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Transfer Pricing Risk Analysis

This video outlines the key concepts, risks, documentation requirements, and proactive management strategies related to Transfer Pricing (TP) in South Africa, based on the provided presentation.

Legal Foundation and Principles

• Section 31 of the Income Tax Act (ITA): Stipulates that tax payable on international transactions between associated enterprises must be based on the Arm's Length Principle (ALP).
• Arm's Length Principle (ALP): The guiding principle under Article 9, Paragraph 1 of the OECD Model Tax Convention. It ensures that conditions between associated enterprises are the same as those that would be made between independent enterprises.
• Affected Transaction: Any transaction, arrangement, or understanding entered into directly or indirectly between associated enterprises.
• Associated Enterprises: Defined broadly under Section 31 to include entities where one participates directly or indirectly in the management, control, or capital of the other, even if not meeting the 20% "connected person" shareholding threshold, as demonstrated in the TechGlobal/InnovateSA example.

Understanding Transfer Pricing Risk

A TP risk arises from a deviation from the Arm's Length Principle.

• Financial Impact: If a transaction is undercharged (e.g., R100 instead of R150), the entity will be taxed as if the full arm's length amount (R150) was received, resulting in an additional tax liability on the understated amount (R50).
• Outcomes of TP Risk:
  • Primary Adjustment: Additional tax liability.
  • Secondary Adjustment: Deemed dividend, subject to a 20% tax.
  • Understatement Penalties: Can be up to 200%.
• Types of Risks:
  • Financial Risk: Direct tax costs, penalties, and cash flow impacts.
  • Operational Risk: Compliance burden and management time disruption.
  • Reputational Risk: Public disclosure of disputes and regulatory relationships.
  • Compliance Risk: Inadequate documentation or missed filing deadlines.
  • Audit Risk: Scope often expands beyond initial focus areas.
  • Litigation Risk: Multiplies costs and timeline uncertainty if unresolved.

Documentation and Evidence

SARS has specific documentation requirements to manage TP risk.

• Three-Tiered TP Documentation: Required for certain thresholds:
  1. Local File: For affected transactions over R100 million.
  2. Master File.
  3. Country-by-Country (CbC) Report: For group revenue exceeding R10 billion.
• Importance: Documentation must be contemporaneous.

Key Risk Areas for SARS Focus

SARS's TP risk assessment often focuses on the following transactions and indicators:

• Transfer pricing adjustments.
• Changes in transfer pricing policy/methodology.
• Transactions with connected persons in low tax jurisdictions.
• Persistent losses in local subsidiaries.
• High-value intangibles & royalty payments.
• Management fees / intra-group services.
• Cross-border financing.

Intangibles and the DEMPE Framework

Intangibles are a high-risk area due to their unique nature and difficulty in valuation.

• Definition of Intangible: Something that is not a physical or financial asset, can be owned/controlled for commercial use, and whose transfer would be compensated between independent parties.
• DEMPE Functions: Returns from intangibles must follow the activities that create their value.
  • Development
  • Enhancement
  • Maintenance
  • Protection
  • Exploitation
• Key Risk: Risk arises when profits are booked in entities that do not perform the DEMPE functions. The SC (Pty) Ltd v CSARS case confirmed that legal ownership offshore is insufficient; substantive DEMPE functions performed in SA justify the local allocation of intangible returns.
• Royalty Risks: Can arise from unrecognised, over/under-priced, or inappropriately allocated royalties, especially if a local entity performs core functions but receives low/no royalty income.

Intra-Group Services

When dealing with intra-group services, two aspects must be considered: determining if a service has been rendered and setting the arm's length price.

• The Benefits Test: Both requirements must be satisfied for a service to be deemed rendered:
  1. The receiving entity must gain or anticipate an economic benefit.
  2. An independent entity in similar circumstances would have been prepared to pay for the services or perform them itself.
• Services NOT Meeting the Benefits Test:
  • Shareholder activities: Activities providing an economic benefit only to the shareholder in its capacity as a shareholder (e.g., corporate governance).
  • Duplication of services: When a service is provided that the recipient has already performed itself or paid an independent entity to perform, unless it's for a second opinion to minimize risk.
  • Passive association: Benefits arising simply from being a member of the MNE group (e.g., getting better pricing from independent suppliers hoping for future group sales).
  • Incidental benefits: Benefits received by other group members that are incidental to a service primarily intended for another entity.
• Compensation: SARS does not adopt the OECD's simplified 5% mark-up approach for low value-adding services, which results in increased compliance obligations for South African taxpayers.

Proactive Risk Management Strategies

Risk assessment should be integrated into business decisions, as proactive management is less costly than post-audit resolution.

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