Antonia Nicoloudakis | Tax Specialist, PKF Octagon

As the world's connectivity expands, and companies strategise to be more dynamic and competitive in the market, tax authorities too are utilising the advancements in technologies to enhance their reach. With this international expansion of businesses comes the constraints and complexities of transfer pricing.

Often our clients ask, "When does transfer pricing become applicable?"

Simply put, as soon as a South African ("SA") company undertakes a cross-border transaction with a connected person or an associated enterprise transfer pricing becomes applicable.

Let us expand...

Transfer pricing essentially requires that cross-border transactions between connected persons or associated enterprises occur at arm's length. The rationale behind this is to ensure that governments receive their fair share of tax.

Without getting into the extremely technical considerations, "arm's length" is the price that should have been charged between two connected persons had those same terms and conditions of an agreement or transaction been undertaken between two unconnected or independent third parties.

Broadly speaking the arm's length price must be charged by one entity to another entity for goods or services, provided where both entities form part of the same group of companies or are considered associated or connected with each other.

There are a number of factors to consider however a good place to start on our transfer pricing journey is to determine whether the entities would qualify as "connected persons" or "associated enterprises".

The next step on our journey, is to look at the transaction/s that occur.

Transactions such as:

• acquiring or selling of goods or products,
• provisions of services,
• right of use of intellectual property,
• loan funding,
• management or support services centres

are some common examples, but not an exhaustive list, of transactions and occur frequently in the usual course of business that may be subject to transfer pricing.

It is in relation to these types of transactions that an arm’s length price must be charged, and it is this arm’s length price that the SA taxpayer must be able to substantiate by providing sufficient documentation to the tax authorities (i.e. South African Revenue Service (“SARS”)). A SA taxpayer is expected by SARS to be able to support the arm’s length nature of such transaction/s.

Mapping out the arm’s length pricing for SARS

Where a SA taxpayer reaches the SA Transfer Pricing threshold, explained below, the SA taxpayer will need to prepare and file specific Transfer Pricing documentation together with the submission of the Income Tax Return to SARS.

The Transfer Pricing Documentation is set out on a “three-tiered” approach (similar to the international standards) which consists of the preparation of:

• Local File - to be prepared per local entity setting out all material transactions,
• Master File – generally compiled by the parent entity and made available to all local entities which contains standard information relevant for all entities; and
• Country-by-Country Report – compiled by the reporting entity (i.e., the Ultimate Parent Entity ("UPE")) of the multinational group and contains information regarding the global allocation of the group's income and taxes paid in each country that the group operates in together with certain indicators of the location of economic activities within the group.

Such Transfer Pricing Documentation will need to be prepared when the SA taxpayer has aggregated cross-border connected party transactions (without offsetting) exceeding or reasonably expected to exceed R100 million for that tax year.

However, if the value of a SA taxpayer’s individual cross-border connected person transaction exceeds or is reasonably expected to exceed R5 million then detailed records pertaining to that transaction must be maintained.

The Country-by-Country Reporting will generally be prepared and submitted to SARS when the UPE (which is resident in SA) of a multinational group has a total consolidated group revenue of R10 billion or more during the fiscal year immediately preceding the Reporting Fiscal Year, as reflected in its Consolidated Financial Statements for such preceding Fiscal Year.

In additional to the documentation requirement, the SA taxpayer will also need to disclose all transfer pricing related information in their corporate Income Tax Return.

Alternatively, where a SA taxpayer has not yet met the Transfer Pricing Documentation threshold (per above) the SA taxpayer will still need to be able to substantiate to SARS that their cross-border connected party transactions are at arm’s length and therefore at inception of the transaction it is therefore advisable to put together a transfer pricing policy or set out a transfer pricing strategy based on suitable comparables.

If this was not undertaken at inception, then we strongly recommend that supporting documentation is compiled to record and support the transaction arm’s length nature retrospectively and make any necessary adjustments.

In addition, the SA taxpayer will be required to make disclosure of all transfer pricing related information in their annual corporate Income Tax Return, additionally the taxpayer will need to confirm that documentation is available for immediate submission to SARS, if requested.

Transfer pricing documentation is to be assessed and updated on an ongoing basis in order to ensure that the arm’s length price is still relevant and to take into consideration any changes for the year.

What happens if the transactions were not at arm’s length?

In the instance that the cross-border transactions between the connected persons or associated enterprises are not aligned with the arm’s length principles the SA taxpayer will be subject to a Transfer Pricing Adjustment.

Transfer pricing adjustments are applied as the “Primary Adjustments” and a potentially a “Secondary Adjustment”.

Primary adjustment

A primary adjustment will occur where a taxpayer does not transact on an arm’s length basis resulting or potentially resulting in a tax benefit being derived by a person that is party to that transaction.

The primary adjustment is essentially an adjustment to increase the taxpayer’s taxable income or the tax payable will be calculated in order to determine the position that would have resulted had the transaction occurred under comparable circumstances between independent persons dealing at arm’s length.

SARS may make a transfer pricing adjustment or the taxpayer may make the transfer pricing adjustment on their own accord should they realise that a transaction was not carried out on an arm’s length basis post finalisation of the annual financial statements and/or during the preparation of the Income Tax return.

The primary adjustment will effectively increase a taxpayer’s taxable income and be subject to corporate tax rate of 27%.

Secondary Adjustment

Where a primary adjustment was made by SARS, a “Secondary Adjustment” will be triggered. Essentially, the Secondary Adjustment deems the amount of the primary transfer pricing adjustment to be a dividend distribution of an asset in specie, which will trigger a subsequent Dividend Tax at 20%. No double tax relief will be available on the Dividend Tax.

In the case of a transaction that is not carried out at arm’s length between a resident individual and inter alia, any other person that is not a resident, the primary adjustment amount, will be deemed to be a donation made by that resident individual to that other person and subject to Donations Tax of 20%.

In the case, that the transfer pricing adjustment relates to a funding transaction, the taxpayer will be unable to recoup the Interest withholding tax already suffered where the amount is also subject to a secondary adjustment.

Other tax implications

Further, the impact of a transfer pricing adjustment may result in additional indirect taxes such as Value-Added Tax (“VAT”) and/or Customs and Excise Tax obligations resulting in underpayments of taxes or duties and therefore further penalties and interest consequences.

In addition to the transfer pricing adjustments mentioned above, a taxpayer may also become liable for various penalties, generally imposed in terms of the Tax Administration Act (“TAA”)

Conclusion

Navigating the transfer pricing landscape is complex and does require assistance from a tax professional to ensure that a company meets its compliance requirements. Failure to do so has dire consequences as noted above however there are various mechanisms to assist taxpayers such as the Voluntary Disclosure Programme (“VDP”) which SARS has in place to rectify past non-compliance.

Should you find yourself being potentially subject to these provisions and require assistance in drafting or reviewing your transfer pricing documentation/policies, regardless of whether you are above or below the mandatory submission threshold please contact your nearest PKF office for assistance as this is regarded as a “high risk” area of tax avoidance which tax authorities around the world are focusing on to ensure that their countries are receiving their fair share of taxes.