One of the main action items identified by South Africa’s National Treasury in its summary of the country’s position on the G20/Organisation for Economic Co-operation and Development (“OECD”) action plan on base erosion and profit shifting (“BEPS”), is the requirement for the South African Revenue Service (“SARS”) to update the Transfer Pricing Practice Note in line with the OECD Transfer Pricing Guidelines to include new guidance on the arm’s length principle and an agreed approach to ensure appropriate pricing on intangibles that are difficult to value.
Action 8 of the BEPS Action Plan mandated the development of transfer pricing rules or special measures for the transfer of Hard-To-Value Intangibles (“HTVI”) and the general rules of how to deal with HTVI can be found in section D.4 of the revised chapter VI of the OECD Transfer Pricing Guidelines, contained in the 2015 Final report on Actions 8-10: “Aligning Transfer Pricing Outcomes with Value Creation” (“BEPS TP Report”), which is now formally adopted as part of the OECD Transfer Pricing Guidelines. However, the BEPS TP Report also mandated the development of guidance for tax administrations on the implementation of the approach to HTVI (“HTVI Implementation Guidance”). Although the transfer of intangibles by a South African resident to a related party non-resident is currently restricted in terms of South African exchange control regulations, the approach towards HTVI is regarded as one of the main focus areas of SARS and therefore, it appears highly unlikely that SARS will issue an updated version of its Transfer Pricing Practice Note until the HTVI Implementation Guidance has been finalised by the OECD.
It is in this context that the discussion draft setting out the HTVI Implementation Guidance (“Draft HTVI Implementation Guidance”), which was released by the OECD on 23 May 2017, appears to be particularly relevant from a South African perspective.
Intangibles are, by definition, mobile and they are also often hard-to-value, in particular, at an early stage of their development. According to the OECD, the misallocation of profits generated by valuable intangibles has heavily contributed to base erosion and profit shifting. This, together with the perceived information asymmetry when it comes to the valuation of intangibles, was also the reason why the OECD deemed it necessary to develop special rules on how to deal with HTVI.
What are HTVI?
The OECD defines HTVI as intangibles or rights in intangibles for which, at the time of their transfer in a transaction between associated enterprises, no sufficiently reliable comparables exist, and there is a lack of reliable projections of future cash flows or income expected to be derived from the transferred intangible, or the assumptions used in valuing the intangible are highly uncertain.
Existing OECD Guidance on HTVI
To deal with this, the OECD’s guidance on HTVI proposes that tax authorities be allowed to use ex post “evidence”, (the use of hindsight to evaluate the appropriateness of the pricing of transactions previously entered into) to assess the arm’s length nature of transfer pricing arrangements in respect of intangibles that fall within the definition of HTVI.
Where the HTVI approach applies, tax administrators are entitled to consider ex post outcomes as presumptive evidence in evaluating the appropriateness of ex ante pricing arrangements.
However, in certain circumstances, a taxpayer can rebut ex-post outcomes as presumptive evidence by demonstrating the reliability of the information supporting the pricing methodology adopted at the time that the controlled transaction took place.
In particular, the use of ex post outcomes/hindsight will not apply in the following cases:
- The taxpayer provides:
- details on the ex-ante projections used at the time of the transfer together with how risks were accounted for; and
- reliable evidence that any significant difference between the financial projections and the actual outcomes is due to unforeseeable or extraordinary events that could not have been anticipated at the time of price setting;
- the transfer of the intangible is covered by a bilateral or multilateral advance pricing agreement;
- a safe harbour threshold where the variation in financial projections and the actual outcomes is no more than 20% of the intangible’s valuation; or
- a commercialisation period of five years has passed following the year in which the HTVI first generated unrelated party revenues for the transferee and in which commercialisation period any significant difference between the financial projections and actual outcomes mentioned in a) 2 above was not greater than 20% of the projections for that period.
Additional guidance provided in Draft HTVI Guidance
The Draft HTVI Implementation Guidance essentially reenforces the principles laid out in the initial OECD Guidance on HTVI.
In particular, no changes have been made to the underlying principle that tax authorities will be entitled to consider ex post outcomes as presumptive evidence in evaluating the appropriateness of ex ante pricing arrangements, unless a taxpayer can rebut ex-post outcomes as presumptive evidence.
Accordingly, once it has been determined that an intangible qualifies as a HTVI, ex post outcomes may be considered. Tax authorities are, however, restricted in using the ex post outcomes, since the Draft HTVI Implementation Guidance makes it clear that tax authorities cannot base any revised valuations on the actual income or cash flows without also taking into account the probability, at the time of the transaction (ie time of transfer of the HTVI) of the income or cash flows being achieved.
In addition, the Draft HTVI Implementation Guidance indicates that in implementing the HTVI approach, tax administrators may make appropriate adjustments, including through the consideration of alternative pricing structures, (ie adjustments that reflect a contingent pricing arrangement that is different from the pricing structure adopted by the taxpayer), if it relates to something that independent third parties would have also considered. This should be of great concern to taxpayers and we therefore caution taxpayers to consider potential alternative pricing structures when determining the pricing for the use or transfer of intangibles that could be regarded as HTVI.
Furthermore, the Draft HTVI Implementation Guidance also indicates that the guidance for the tax administrators in implementing the approach to HTVI should not be used to delay or bypass normal audit procedures. It is further stated that, in fact, it remains important for tax administrators to identify HTVI transactions as early as possible and to act on the information at hand as a matter of good administrative practice. The Draft HTVI Implementation Guidance does, however, recognise that some countries may encounter difficulties in implementing the approach to HTVI due to short audit cycles or a statute of limitations. The Draft HTVI Implementation Guidance therefore suggests that tax authorities identify transfers of potential HTVI and seek information about ex post outcomes, even where those outcomes arise in years subsequent to those under audit, to be in a position to consider the appropriateness of the ex-ante pricing at an early stage.
The Draft HTVI Implementation Guidance is an important missing piece of the puzzle in the OECD’s approach towards BEPS and, once finalised, should put SARS in a position to issue a first draft of its own Transfer Pricing Practice Note.
From a transfer pricing technical point of view, it does not provide anything substantially new, but to a large degree reconfirms the underlying principles as set out in the existing OECD Guidance on HTVI.
In order for taxpayers to be able to rebut the use of ex post outcomes as presumptive evidence by tax authorities in determining the arm’s length nature of transactions involving HTVI, it is important that, at the time the transaction is entered into, that a detailed analysis is performed, which clearly sets out the following:
- the nature of the intangible, and whether it could be regarded as HTVI;
- the details of the projections used at the time of the transactions and how the main risks were accounted for; and
- if applicable, whether alternative pricing structures were considered to cater for potential substantial deviations of the projections used at the time.
While the use of an advance pricing agreement provides for an alternative option to manage the risks around HTVI, this option is, unfortunately, not available for South African taxpayers at this stage.