FW moderates a discussion on transfer pricing in South Africa between Jens Brodbeck and Okkie Kellerman at ENS.
FW: What factors are causing the tax authorities in South Africa to pay more attention to corporate transfer pricing policies?
Brodbeck: Africa is no different from the rest of the world in this respect – there is huge budgetary pressure on the South African government and therefore pressure on the South African Revenue Service (SARS) to recover as much money as possible. Although South Africa was less affected by the global downturn than many other countries, especially those in Asia and Southern Europe, the economy failed to fully recover in the 2009-10 period. With that came an increased focus on transfer pricing, traditionally a lucrative area for tax enforcement. Audits are an effective way to collect money and the tax authorities have increased their manpower and become more aggressive. Areas that are quite topical at the moment are the transfer of intellectual property from South Africa, intergroup loans and thin capitalisation.
FW: How important is it to record documentation, such as intercompany agreements, to anticipate transfer pricing issues?
Kellerman: The South African tax legislation does not prescribe any valuation method for assets, so the general methods are those used for accounting purposes. When putting agreements in place, it is of paramount importance that companies have all the cross-border transactions defined, highlight the functions and risks performed by each part, and clearly outline the price that will be charged on these cross-border transactions. Legal agreements should flow from transfer pricing documentation, as the legal foundation for activities between various group companies. These legal agreements must support pricing structures as far as SARS is concerned.
FW: What do companies need to consider when responding to a government audit or investigation?
Brodbeck: A number of typical transfer pricing structures have been questioned through the recession. In the past, structures were set up relying on arrangements where companies were able to trade away their risk and in return accepted a limited but guaranteed return. Through the experiences gained during the economic crisis, the question was raised whether there is such thing as a limited but guaranteed return. The harsh realities of the recession have shown that these and other one-sided approaches tend to be too inflexible and do not reflect commercial realities. This was also one of the issues identified and addressed by the OECD in its 2010 update of the OECD guidelines. While the one-sided approaches relying on the cost-plus or resale price methods have come under greater pressure, other methods like the profit split method have become more viable, or in some cases appear to be the only realistic option, especially where the outcome of the application of a particular pricing policy is uncertain because of fluctuations in interest rates, exchange rates and market conditions. Often a company will establish a policy with certain expectations of where it is headed, but two years down the line it might end up in a completely different economic situation and the result is different from what was expected. Methods like the profit split method put the company in a much better position because it allows it to adapt to changing market conditions and the resulting changes in profitability. It’s more flexible, and we have seen it work quite well through difficult economic times. It is also being implemented more frequently because companies look at risks differently now than they did before the economic crisis. The lesson we all learned is there’s no certainty in terms of risk.
FW: What initial steps should companies take if they find themselves in dispute with South Africa’s tax authorities?
Kellerman: When dealing with SARS on a dispute, companies need to carefully consider the information they supply. Obviously they will have to provide the information that SARS requires, but they should supply only the information requested by SARS. Don’t anticipate what SARS wants; only provide what it has requested. Once the company has provided SARS with the information, it should take legal advice as soon as possible on the merits of the case. If the situation involves a company that has made a mistake, and SARS has a strong case against it, taking legal action may not be cost-effective. Better to settle as quickly as possible, with the least possible cost. On the other hand, if the company has a strong case for the tax position it took, it should keep in mind that the matter may end up in litigation. Once SARS has received a response to its query, at some point it will issue an assessment. There is a ‘pay now, argue later’ principal in South Africa whereby the company pays the tax immediately, and then objects to the assessment if it chooses. SARS will then either accept the objection or turn it down. The company may then go to an appeal process, and if SARS still does not give in, the company can go to the tax court. If the taxpayer is unsuccessful in the tax court, it needs to decide whether it wants to take the matter further or whether it should consider negotiating a settlement with SARS, as the legal process through the South African courts could be costly and time-consuming. It’s not just about the legal cost, but also the cost of taking senior staff out of their daily role; sitting through the court case. In addition, remember that a transfer pricing case has never gone to court yet, so there is no South African transfer pricing case law available. Everyone at this stage is really trying to avoid going to court.
FW: How has the recession affected transfer prices policies and methods in South Africa?
Brodbeck: A number of typical transfer pricing structures have been questioned through the recession.
In the past, structures were set up relying on arrangements where companies were able to trade away their risk and in return accepted a limited but guaranteed return. Through the experiences gained during the economic crisis, the question was raised whether there is such thing as a limited but guaranteed return. The harsh realities of the recession have shown that these and other one-sided approaches tend to be too inflexible and do not reflect commercial realities. This was also one of the issues identified and addressed by the OECD in its 2010 update of the OECD guidelines. While the one-sided approaches relying on the cost-plus or resale price methods has come under greater pressure, other methods like the profit split method have become more viable, or in some cases appear to be the only realistic option, especially where the outcome of the application of a particular pricing policy is uncertain because of fluctuations in interest rates, exchange rates and market conditions. Often a company will establish a policy with certain expectations of where it is headed, but two years down the line it might end up in a completely different economic situation and the result is different from what was expected. Methods like the profit split method puts the company in a much better position because it allows it to adapt to changing market conditions and the resulting changes in profitability. It’s more flexible, and we have seen it work quite well through difficult economic times. It is also being implemented more frequently because companies look at risks differently now than they did before the economic crisis. The lesson we all learned is there’s no certainty in terms of risk.
FW: How does transfer pricing interact with customs administration in South Africa?
Kellerman: Given that South Africa is a fairly high tax jurisdiction, at 28 percent, one would always like to bring goods into South Africa at a high value to make the profits as low as possible, thereby reducing the tax cost in South Africa. However, the customs duties levied in South Africa could be high, so having a high value of goods to bring down the profit may lead to a very high customs duty liability. Although one may be able to recover those duties by adding it to the cost price of the goods, this may price the company out of the market. Companies need to find a balance when looking at transfer pricing for goods into South Africa. Transfer pricing and customs are both administrated by SARS but these administration is undertaken by difference divisions, all falling under the commissioner for Inland Revenue. Obviously, transfer pricing is a profit-driven, year-end calculation, while customs is more a transaction driven tax applied on an ongoing basis. In South Africa, if a company in it’s year end accounts wants to adjust its transfer pricing upwards, SARS may want it to pay more customs because it has increased the value of its goods. If, on the other hand, it down-values those goods, it would be interesting to see whether SARS provides a refund.
FW: What developments in transfer pricing regulation are on the horizon?
Brodbeck: South Africa has recently completely revamped and modernised its transfer pricing laws to fall in line with the latest updates to the OECD Guidelines. The new legislation will come into effect on 1 October 2011 and apply in respect of years of assessment commencing on or after that date. Apart from the alignment with the latest OECD Guidelines, the most important change is in respect of the thin capitalisation rules. Currently the legislation is split into Section 31(2), which deals with the supply of goods and services, and Section 31(3), which contains the specific thin capitalisation provisions. That distinction has been abolished and the thin cap rules will fall within the ambit of the normal transfer pricing legislation, applying the arm’s length principle. The introduction of the new legislation will also result in the practice note on thin capitalisation being withdrawn, taking away the current safe harbour based on a debt to equity ratio of three to one. SARS has promised to issue a new interpretation note, dealing with transfer pricing in general and the thin capitalisation issue in particular, before the new rules come into force. At this stage, however, SARS has still not provided a draft version of the interpretation note and we are waiting with baited breath on SARS’ interpretation of the application of the arm’s length principle in the context of thin capitalisation.
FW: How would you describe the development of global rules related to transfer pricing, particularly in relation to OECD Guidelines?
Kellerman: South Africa is not a member of the OECD, but it follows the OECD guidelines. The current South African transfer pricing rules, which were introduced in 1995, follow the OECD guidance at the time. In terms of the practice note that was issued in 1999, SARS made it very clear that in the absence of any specific guidance, SARS would follow the OECD guidelines. This is helpful as companies can rely on international references, precedents and developments. New transfer pricing rules will take effect in October 2011. These new rules were actually issued in draft form before the updated 2010 OECD guidelines were released, effectively pre-empted them. South Africa is a keen adopter that strives to remain in line with the OECD and receives substantial support from the OECD in drafting rules. The international trend is to move away from a transaction basis, towards substance and looking at different methods. There is, in the practice note, guidance on what transfer pricing documentation SARS expects a company to have, but there is no specific requirement in terms of South African law that necessitates a transfer pricing policy or any form of documentation. Obviously it is in the best interests of any taxpayer to have documentation because this effectively shifts the burden of proof from the taxpayer to SARS, regarding the arm’s length principle, and makes it more difficult for tax authorities to challenge the pricing mechanism implemented by the company.
There is, however, no formal requirement to have a documented transfer pricing policy.
FW: To what extent are you seeing an increased focus on transfer pricing throughout Africa?
Brodbeck: At the moment, many other sub-Saharan African countries are starting to focus on and enforce transfer pricing. In the past, the preparation of transfer pricing documentation for South African companies doing business with the rest of Africa was often a one-sided approach, as it only had to ensure that the transfer price was right from a South African perspective. Other African countries typically lacked transfer pricing rules or did not enforce them. Now, with other African countries enforcing transfer pricing rules, companies need to establish a price that is truly arm’s length and therefore defendable in both jurisdictions. This has resulted in the need to update existing transfer pricing policies that were set up the 1990s and used to extract profits out of Africa back to South Africa. Some of the bigger jurisdictions, such as Kenya and Nigeria, and some of the smaller jurisdictions, like Botswana and Namibia, are battling revenue collection as much as anyone else. And they are realising that many multinationals are effectively using transfer pricing to extract profits out of their countries. Interestingly, this is not just a tax issue; it has also become an issue of corporate governance and social responsibility. Multinationals are under increasing pressure not to transfer profits out of poorer developing countries, an example being SABMiller which has come under attack by ActionAid, a global NGO, for its perceived ‘aggressive tax management policies’. It is therefore more important than ever, for multinationals to ensure that their transfer pricing policies are correct from a technical perspective as well as looking at the bigger picture, which is the impact of these policies on local economies and the message they are sending out.
FW: What advice would you give to companies in South Africa on implementing a sound transfer pricing policy that reduces the chance of attracting unwanted attention from SARS?
Kellerman: Most larger South African companies that carry out cross-border transactions do have some form of transfer pricing policy, but they do not necessarily always live that policy. Often the policy document sits somewhere in a head office tax department. When you dig a bit deeper and look at the implementation of the policy – the methodology used to calculate prices, update details and so on – the company falls short. Too few people within these multinational companies know about and understand the policy and can therefore ensure its implementation. It is important that these policies are rolled out across an organisation, and that the real decision makers responsible for the company really understand what the policy is and what they need to keep in mind. We have seen companies start with a good policy but within two years much of the policy has not been implemented properly, or at all. Another important point to consider about South African transfer pricing is that the country is moving on to a new transfer pricing regime now, and a lot of transactions will have to be re-examined. Some of the typical transfer pricing methods like cost plus for services and the use of CUP methods for other services or for certain transactions will be questioned by SARS. Arguments put forward in the past might have been good enough, but under the new rules there will be a different level of scrutiny. This is a good time for South African companies, or international companies with activities in South Africa, to re-examine the issue and ask the question “is the policy that we currently have in place still appropriate in terms of context of the new rules, or do we need to question and restructure some of these transactions?” Over the next 12 to 24 months, this will be a key issue.
Jens Brodbeck is a tax executive at ENS. He currently practices as an attorney in the tax department, specialising in corporate international tax, with a specific focus on transfer pricing, inbound investments and cross-border tax planning. Mr Brodbeck has been involved in transfer pricing since the introduction of the South African transfer pricing rules in 1995. He has acted for corporate clients in a diverse range of industries, such as print and electronic media, automotive, financial services, construction and aviation. He also advises a range of international and South African multinationals on the tax and exchange control consequences of their investments into or out of South Africa. Mr Brodbeck can be contacted on +27 83 442 7401 or by email: email@example.com.
Okkie Kellerman is tax executive at ENS and has 19 years experience as a tax advisor. He is a chartered accountant and specialises in advising large multi-nationals with the structuring of various aspects of their international and local operations and investments, assisting and advising clients with the drafting of their transfer pricing policies and restructuring their international or local operations to achieve an optimal transfer pricing position. Mr Kellerman has acted for clients from various sectors including the construction, mining, manufacturing, and services industries. His practice experience includes advising on the exchange control implications of inward and outward investments as well as the ongoing compliance with exchange control regulations. Mr Kellerman can be contacted on +27 83 454 2882 or by email: firstname.lastname@example.org.
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