Attacks by the South African Revenue Service (“SARS”) on the transfer pricing practices of multinational enterprises (“MNEs”) are on the rise, leading to tax disputes with SARS over significant amounts of tax. MNEs operating in South Africa provide information to SARS in various forms such as annual Corporate Income Tax returns, Country-by-Country reports as well as the extensive Transfer Pricing documentation. It is therefore important to ensure that all information submitted to SARS in these various formats is aligned as any difference could assist SARS in challenging not only the Transfer Pricing policies but ultimately also the tax structure of the group as well as the substance of how a group operates across the globe. While a Functional Analysis identifies the functions performed, the risks assumed and the assets utilsed by various members of an MNE, it has also become important to do a proper Value Chain Analysis (“VCA”) in order to identify the jurisdictions where the key functions are performed, where the real value is created and where the actual profit is. A proper VCA will provide a much clearer picture as to whether the profits of an MNE are actually generated in those jurisdictions where the real value is added, critical information for preparing a response to any attack from SARS on the transfer pricing policies of the MNE.
Intangibles vs value enhancers vs synergies
In conducting a VCA, it is important to distinguish between intangibles, value enhancers and synergies. Intangibles are defined as physical or financial assets that are owned or controlled for use in commercial activities and the use or transfer thereof will be compensated had it been a transaction between independent parties. Value enhancers are generally hard to identify, not registered or protected and not recognised for accounting purposes (off balance sheet item).
Group synergies could contribute to the amount of income earned by an MNE and could include:
- streamlined management;
- elimination of cost duplication;
- integrated systems; and
- increased capacity to borrow.
Synergies should, however, not be confused with passive associations, as incidental benefits arising solely by virtue of group affiliation and in the absence of deliberate concerted action need to be separately compensated or allocated. Where synergy is indeed the result of deliberate concerted action, it is necessary to evaluate:
- the nature of the advantage or disadvantage;
- the amount of the benefit or detriment provided; and
- how that benefit or detriment should be divided among members of an MNE group.
The benefits of synergies should, in general, be shared by members of an MNE group in proportion to the contribution each member makes in the creation of the synergy. For instance, benefits from large scale purchasing synergies should be shared in proportion to purchase volumes. A Central Purchasing Office (“CPO”) is a good example of concerted action that could result in discounts or gain. These discounts and gains should be shared by the members of the MNE group based on purchase volumes while the CPO will receive a service fee as compensation for its services. However, if the CPO has unique skills, competencies, leverage or intangible assets, a portion of the gains realised by the CPO can be retained or a higher margin should be added to the cost of the CPO on calculating its service fee. In fact, the compensation earned by the CPO will depend on the purchasing model used such as being a buy-sell distributor or merely acting as an agent.
Location savings vs market characteristics
Location savings are another aspect that has to be carefully considered during a VCA and in considering the impact of location savings, it is important to differentiate between:
- local market advantages or disadvantages that may not be directly related to location savings; and
- cost savings that are attributable to operating in a particular market.
Local market features include aspects such as disposable income of households and the size and competitiveness of the market. Location savings should be differentiated from market features and are not considered to be an intangible. Location savings include cost savings through operating the same business in different markets as well as additional profits derived by operating in a jurisdiction with unique qualities, impacting on the sale and demand of the services or products offered by an MNE group. Such location savings should be allocated among the members of an MNE based on functions performed, risk assumed and assets utilised.
Legal ownership vs functions performed, risks assumed and assets utilised
Although the legal owners of an intangible within an MNE group are entitled to the proceeds from the exploitation of such intangible, other members of the MNE group may have performed functions, or assumed risks or utilised assets which contribute to the value of the intangible. These other members of the group must then be compensated for this contribution under the arm’s length principle. In other words, legal ownership of an intangible no longer confers the ultimate right to returns to the owners of an intangible within the MNE group. In other words, the development, enhancement, maintenance, protection and exploitation, in short “DEMPE”, of an intangible, and not only the beneficial ownership of such intangible, should also be considered when allocating the compensation earned from an intangible. The sooner MNE groups come to grips with the new transfer pricing realities, the sooner they will be able to reduce their tax disputes with SARS.