In essence the provisions under section 31 of the Income Tax Act (58 of 1962), as amended, (the ITA) provide that parties within the same group of companies, in respect of cross-border transactions, are required to conduct transactions/agreements on terms and conditions that would have otherwise been negotiated and concluded between the parties on an arm's length basis.
The rationale behind transfer pricing (TP) is that the consideration paid to a multinational has a direct bearing on the proportional profit it derives in each country in which it operates. If consideration for the transfer of goods and/or services between the members of a multinational is not market related, the income calculated for each of those members will impact the tax revenues of the relevant tax jurisdictions in which they operate.
When is TP applicable?
Section 31(2) of the ITA provides that TP is applicable where:
- any transaction/agreement has been in/directly entered into between "connected persons" with a cross-border connection;
- any term or condition of that transaction/agreement differs from any term or condition that would have existed had those parties been independent persons dealing at an arm's length; and
- the transaction/agreement results, or will result, in a "tax benefit" being derived by any party to it. The term "tax benefit" is defined in the ITA to include "...any avoidance, postponement or reduction of any liability for tax".
The term "connected persons" is defined essentially to cater for entities within the same group of companies, such as a HoldCo and its subsidiaries/affiliates.
The arm's length principle
The overriding principle in TP is that transactions of a cross-border nature, between connected persons, are to be conducted at arm's length.
This requires that the transaction or agreement to have the substantive financial characteristics of a transaction between independent parties, where each party will strive to get the utmost possible benefit from the transaction.
The arm's length principle provides that a comparable transaction between independent parties should be used as a yardstick against which to appraise the multinational's prices. Any apparent difference between the two transactions can then be identified and adjusted.
Conditions between connected persons
In the event that the conditions of the transactions between the connected persons are not market related, the following is applicable in respect of the cross-border inter-company transactions:
The Commissioner may adjust the consideration for the goods or services supplied by the foreign entity to the local entity to reflect an arm's length consideration, which potentially results in a higher tax liability for the relevant taxpayer.
Section 89 of the ITA provides for interest on the underpayment of tax, this will also apply if the underpayment of tax results from non- compliance with section 31.
• Dividend/withholding tax
Section 64C provides that certain amounts distributed to a "recipient" by a company are deemed to be a dividend declared by the company. The term "recipient" is defined to include any shareholder of the company.
Hence, section 64C(2)(e) deems the difference between the arm's length consideration that should have been paid and the actual consideration paid to be a dividend.
Dividend/withholding tax attracts a rate of 15% on the amount distributed by the local entity to a recipient. However, there are various exceptions to this rule and this amount may be reduced. Such an exception arises where dividends declared by a company, which is resident of a contracting state that is a party to a Double Tax Agreement (DTA), are paid to a resident of the other contracting state, which is party to the DTA.
• Commissioner penalties
In addition to those already mentioned, the Commissioner, in terms of section 223(1) of the Tax Administration Act (28 of 2011), as amended, may impose penalties of up to 200% on the underpayment of any adjusted tax amount, together with interest.
The lack of TP documentation
Though there is no explicit statutory requirement to prepare and maintain TP documentation, it is in the taxpayer's best interests to document how TP has been determined. Adequate documentation is the best way to demonstrate to the Commissioner that TP is consistent with the arm's length principle prescribed by section 31 of the ITA.
A taxpayer who elects not to prepare TP documentation is at risk on the following counts:
- There is a greater probability that the Commissioner will examine a taxpayer's TP in detail if the taxpayer has not prepared supporting documentation.
- If the Commissioner, as a result of this examination, substitutes an alternative arm's length amount for one adopted by the taxpayer, the lack of adequate documentation will make it increasingly difficult for the taxpayer to rebut that substitution, either directly to the Commissioner or in the courts.
- Should the relevant taxpayer be subject to a SARS audit, the Commissioner generally relies on information supplied by the relevant taxpayer, including information relating to TP policies, in determining TP compliance. However, in the event that the taxpayer has not maintained appropriate records, the Commissioner will rely on extrinsic information to ascertain whether the relevant taxpayer has complied with TP, notably with regard to the arm's length principle. Should the Commissioner rely on extrinsic information, it can become increasingly difficult for the relevant taxpayer to influence the Commissioner's findings as to whether the relevant agreements are compliant with the arm's length principle.
- Income tax returns for companies require taxpayers to supply certain specific information regarding transactions and agreements entered into between connected persons. It is very difficult for a taxpayer to comply with this where that taxpayer has not addressed the question whether its dealings comply with the arm's length principle.
- The annual income tax returns for companies require disclosures relating to transactions with connected persons. A failure to provide accurate responses will lead to the three-year prescription period not applying to the return, which would mean SARS could challenge TP issues at any time, and not be limited to the prescription period of three years after the relevant assessment date.
Therefore, it is important to consider whether TP is applicable to your business. If it is, the company should prepare the necessary TP documentation to demonstrate that it has developed a sound TP policy in accordance with the arm's length principle. In such an event, the Commissioner is more likely to conclude that the TP policies are reasonable, in which event the risk of a possible adjustment will be diminished or eliminated.
As published in Without Prejudice in September 2016.