Transfer Pricing Timing Limitations – Country by Country Reporting.
View our slides below for more information.
Transfer Pricing Timing Limitations – Country by Country Reporting.
View our slides below for more information.
The latest trend when it comes to inbound interest free loans into an entity in Africa from either a local or an offshore group company, is that numerous Tax Authorities across Africa are imputing an interest amount into the hands of the group company who is the borrower with a view to raising the withholding tax on the interest. Their argument is that in a normal arm’s length scenario, money would never be advanced at a zero rate of interest.
And as such the Revenue Authorities make these transfer pricing adjustments in accordance with domestic transfer pricing legislation in that country.
There are more onerous transfer pricing documentation requirement regulations for companies as has been unveiled by Finance Minister, Mthuli Ncube . This is in line with Ncube’s objective of protecting and broadening the tax base of Zimbabwe and prevent Base Erosion and Profit Shifting.
Under Statutory Instrument 109 of 2019 published in the latest Government Gazette dated 10 May 2019, Ncube has with immediate effect introduced the new measures. The Statutory Instrument states that “A taxpayer must have in place contemporaneous documentation that verifies that the conditions in its controlled transactions for the relevant tax year are consistent with the arm’s length principle”.
Transfer pricing documentation is required to include:
NESTLE Zambia Trading Limited vs Zambia Revenue Authority  TAT 03
(30 and 31 October 2018 and 28th March 2019)
The Zambia Revenue Authority (the ZRA) performed a transfer pricing audit with respect to Nestlé Zambia’s operations on the basis that Nestlé Zambia had reported losses for the financial years 2010-2014. Nestlé Zambia had declared losses since incorporation, and the net profit margins were negative for the five-year period under review.
The ZRA’s attention was drawn to the fact that there were significant related party transactions, management fee payments ad payments for the use of intellectual property .As a result of the audit, the ZRA adjusted Nestlé Zambia’s profit.
Nestlé Zambia filed an appeal to the Tax Appeals Tribunal and challenged the ZRA’s assessment on six grounds:
With specific reference to Nestlé Zambia being re–characterised as an LRD, the ZRA argued that:
Nestlé Zambia succeeded on all grounds of appeal, except for its position on the characterisation of the entity as an LRD.
The Tribunal found that there was a significant level of control by Nestlé Zimbabwe as regards the strategic direction of its operations and that “know how” was owned by Nestle SA who assumed the risks attributable to marketing, warehousing and distribution of products which supported the characterization of LRD.
Have you considered these important international tax principles?
The ramping-up of country-by-country (CbC) reporting to regulate transfer pricing and combat cross-border tax evasion, in terms of the Organization for Economic Co-Operation and Development’s (OECD) base erosion and profit shifting (BEPS) policies heralds a new tax landscape. It makes different demands of tax authorities worldwide and considers information at a finer level of detail. It also creates greater visibility amongst tax authorities and exposes companies with international structures especially those that have not been implemented correctly. The risk associated with international structures thus rises significantly and companies need relevant strategic advice to ensure that these structures withstand the scrutiny of tax authorities across the world. It is important to note that ‘tax’ should always follow business and never the other way around. There should always be a valid business purpose and commercial rationale for setting up an offshore structure.
The following international tax principles should always be considered:
Substance over form, whereby true effect will only be given to the legal form of a transaction if the substance is the same. It would be important to demonstrate that there are capital infrastructure and people in the offshore entity sufficient to support the revenue that is being recognized in that country. You cannot have a post box in a tax favourable jurisdiction without people functions, risks and assets that are commensurate with the revenue being recognized there. How would a revenue authority know, you may ask? They could request the financial statements of the offshore entity and soon deduce that there is no substance by virtue of income being accounted for but no corresponding rental expense, payroll and other expenses that would need to be incurred in the production of that income, in other words, no substance.
Residence, place of effective management (‘POEM’) or management and control are basic tests of residency in most countries. In other words, you cannot have an offshore entity in country B that is effectively managed in another country, country A. In that case, the offshore entity in country B could be considered to be a tax resident of country A. The basic principle around POEM is it is the place where the key decisions are taken by directors and senior managers i.e. the place where the ‘shots are called’.
Controlled Foreign Company Rules (‘CFC’) which are implemented in tax legislation in most countries. In South Africa, these rules apply if an SA tax resident or residents, either individually or jointly, hold more than 50% of the participation rights or are able to exercise more than 50% of the voting rights either directly or indirectly in a foreign entity. In that case that foreign entity is considered to be a CFC and subject to tax in SA subject, to certain exclusions one of which is the Foreign Business Establishment exclusion which in broad strokes means that it must have an office that it intends to occupy for at least a year with people, capital infrastructure and resources.
Transfer pricing generally relates to all intercompany transactions. In South Africa, the legislation applies to all cross-border intercompany transactions between connected parties which generally means where there is at least a 20% shareholding. It would need to be supported to Revenue Authorities across the globe that pricing is market-related. The recent implementation of Country by Country reporting creates greater visibility to tax authorities’ across the world on the activities, size, financial and tax position of companies within the Multinational Entity Group. South Africa Sourced Income – South Africa has a worldwide basis of taxation whereby non-residents are taxed on South African sourced income. As such if your offshore entity conducts activities in South Africa and these activities are considered the originating cause of income, such income would be subject to tax in South Africa subject of course to any double taxation relief that may exist by virtue of a Double Taxation Agreement.
General Anti Avoidance Provisions would be the overarching wrapper to ‘catch all other’ not caught by one or more of the above principles.
South African beneficiaries of Offshore Trusts – South African resident beneficiaries as a general rule are taxed where a donation is made to an offshore trust but also where interest-free loans are advanced. In such case, the attribution rules apply to attribute income and capital gains of the offshore trust which are taxed in the hands of the SA beneficiary. Where a distribution is made by the offshore trust to an SA beneficiary the latter will be taxed on that distribution based on the nature of the income out of which it was distributed e.g. if it was a foreign dividend the beneficiary will be taxed at an effective rate of either 0% or 20% depending upon the shareholding in the foreign company declaring the dividends and if it is interest, a marginal tax rate of 45% may be applied or a tax rate of 18% on a capital profit.
In terms of the Act, there is an exemption from tax on foreign dividends where the person holds at least 10% of the equity shares and voting rights in the foreign company; referred to as the participation exemption. This exemption also applies to the disposal of share where the disposal is exempt from CGT. As such, if the current year’s income of the trust comprised a dividend, that dividend is not taxable in the hands of the donor or the lender under the interest-free loan and neither is it taxable as a capital gain if the trust had disposed of the shares. Similarly where such dividend or gain has been capitalized and in a future year that capital was awarded to a beneficiary in SA that award would be exempt from tax on the dividends or the CGT. However if the trust had earned the dividend and distributed in the current year, the beneficiary would have been taxable at the rate of 20% while a capital profit made in the same year is not taxable.
Draft legislation has now been put out for public comment incorporating the following changes to the attribution and distribution rules. In determining an amount that should be included as taxable income in the hands of a resident who made a donation, settlement or other dispositions to a foreign trust and that foreign trust holds shares in a foreign company, it is proposed that the participation exemption in respect of foreign dividends should be disregarded, provided that those foreign dividends are paid by a foreign company where more than 50 per cent of the total participation rights or voting rights in that foreign company, are directly or indirectly exercisable by that resident who made a donation settlement or other dispositions to a foreign trust or connected person in relation to the resident.
If these attribution rules do not apply and a trust receives a dividend where it holds a greater than 50% interest, and the dividend is capitalized, an award out of capital in the future year to a beneficiary in SA will be taxable at an effective rate of 20%. The participation exemption will not apply. The new rules if included in the legislation will also apply to CGT so that where CGT would not have applied under the attribution rules, or out of an award of capital in the current or future year, will in future be subject to CGT. The participation exemption will not apply. The new rules are intended to apply to any dividend received or disposal of shares on or after 1 March 2019. If these changes are successfully implemented, it should mean that any dividend on a qualifying interest or any profit on disposal of a qualifying interest derived by an offshore trust on or before the 29 February 2019 and capitalised should still be able to be awarded out of capital, tax-free in the following year.
Transfer Pricing Business Solutions (Pty) Ltd 2013/203057/07
Roxanna Nyiri: Director of Transfer Pricing and International Tax
Mobile: +27(82) 6590797
South Africa: Crookes Brothers Limited v Commissioner for the South African Revenue Service (May 2018)
Malawi: Eastern Produce (MW) V Malawi Revenue Authority (July 2018)
Zambia: Nestle vs ZRA (March 2019)
Ghana: Biersdorf GH Ltd and the Commissioner General(August 2018)
The ramping-up of country-by-country (CbC) reporting to regulate transfer pricing and combat cross-border Base Erosion and Profit Shifting, heralds a new global tax landscape. It makes for different demands by tax authorities worldwide and requires the provision of information at a much finer level of detail. As a result, the risks associated with transfer pricing rises significantly and companies need to strategically manage this new policy environment, especially given that the first CbC reports were required to be filed with SARS from 31 December 2017.
The Organisation for Economic Co-operation and Development’s (OECD) base-erosion and profit shifting (BEPS) policies apply in South Africa through the SARS regulations issued by the Minister of Finance (section 257 of the Tax Administration Act). The regulations impact the ultimate parent entity of a multinational enterprise that is South African tax resident and has a consolidated group turnover of more than R10 billion, and requires filing of a CbC report with SARS. South African tax resident multinational enterprises with potentially affected transactions for a year of assessment (without offsetting any potentially affected transactions against one another) that exceed or are reasonably expected to exceed R100 million, must also provide documentation which support that transactions are entered into at arm’s-length. Additional documentation should also be submitted for any potentially affected transaction that exceeds or is reasonably expected to exceed R5 million in value.
The implications of the new transfer pricing rules are worth bearing in mind. The focus on goods and services has been revised, to place greater emphasis on cross-border transactions, operations, schemes, agreements or understandings. Under these conditions, SARS may impose transfer pricing adjustments if, firstly, terms or conditions are imposed on transactions, operations or schemes that differ from terms and conditions that would have existed between independent persons acting at arm’s length and, secondly, if the difference confers a South African tax benefit on one of the parties. Another implication of the transfer pricing legislation (section 31(3) of the Income Tax Act) is that an adjustment of a transaction is deemed to be a dividend in specie and subject to a 20% withholding tax. The Act contains exclusions in respect of non-resident persons who grant financial assistance to a headquarter company and the headquarter company directly applies the financial assistance to any foreign company in which the headquarter company holds at least 10% of the equity shares and voting rights. If a non-resident grants the use of intangible property (“IP”) to the headquarter company, the transfer pricing provisions do not apply to the royalty paid by the headquarter company to the extent that the headquarter company gives the use of the IP to a foreign company in which the headquarter company holds at least 10% of the equity shares and voting rights. The royalty paid by the foreign company to the headquarter company is also not subject to the transfer pricing provisions.
The CbC reporting requirements follow a three-tiered approach. They require the compilation of a standardised Master File, with a high-level overview of the multinational group business. A Local File should contain detailed information on specific group transactions. And, the CbC report should contain aggregate, jurisdiction-wide information on the global allocation of the enterprise’s income, taxes paid, indicators of economic activity. The CbC report enables tax authorities to make a BEPS risk assessment of the company. Once filed with SARS, the CbC reports will be shared with 31 different tax authorities. In terms of the OECD principles, SARS may only use the CbC report to assess transfer pricing and BEPS risks, and to perform economic and statistical analysis.
Rising to the compliance challenges of the new Country-by-Country reporting environment will require co-operation between companies, tax specialists and tax authorities.
Over the past two decades’ insurance companies are increasingly operating on a global level. As part of an overall global business strategy, many companies utilize intercompany reinsurance to manage risk and capital more effectively while ultimately improving profitability. As such, tax authorities in many jurisdictions are challenging the pricing related to intercompany transactions.
A reinsurance contract is an agreement between an insurer and reinsurer. The insurer writes the policy for the policyholder and is contractually liable for any payments to the policyholder that become due under the policy even if those insured risks are eventually covered by another insurer as part of the reinsurance contract. The insurer markets the policy, received the premium income and bears the cost of its sale and ongoing administration.
In a reinsurance contract the insurer (cedant) cedes the insured risks to a reinsurer who receives a corresponding reinsurance premium from the cedant. In return the cedant will receive a payment (referred to as a cedant’s commission) to cover the costs that it incurred in obtaining the policy and make a profit. The result is a net payment made by the cedant to the reinsurer. A common circumstance arises where South African based companies have subsidiaries in jurisdictions such as the Isle of Man or Bermuda where there is no corporate tax or in favourable tax jurisdictions such as Mauritius. In such cases the South African Revenue Service (‘SARS’) may challenge the South African company in its pricing of reinsurance ceded to such subsidiary with a view to demonstrating that the SA company is paying insurance premiums that are greater than what would have been established between unrelated parties.
The arm’s length principle is the single most important guiding principle of transfer pricing and is based on the arm’s length standard. The arm’s length standard is an internationally accepted concept which requires the price of an intercompany transaction to be consistent with the price that would have been charged between unrelated parties. On 5 October 2015, the Organisation for Economic Co-operation and Development (OECD) released its final 2015 reports under its Action Plan on Base Erosion and Profit Shifting (BEPS). The report of Action 8-10, Aligning Transfer Pricing Outcomes with Value Creation (the Final Report (contains Revisions to Chapter VII of the OECD Transfer Pricing Guidelines for low-value-adding intragroup services which would apply equally to the insurance industry. A summary of the six-step risk framework is set out below.
|01.||Identify economically significant risks||Identify economically significant risks with specifity. Non-significant risks do not need to be considered|
|02.||Determine contractual risk allocation||Determine how each economically significant risk is contractually assumed under the terms of the contract|
|03.||Perform functional analysis||Perform functional analysis of each economically significant risk. Attention to be given to (i) control and risk mitigating functions (ii) risk actually borne by each enterprise and (iii) financial capability of each enterprise to bear the risk|
|04.||Consider whether functional conduct is consistent with contract terms||Decide whether the contractual assumption of risk identified in step 2 is consistent with entities conduct identified in step 3|
|05.||Allocate risk||Reallocate risk based on conduct established in step 3 if required.|
|06.||Transfer pricing analysis||Conduct transfer pricing risk analysis based on allocated risk from Step 5|
This new framework adds a further complexity in terms of the requirement to support the ‘substance’ of the reinsurance operation. This would mean that the reinsurance operation would need to have people and resources with sufficient management expertise on the ground who manage the risks, and in addition, the capital infrastructure and financial capacity to bear the risk. This would need to be evidenced in the day to day operational activities of the reinsurer. From a pricing perspective since no two reinsurance contracts are identical, demonstrating arm’s length intercompany contract pricing can be challenging.
A commonly used method is the Comparable Uncontrolled Price Method (CUP) which is based on contract comparisons. In terms of the CUP method one would need to establish whether a comparable transaction exists in the open market between independent parties. If not, one would look to whether the ceding entity underwrites business with third party unrelated entities similar to the intercompany transaction (internal CUP). It may be appropriate to use the cedant’s reinsurance pricing model to determine a comparable price (internal CUP). Another method involves an actuarial approach to calculating the net present value of future profits from the cedants book of business before and after the reinsurance. The difference would equate to a theoretical cedant’s commission.
This actuarial model is based on a number of key inputs and assumptions including premium income, cost of claims, payment patters of premiums and claims, acquisition costs and other expenses, return on investments, capital considerations and choice of discount rate. The onus is on the taxpayer to ensure that transfer pricing is correct and supporting documentation is in place. Intragroup transactions should be reviewed especially reinsurance premiums and ceding commissions to make sure that the pricing is supportable with robust transfer pricing documentation and an economic analysis to prevent costly adjustments and penalties.
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