Transfer pricing – are you the next target for a sars audit
The Arm’s Length Standard
South African Edition - January 2009
Included in this issue
TRANSFER PRICING IN HARD TIMES
Written by: Billy Joubert (Deloitte South Africa)
In the current economic environment companies worldwide are grappling with the implications of plummeting profits. One of the areas which may be impacted by this phenomenon is transfer pricing.
TRANSFER PRICING AND EXCHANGE CONTROL APPROVAL
Written by: Carla van der Merwe (Deloitte South Africa)
With Exchange Control Regulations in place in many African countries, the Central Banks often
require approval before certain payments can be made to foreign related parties. This article provides
insight as to the requirements of the South African Reserve Bank in terms of these payments. OECD ISSUES DISCUSSION DRAFT ON TRANSFER PRICING ASPECTS OF
Written by: Owen Crassweller (Deloitte UK). South African perspective provided by Michael Hewson
(Deloitte South Africa).
There are various incentives that are increasingly luring multi-national organisations to restructure their
operations more favourably. The Discussion Draft on Transfer Pricing Aspects of Business
Restructurings clearly indicates the intentions of the organisation to pay considerably more attention to
CANADIAN COURT DECISION CAUSES INDIGESTION FOR GLAXO
Written by: Sandra Goldberg (Deloitte Canada), Gary Zed (Deloitte Canada), Bernard Barsalo (Deloitte Canada), Muris Dujsic (Deloitte Canada)
The court cases of GlaxoSmithKlein and Roche Products (Pty) Ltd Roche Products Pty Limited v. The Commissioner of Taxation
, could be the first wave of transfer pricing cases making their way through the courts. Although these cases were in Canada and Australia respectively, they provide useful principles for the application of transfer pricing. This article explains the courts findings on the GlaxoSmithKlein case relating to royalty fees that the Canadian Revenue Authority found to be excessive.
TRANSFER PRICING IN HARD TIMES
In the current economic environment companies worldwide are grappling with the implications of
plummeting profits. One of the areas which may be impacted by this phenomenon is transfer pricing (TP).
This is because TP policies often operate by examining the profitability of a company.
To use a simple example, assume that there is a South African company (SACo) whose only business
activity is to buy goods from its parent company in the US (USCo) and distribute those goods in SA. If
SACo is sufficiently profitable then, from a TP point of view, the assumption would be that SACo could
not have overpaid when buying the goods from USCo.
The company whose profitability is scrutinised is usually referred to in TP jargon as the tested party. In
determining whether the tested party’s profitability is acceptable it is compared against a set of companies
which carry on a similar type of business. In practice the comparable set is usually identified by means of
a database search. There are no such databases available of South African companies. Therefore the South
African Revenue Service (SARS) favours the use of the Amadeus Database of pan-European comparables
where the SA company is the tested party.
In the current environment there might be all sorts of reasons why a tested party’s profitability has
dropped. Using the example described above, SACo might have been forced, due to reduced demand for
its products, to drop its prices into the SA market. This would have a corresponding effect on its
profitability, even though the transfer prices (in other words, the prices paid when purchasing the goods
from USCo) might have remained unchanged from last year.
It may be that an updated comparability analysis would show a corresponding drop in the comparable set.
This would solve the problem of how to explain such a drop in profitability to the TP team at SARS.
However, while databases such as Amadeus try to provide the most recent available information, there is
an unavoidable lag between the financial information of the companies in the comparable set and those of
the tested party. In times of uncertainty and volatility that mismatch can make a significant difference.
Comparability analyses are also expensive. In practice we recommend that they generally be updated
every three years. From an affordability point of view it is often not practical to do this more often in
There are number of other ways of dealing with the issue. This point is being debated at length by our
international team of TP professionals. The answer in a particular case will depend on the facts. With
reference to our factual example, a pragmatic (and low tech) strategy might be to provide SARS with
evidence of the falling prices into the SA market and also of the stable transfer price. This would
demonstrate to SARS that the drop in the profitability of SACo is not due to manipulation of the transfer
Of course SARS might query whether USCo should not have lowered the transfer prices in view of the
reduced prices into the SA market. That would be a separate debate!
There are also various more technical options available from a TP point of view. These include looking
more selectively at potential comparables, making capital adjustments, exploring alternative measures of
profitability (known in TP jargon as a profit level indicators) etc. This type of approach essentially means
looking at the available information slightly differently.
I would suggest that SA companies whose profits have dropped might be well advised to do some
proactive planning to ensure that TP is not added to the list of current hardships.
Written by: Billy Joubert (Deloitte South Africa)
TRANSFER PRICING AND EXCHANGE CONTRL APPROVAL
A new trend seems to be developing when requesting approval for exchange control from the South
African Reserve Bank (“SARB”).
Over the last few months we have noticed that SARB is requesting confirmation from the South African
Revenue Services (“SARS”) as well as from the auditors that the Transfer Pricing methods applied to
calculate the payments are arm’s length.
Where a new application for exchange control approval is submitted to SARB, it is likely that SARB will
request the following from the taxpayer:
Copies of signed agreements together with full details of the services rendered (if the application
is for anything other than services, full details of such a transaction for which payment is to be made should be provided);
Confirmation that the fees are calculated according to the OECD guidelines applicable to
Confirmation from the auditors and from SARS that they have evaluated the calculation method
of the fees in question and that they are satisfied that the fees are fair and market related.
From the above it would appear that, without a properly documented and researched Transfer Pricing policy document, a taxpayer would find it difficult to obtain approval for exchange control from SARB for any payments that are to be made to offshore related parties. Since it is not the practise of SARS to give any advance rulings to taxpayers on Transfer Pricing matters we have contacted SARS to determine what the best way of handling such queries from the Reserve Bank would be. Following our conversations with SARS, SARS then had a meeting with SARB officials to discuss the issue of obtaining SARS sign off on the arm’s length nature of such payments, as a pre-requisite to SARB approval. SARS did not want to indicate to us that this is the process that would be followed every time a similar request is made by SARB but we can only assume that they will. I quote below an extract from our correspondence with SARS:
“From a SARS perspective it is practically not possible to provide sign off without conducting a full audit. Such an audit usually spans a couple of months. Furthermore, it was important from a SARS perspective that any sign-off on any Transfer Pricing arrangements not be seen as a SARS ruling (as you are aware SARS does not provide rulings with respect to Transfer Pricing).
Therefore, as a solution it has been agreed that SARS will perform a high level review of the arrangements entered into. The outcome of such review will be provided to SARB and the relevant taxpayer will then be informed as to the status of his application
SARS also indicated to us that this high level review would take them approximately 2 weeks and that they would only provide feedback directly to SARB and to the taxpayer. SARS require the full Transfer Pricing documentation as well as all signed agreements in order to perform this high level overview. In order to assist we also suggest that the taxpayer provides SARS with a letter summarising the transactions under review, the methods applied and the conclusions reached. The conclusion that can be reached from this latest trend is that it seems unlikely that SARB will provide approval for a new application for exchange control for payments that are to be made to an offshore related party unless they obtain the necessary confirmations from SARS. It is therefore in the taxpayer’s
interest to ensure that it has up to date Transfer Pricing documentation that would be sufficient to
demonstrate that the transactions were entered into at arm’s length as required by Section 31 of the
Income Tax Act. Such documentation must be up to date.
By not having up to date or contemporaneous documentation in place a taxpayer not only faces the risk of
a Transfer Pricing review from SARS but also the risk of SARB not approving any payments that are to
be made to offshore related parties until such time as the Transfer Pricing documentation has been
prepared. Written by Carla van der Merwe (Deloitte South Africa)
OECD ISSUES DISCUSSION DRAFT ON TRANSFER PRICING ASPECTS OF
On 19 September the OECD issued a discussion draft on the transfer pricing aspects of business
restructuring. On the whole the discussion draft is a very helpful document and should support a
principled and fact-based analysis of the tax and transfer pricing implications of business restructurings.
Some aspects of the discussion draft will require discussion and clarification, but it should be welcomed
as a constructive contribution to an extremely difficult and contentious issue for both business and tax
The deadline for submission of comments on the discussion draft is February 19, 2009.
The discussion draft considers the transfer pricing issues in four Issues Notes:
Issues Note 1 – Special consideration relating to the allocation of risks in limited-risk structures; Issues Note 2 – The possible need for compensation for the restructuring itself; Issues Note 3 – The remuneration of post-restructuring transactions; Issues Note 4 – The circumstances in which the tax authorities may disregard the actual
transactions undertaken by the taxpayer.
Issues Note 1
Theoretically the assumption of increased risk must be compensated by an increase in the expected return,
although the actual return may or may not increase depending on the degree to which the risks are
actually realised. Risk allocation and risk transfers are significant factors in many business restructurings.
The contractual allocation of risk between associated enterprises, however, is respected only to the extent
that it has economic substance. Therefore, the review of contractual terms must be completed by a review
of the following matters:
Whether the related parties conform to the contractual allocation of risks; Whether the contractual terms provide for an arm’s length allocation of risks; Whether the risk is economically significant; and What the transfer pricing consequences of the risk allocation are.
The parties’ conduct should generally be considered the best evidence concerning the true allocation of risk. The mere fact that independent enterprises do not allocate risks in the same way as a taxpayer in its controlled transactions is not sufficient to not recognize that risk allocation. When no comparables exist to support a contractual allocation of risk between related parties, it becomes necessary to determine whether that allocation of risk might be expected between independent parties in similar circumstances. One factor that can assist in this determination is the examination of which party has control over the risk. “Control” is the capacity to make decisions to take on the risk (decision to put the capital at risk) and
decisions on whether and how to manage the risk, internally or using an external provider. This would
require the company to have people who have the authority to, and effectively do, perform these control
functions. When one party bears a risk, the fact that it hires another party to administer and monitor the
risk on a day-to-day basis is not sufficient to transfer the risk to that other party. Issues Note 2
Business restructurings involve transfers of functions, assets and/or risks with associated profit/loss
potential between associated enterprises. Restructurings can also involve the termination or substantial
renegotiation of existing arrangements. The second Issues Note discusses the application of the arm’s
length principle and transfer pricing guidelines to the restructuring itself, in particular the circumstances
in which at arm’s length the restructured entity would receive compensation for the transfer of functions,
assets, and/or risks, and/or indemnification for the termination or substantial renegotiation of the existing
arrangements. The main conclusions in Issues Note No. 2 are as follows. It is essential to understand the
restructuring, including the changes that have taken place, how they have affected the functional analysis
of the parties, what the business reasons for and the anticipated benefits from the restructuring were, and
what options would have been realistically available to the parties at arm’s length. Profit/loss potential is
not an asset in itself, but is carried by some rights or other assets. The arm’s length principle does not
require compensation for loss of profit/loss potential per se. The question is whether there are rights or
other assets transferred that carry profit/loss potential and should be remunerated at arm’s length.
Whether a transfer of profit / loss potential that follows from a business restructuring is an arm’s length
transaction depends on a number of factors, including but not limited to the following:
The options that would have been realistically available to the transferor and transferee at arm’s
length, based on the rights and other assets of each at the outset of the restructuring, that determine the profit/loss potential of either; and
The expected return to the transferor and transferee after the restructuring, and the compensation
that might be required to appropriately remunerate the transferor’s surrender of profit potential, in cases in which the transferor has transferred or surrendered rights or other assets that carry that profit potential.
There should be no presumption that all contract terminations or substantial renegotiations give rise to a
right to indemnification. To assess whether indemnification would be warranted at arm’s length, it is
important to examine the circumstances at the time of the restructuring, particularly the rights and other
assets of the parties as well as the options that would have been realistically
available to the parties at arm’s length. Issues Note 3: Remuneration of Post-Restructuring Controlled Transactions
The third Issues Note examines the application of the TP Guidelines to post-restructuring arrangements.
The main conclusions are as follows.
The TP Guidelines do not apply differently to post-restructuring transactions than to transactions
that were structured as such from the beginning.
Business restructurings involve change, and the arm’s length principle also must be applied to
transactions that take place upon the restructuring.
The comparability analysis of an arrangement that results from a business restructuring might
reveal some factual differences compared to an arrangement that was structured as such from the beginning. While these factual differences do not affect the arm’s length principle or the way the TP Guidelines should be applied, they may affect the comparability analysis and therefore the outcome of this application. For this reason, it is essential in business restructuring cases that a comparability (including functional) analysis be performed both for the pre-restructuring and the post-restructuring arrangements, and that the actual changes that took place upon the restructuring be documented.
Comparisons of profits earned before and after the restructuring would not suffice to support a transfer
pricing adjustment, but they could play a role in understanding the restructuring itself and could be part of
a before-and-after comparability analysis to understand the value drivers and the changes that accounted
for the changes in the allocation of profits among the parties. Location savings should be attributed
among the parties depending on what independent parties would have agreed, and normally depends on
each party’s functions, assets, and risks and on their respective bargaining powers, and in particular on
whether or not the relocated activity that gives rise to the location savings is a highly competitive one. Issues Note 4: Recognition of Actual Transactions Undertaken
The fourth Issues Note discusses important notions regarding the exceptional circumstances in which a
tax administration may consider not recognizing a transaction or structure adopted by a taxpayer.
Depending on the circumstances and on the countries involved, domestic anti-abuse rules, such as CFC
rules, might be applicable, but such domestic rules and their relationship with tax treaties are not within
the scope of this project.
The actual transactions can be disregarded when two conditions exist:
The arrangements made in relation to the transaction, viewed in their totality, differ from those
that would have been adopted by independent enterprises behaving in a commercially rational manner; and
The actual structure practically impedes the tax administration from determining an appropriate
transfer price. If an appropriate transfer price can be arrived at in the circumstances of the case, irrespective of the fact that the transaction may not be found between independent parties and that the tax administration might have doubts as to the commercial rationale for the taxpayer entering into a transaction, the transaction would be recognized under Article 9 of the Model Tax Convention.
Otherwise, the tax administration may need to decide whether this is a case for not recognizing the transaction. The OECD believes that at arm’s length, an independent party would not enter into a restructuring transaction that is expected to be clearly detrimental to it, if it has a realistic option not to do so. In evaluating whether a party at arm’s length would have had other options realistically available to it that were clearly more attractive, due regard should be given to all the relevant conditions of the restructuring, to the rights and other assets of the parties, to any compensation or indemnification for the restructuring itself, and to the remuneration for the post-restructuring arrangements, as well as to the commercial circumstances arising from participation in an MNE group. In assessing the commercial nature of a transaction that is part of a broader overall arrangement, it is important not to examine the transaction in isolation, but to look at the totality of the arrangements to determine whether the terms make commercial sense for the parties. For instance, when examining a transaction consisting of a sale of an intangible by a taxpayer to a foreign related party, it would be relevant to consider whether the sale is part of a broader restructuring involving changes to the arrangements relating to the development and use of the intangible. The OECD recognizes that there can be legitimate group-level business reasons for an MNE group to restructure. In practice, when a restructuring is commercially rational for the MNE group as a whole, it is expected that an appropriate transfer price would generally be available to make it arm’s length for each individual group member participating in it. In this respect, it is worth emphasizing that the arm’s length principle treats the members of an MNE group as separate entities rather than as inseparable parts of a single unified business. As a consequence, it is not sufficient from a transfer pricing perspective that an arrangement makes commercial sense for the group as a whole: the transaction must be arm’s length at the level of each individual taxpayer, taking into account its rights and other assets, expected benefits from the restructuring arrangement, and realistically available options.
This discussion draft broadly supports the view that the arm’s length standard must be applied to business
restructurings based on a thorough analysis of the facts and circumstances and consideration of what
independent enterprises acting at arm’s length would have agreed.
The strong incentives that exist for an organisation to restructure or to move its operations elsewhere
mean that these guidelines will have a significant impact on the future of the global business community.
The South African Revenue Services (SARS) has based its transfer pricing legislation on the OECD
Guidelines to transfer pricing. Therefore there is every reason to believe that it will apply these
Guidelines to business restructurings affecting South African companies. Written by Owen Crassweller (Deloitte UK). South African perspective provided by Michael Hewson
(Deloitte South Africa)
CANADIAN COURT DECISION CAUSES INDIGESTION FOR GLAXO
The Tax Court of Canada, in a decision dated May 30, found for the Canada Revenue Agency (CRA) in
the long-running dispute with GlaxoSmithKline Inc. (GSK), the Canadian distributor of the patented anti-
ulcer drug Zantac. The dispute centered on the transfer price for ranitidine, the
active ingredient in Zantac, for the 1990 to 1993 years. The CRA had originally added
approximately $51 million as additional income to GSK that should have been earned in Canada.
In the years in question, GSK paid a related Swiss company approximately $1,600 per kilogram for
ranitidine manufactured by a related Singapore company. During the same period, Canadian
generic drug companies were paying between $200 and $300 per kilogram for ranitidine to third party
The Tax Court found that the price paid to the related Swiss company was not reasonable in the
circumstances, and that what was reasonable was the highest of the prices paid by a group of
selected generic companies. The final price was subject to a minor adjustment ($25 per kilogram)
for an additional granulation manufacturing function carried out by the related Singapore
manufacturer. The decision was made under the transfer pricing rules of section 69 of the Canadian
Income Tax Act, the predecessor to the current Canadian rules in section 247. Under the former regime,
the standard was whether the price paid between the parties was “reasonable in the circumstances”; the
current rules refer to amounts that would have been paid between arm’s length persons. The decision also
makes extensive reference to the 1979 and 1995 OECD Transfer Pricing Guidelines, including discrete
analyses of the comparability factors and the application of transfer pricing methodologies, including the
hierarchy of methods.
In the end the court concluded that the comparable uncontrolled price (CUP) method is the
preferred method, and the price the generic companies paid for their purchases of ranitidine from
third parties is the amount GSK should have paid to its related supplier. The court further held that the
amounts in excess of the reasonable amount are taxable under Part XIII of the Income Tax Act,
confirming the application of the indirect benefits and deemed dividend provisions of the Canadian
decision is a long-awaited and significant win for the CRA in the transfer pricing arena, where
to date there has been very little Canadian jurisprudence. It may embolden the CRA in the current transfer
pricing audit environment, where a number of ongoing controversies with
significant amounts in dispute, albeit with different fact situations, are still pending.
The court’s comments on the applicability and interpretation of the past and most recent OECD guidance are also significant. For example, the court addresses the comparability factors, the hierarchy of methods, and the quality of the comparables under the resale price method. How the CRA and the Tax Court apply these comments in cases in which the transfer prices in dispute are not so divergent remains to be seen. In the interim, MNEs should be on the lookout. This Canadian case, together with the recent Australian preliminary decision in Roche Products Pty Limited v. The Commissioner of Taxation
, could be the first of a wave of transfer pricing cases making their way through the court system. It is not clear whether this case will be appealed. Written by: Sandra Goldberg (Deloitte Canada), Gary Zed (Deloitte Canada), Bernard Barsalo (Deloitte Canada), Muris Dujsic (Deloitte Canada)
For further information or assistance, please contact your local Deloitte & Touche
Billy Joubert +27 (0)11 806 5352 Philip Fouche +27 (0)21 670 1545
Carla van der Merwe +27 (0)11 806 5230 Michael Hewson +27 (0)11 806 5322
This newsletter contains transfer pricing information prepared by professionals of Deloitte & Touche for international investors in major countries. It is intended as a guide only, and the application of its contents to specific situations will depend on the particular circumstances involved. Accordingly, we recommend that readers seek appropriate professional advice regarding any particular problems that they encounter, and this bulletin should not be relied on as a substitute for this advice. While all reasonable care has been taken in the preparation of this bulletin, Deloitte & Touche accepts no responsibility for any errors it may contain, whether caused by negligence or otherwise, or for any losses, however caused, sustained by any person that relies on it. NOTE: This newsletter and its attachments are subject to the disclaimers as published at http://www.deloitte.co.za/disc.htm#emaildisc 2007 Deloitte & Touche. All rights reserved. Printed in South Africa
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