Author: Wendy Lumsden (Mazars)
In South Africa, as is the trend internationally, the focus on transfer pricing is growing. Both the Organisation for Economic Co-operation and Development (OECD) and the Davis Tax Committee have recommended changes to enforce arm’s length transacting within multinationals.
As the focus by tax authorities on transfer pricing continues to escalate, we consider the necessity for South African clients to properly determine arm’s length prices and prepare transfer pricing policies based on transfer pricing research and analysis.
In terms of section 31(2) of the Income Tax Act1 taxpayers must accrue for tax purposes, arm’s length charges in respect of all goods and services provided by or to a non-resident connected person. Where the Commissioner for the South African Revenue Service (SARS) is of the opinion that the charges are not at arm’s length, he may adjust the prices accordingly for tax assessment purposes. It is worthy to note that the definition of connected person is very wide. In addition, the term ‘transactions’ for the purpose of transfer pricing includes transactions, arrangements, operations, schemes, agreements or understandings, whether recognised for accounting purposes or not. For example the rate of interest, terms and conditions for funding provided by a non-resident connected party must, for tax purposes, be that which would have been charged by an independent finance provider operating on an arm’s length basis.
The need for transfer pricing documentation
Currently there is no statutory requirement in South Africa to prepare transfer pricing documentation. However, the annual tax return asks for details of all cross-border related party transactions and requires disclosure of whether a transfer pricing document has been prepared. SARS therefore has the required information to request proof that arm’s length prices are being charged for relevant transactions or services.
The onus lies with the taxpayer in proving that prices of transactions with connected non-residents are at arm’s length. In terms of the Tax Administration Act (TAA)2 SARS may request a taxpayer to furnish proof of transacting at arm’s length within 10 business days of the date of request.
The Davis Tax Committee recommended that South Africa should follow the OECD standardised transfer pricing documentation approach and that it should be compulsory for multinational businesses.
The benefits of transfer pricing documentation
Undertaking a benchmarking or comparative pricing exercise and preparing a transfer pricing policy with supporting documentation will reduce the risk of SARS adjusting taxable income or deductions for taxpayers in respect of international connected party transactions. If such adjustments resulted in an increased tax assessment, this may be subject to additional tax payable, tax penalties and interest on outstanding tax and penalties.
The penalties for understatement of tax range from 10% (for voluntary disclosure) to 200% (for ‘intentional tax evasion’)3. Therefore, a transfer pricing adjustment may raise a very material tax liability when taking into account that understatement penalties can be levied even if the taxpayer is in an assessed loss situation.
The impact of transfer pricing adjustments:
The financial impact of a transfer pricing adjustment is best described by way of example. A South African company (SACo) provides management and technical services to a Nigerian mining company in which SACo has a 60% interest and charges R1m per annum. The arm’s length price of such services is R1.5m per annum.
Corporate tax in Nigeria is levied at 30% and a 10% withholdings tax on services applies to service payments to non-residents.
|Taxable Income in SA:||R1 000||000|
|Transfer pricing adjustment:||R500||000|
|Tax at 28%:||R420||000|
|Less foreign tax rebate||-R100 000|
|Plus dividends tax @ 15%||R75||000|
|Total tax||R395 000||before penalties|
|Effective tax on R1m||39.5%||before penalties and interest|
Taking into account the fact that the R500 000 transfer pricing adjustment by SARS is unlikely to be deductible in Nigeria, the tax leakage for the International Group is likely to be more material than illustrated above.
Developing a Transfer Pricing Policy and managing international tax risks is therefore vital to any multinational company operating in South Africa.
1 Income Tax Act No. 58 of 1962
2 Tax Administration Act No. 28 of 2011
3 Per section 223 of the TAA
This article first appeared on mazars.co.za.