2 (“PN2”), dated 14 May 1996 (“the Practice Note”), issued by SARS in relation to thin capitalisation, could only be applied where a non-resident connected person (referred to as an “investor”) granted financial assistance in the form of an interest-bearing loan, advance or debt to a resident, as well as where that investor provided any security or guarantee to the resident concerned.
PN2 contained the guidelines for the application and interpretation of the thin capitalisation provisions in South Africa. In terms of PN2, the Commissioner of SARS would generally not regard a company as being thinly capitalised provided its interest-bearing foreign debt to fixed capital ratio does not exceed a ratio of 3:1. Where the South African resident company did not comply with the 3:1 safe harbour ratio prescribed in terms of PN2, the Commissioner would disallow a deduction claimed in terms of section 11(a), read with section 23(g) of the Act on the portion of interest relating to the excessive portion of financial assistance.
The advantages that a safe harbour system can offer SARS and taxpayers include:
- Simplifying compliance and reducing compliance costs for eligible taxpayers in determining and documenting appropriate conditions for qualifying controlled transactions;
- Providing certainty to eligible taxpayers that the price charged or paid on qualifying controlled transactions will be accepted by the tax administrations that have adopted the safe harbour with a limited audit, or without an audit beyond ensuring the taxpayer has met the eligibility conditions of, and complied with, the safe harbour provisions;
- Permitting tax administrations to redirect their administrative resources from the examination of lower risk transactions to examinations of more complex or higher risk transactions and taxpayers;
- Reducing or eliminating the possibility of litigation; and
- Helping boost foreign direct investment.
Simplification of the rules and reduction of taxpayer administrative burdens are high-priority government objectives in themselves. The above suggestions for safe harbour approaches recognise this situation while attempting to strike an appropriate fiscal balance. Therefore, the issue that SARS must consider is not whether or not to apply safe harbour, rather it is an issue of how. The method employed should be thought out thoroughly, profit level indicators considered, arm’s length ranges periodically published, proper competent authority assistance as well as anti-abusive rules considered.
Thus, it is a matter of considered calibration, where risk and efficiency are balanced. Furthermore, bilateral or multilateral safe harbours should also seriously be considered by SARS, because they can mitigate the major problem of double taxation. This would be particularly attractive with some of our major trade partners within SADC as well as in the BRICS.