The heart of transfer pricing tested for the first time in SA courts

The complexity of transfer pricing disputes has rarely been tested in South Africa. However, a recent case centred on the application of the arm’s length principle, which is at the heart of transfer pricing.

ABD Limited, a South African multinational company, won its appeal in the Tax Court against an additional assessment of around R1.2 billion. The assessment has been set aside. Sars is appealing the judgment.

The assessment followed an audit of ABD’s transfer pricing methodology by the South African Revenue Service (Sars). Experts believe this precedent-setting case provides a glimpse into how courts may approach transfer pricing cases in future.

It suggests a preference for “established and recognised” methods as opposed to “novel and untested approaches” to transfer pricing disputes, says Pieter van der Zwan, independent tax advisor and accounting specialist, in his analysis of the case.

The dispute stems from an audit conducted in 2014 relating to the royalty rate ABD charged its operating companies in different jurisdictions for the use of its intellectual property (its brand) during the period 2009 to 2012.

ABD charged all of them the same royalty rate of 1%. The audit resulted in an additional assessment of R7.5 billion, which was reduced to R1.2 billion by the time the case went to court around 2021.

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Different methodologies

Experts used different methodologies, in line with the guidelines of the Organisation for Economic Cooperation and Development (OECD), in performing the calculations to arrive at the appropriate rate.

The royalty must be at arm’s length – what it would be if it were between two independent enterprises, as opposed to a company taxed in one jurisdiction and its subsidiary taxed in another.

Sars contended that the 1% was not an arm’s length royalty. It has the power to adjust the rate if it believes the price does not reflect an arm’s length transaction. Sars based its initial additional assessment on the report of a Dr David, who used the Transactional Profit Split Method (TPSM).

Daniel Erasmus, lead attorney in the ABD case, said Sars and ABD had been arguing from the same page for seven years.

“One month before the trial Sars booted their expert witnesses and brought in an entirely new expert with an entirely new methodology driven by the willingness to pay method.”

The new expert, a Dr Slate, proposed higher, variable royalty rates based on a “willingness to pay” survey. According to the judgment, the fluctuations created by adopting this approach were considerable – ranging from 1% to 9.2%.

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No incentive to shift profits

Multinational companies use transfer pricing to allocate profits.

The Corporate Finance Institute explains that “effective but legal transfer pricing” takes advantage of different tax regimes in different countries by raising transfer prices for goods and services produced in countries with lower tax rates.

ABD argued that it had no incentive to charge its subsidiaries a lower royalty to avoid paying higher taxes in SA.

The tax rates in the jurisdictions where the subsidiaries operated were equal to or higher than the SA tax rate.

Sars and ABD used different methodologies to support their approaches. Sars relied on the TPSM, and ABD relied on both the TPSM and the Comparable Uncontrolled Price (Cup) method. The latter method, when available, is the preferred method of the OECD.

Judge Norman Manoim considered the case in terms of the arguments based on the Cup method.

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Criticism against approaches

According to the judgment, the “most significant critique” of Slate’s (Sars’s expert witness) valuation was a legal one, but it had profound implications for his survey on which it is contingent.

Slate assumed that the licensed rights included goodwill.

“This error then had implications for the survey questions on which the willingness to pay calculations were based. Questions in the survey were based on the goodwill of the ABD brand,” Manoim said.

A further criticism of its reliability is that the survey was performed in 2020. Yet respondents had to indicate what they might have done in the period 2009-2012.

Four of every 10 of the respondents would have been teenagers a decade before. Some may not have been old enough to have a phone in that period let alone pay for it.

ABD used a transaction that resembled the preferred Cup method, and while there were criticisms of its application, they were not conclusive, Manoim concluded.

However, the criticism of Slate’s approach had a solid factual basis. “Its assumptions, legal, economic, and accounting have been dismantled. If this were not enough it is an untested methodology for use in litigation in transfer pricing cases.”

Extensive resources

Manoim said he appreciated that the outcome of the case would be a disappointment to Sars as it had put extensive resources into it to create a precedent in a seldom-litigated field of tax law.

Sars not only fought a case that ran contrary to the opinions and approach of its initial expert, but “there appeared to be no rationale for ABD to have any motive to short-change the South African fiscus,” Manoim concluded.

ABD attorney Erasmus warned that Sars will challenge taxpayers on their research and surveys used to support the methodology they rely on. “You must have the information at your fingertips.”

This article was republished from Moneyweb. Read the original here.