July 2010 : issue 3

TRANSFER PRICING: Optimising tax costs

For many businesses with an international footprint, tax advisors often raise the spectre of Transfer Pricing. In fact, transfer pricing provisions provided for in section 31 of the Income Tax Act are deemed to be tremendously complex and have many seeking transfer pricing experts despite the relatively limited coverage given to transfer pricing in South African tax legislation.

There are bigger sections within the Income Tax Act but none receive as much attention as the rather inconspicuous but potentially insidious section 31. There are transfer pricing experts in tax but very little is heard about Tax Avoidance specialists or Dividends specialists despite these two areas being rather elaborate and notoriously complex. This speaks to the awe with which many treat this particular aspect of tax. The issue then is, whether taxpayers should always approach transfer pricing with fear, trembling and deep pockets.

Transfer pricing provisions are anti-avoidance clauses especially for taxpayers with a multiple jurisdictional footprint. Ultimate shareholders view a group of companies that they own as an economic unit that should work together for maximum profitability. Group companies sometimes price goods and services to each other in different jurisdictions at unsustainable prices in order to reduce tax in higher tax jurisdictions. An example is companies X and Y which are part of the same group. X is located in a lower tax jurisdiction than Y. X manufactures components that are required by Y in Y's enterprise. X sells the components to Y at a price higher than they would normally sell the same components to other independent parties. They do this so that the profit margin for X is higher in the lower tax jurisdiction and Y's profits in the higher tax jurisdiction are depressed because of the high costs of sales. This would be an avoidance scheme that results in the shareholders of both X and Y, getting higher after tax returns from X. They therefore get the returns they would have got from company Y from X.

The tax collectors in the higher tax paying jurisdiction as a result cannot collect as much tax as they would have if the goods that X sells to Y were fairly priced. Section 31 allows SARS to make transfer pricing adjustments i.e. re-value the goods that have exchanged hands and deem the adjusted values to be the correct values. SARS can then recalculate the tax due based on the new values. In addition to these adjustments, SARS may also add penalties and interest for their trouble. For transactions worth many millions of rand, the tax due plus any punitive charges can be devastating. This is what drives the need for transfer pricing documents. Transfer pricing documents explain why a taxpayer prices goods in a certain way and comes with explanations that inform such prices.

It is this transfer pricing documentation that becomes the big issue to taxpayers. It not only sounds complex, it very often confounds many a tax pundit. It is because of this reputation of transfer pricing that taxpayers must be aware that SARS has issued practice note 7 with regards to transfer pricing. This practice note encourages taxpayers to have a pricing document in their possession. It however tempers this by stating that it is not a legal requirement and that it is not expected for taxpayers to enter into arrangements that are excessive in relation to the "nature, scope and complexity of the international agreements." The agreement between two connected persons must be the focal point. It means that the less complicated an agreement, the less intensive a transfer pricing document has to be. In fact in the addendum to the transfer pricing document SARS adds, "where a taxpayer has provided full details of the international agreements that it has entered into with connected parties, the absence of formal transfer pricing documentation will not be regarded as non-disclosure." Not only can a transfer pricing document be watered down, it can be avoided altogether.

SARS very clearly offers an alternative way to do an international transaction with a connected person without being unduly pedantic. They seem to be catering for smaller entities and straightforward transactions that do not warrant complex documentation. Before one pops the corks in celebration, bear in mind that there is a reason why Transfer Pricing specialists are necessary, things are not always simple.
The essential point of this article is that transfer pricing can be done another way. If transfer pricing costs are a hindrance for related companies concluding deals perhaps this information may encourage them to go forth boldly. It all depends on the details of the arrangements. It is still not advisable to rush in without full-bodied advice. In a field that does not offer much multiplicity in approaches the option that the practice note offers is a worthy alternative. In conclusion therefore, complex or multiple agreements are more likely to require a transfer pricing document. If you decide not to have a document, then you must have all the information regarding the deal available for scrutiny.