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Are you prepared for a transfer pricing audit?

08 Oct 2014

AJ BeukesMultinational corporations have to take various international tax provisions into account, e.g. transfer pricing, the effect of the Controlled Foreign Company Rules, the foreign exchange control provisions, etc.  

A significant volume of global trade consists of transactions where goods, services, capital and intangibles (such as intellectual property and royalties) are transferred among the various entities of a multinational corporation. Should one of these entities be a South African resident, SARS may test the transactions against the provisions of Section 31 of the Income Tax Act and its interpretation, as set out in Practice Note No 7 of 1999 (PN 7), to establish whether any party has derived a tax benefit.

If such tax benefit has been derived by a South African entity, Section 31 enables SARS to adjust the consideration for the supply or acquisition of goods or services in terms of an international agreement between connected persons. SARS may adjust the consideration, for tax purposes, if the actual price is either less or greater than the price that would have been charged if the supply or acquisition had occurred between independent parties on an arm’s length basis.

Section 31, therefore, provides SARS with a mechanism to adopt the internationally accepted “arm’s length principle” for taxation purposes to ensure that the South African fiscus receives its fair share.

The application of Section 31 may lead to a situation where the total percentage of tax paid on a transaction is higher than the highest tax percentage levied by either of the two tax authorities, e.g.:

Company A, a resident of South Africa, manufactures and sells product x to its subsidiary, Company B. Company B is a resident of Country B, where the effective tax rate for companies is 20%.

The total cost to manufacture product x is R100. Shipping to Country B is R10 per unit.

If company A should decide to sell product x in South Africa, it will be able to sell the product for R200. Company A, however, sells the product to its subsidiary company B for an amount of R130, thereby realising a profit of R20 after shipping costs have been paid. Company B sells product x for the equivalent of R250 in Country B, thereby realising a profit of R120. It is taxed at a rate of 20%.

If SARS successfully argues that a tax benefit has been derived, Company A will be taxed on a profit of R90 per product x. This is called the primary adjustment.

A secondary adjustment results due to the difference between the R130 received and the adjustment to R200. The difference of R70 is deemed a loan to company B and an arm’s length interest rate will now be raised on this loan resulting in a further increase in taxable income. The results are shown below.

 
 
It is clear that in circumstances such as these, the application of Section 31 will drastically reduce profit margins. It is therefore imperative to manage this risk in order to protect your company against an application of Section 31.

The deemed loan will accrue interest ad infinitum, resulting in additional future tax on the interest every year. However, this situation has been addressed and the draft Taxation Laws Amendment Bill, released for public comment on 17 July 2014, proposes that the secondary adjustment will be deemed to be a dividend in specie paid by Company A (the resident). Company A will therefore be responsible to pay the dividend tax of 15% on the secondary adjustment.

By following the guidelines provided in PN 7, supported by the Organisation for Economic Cooperation and Development’s (OECD) Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations, a transfer pricing policy can be drafted based on the results of a functional analysis of the multinational corporation and the affected transactions. Depending on the result, one of the recognised transfer pricing methods can be applied to the affected transactions. This will support an argument against the application of Section 31.

When considering the tax implications for a multinational corporation, various other international tax provisions must also be taken into account, e.g. the effect of the Controlled Foreign Company Rules, the foreign exchange control provisions, etc.  

•    For more detailed information, please contact AJ Beukes, tel 021 882 8140 or aj@exceed.co.za

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