SA’s Courts issue a seminal ruling on transfer pricing (TP)

 

A recent court case is being called “SA’s first real TP case” as, although the case dealt with an administrative issue and is based on the SA TP legislation in 2011, it deals with some key issues that remain important: The relevance of the OECD guidelines as they pertain to South Africa and also the critical importance of TP documentation to support the arm’s length nature of connected party transactions.

Background of the case

A South African manufacturing company appealed to the Tax Court of South Africa to rule for a separation of a legal issue, in relation to their appeal against a TP assessment.

The TP transaction under review was the purchase of materials from a connected party in Switzerland, which were used in manufacturing in SA before the final product is sold to unconnected local customers. SARS audited the company and, using its chosen TP method, which differed to the taxpayer’s view, found that the purchase of materials was not at arm’s length. This resulted in an adjustment to their profit of R114 million. Quite the nasty surprise for the taxpayer!

SARS looked at the arm’s length nature of the company’s mark-up earned based on the full transaction i.e., its profitability of the transaction taking account of a full analysis of the cost base, functions, assets, and risks involved with the transaction (known as the TNMM method). The company believed that only the consideration paid to the connected party was relevant (known as the CUP method).

The TP legislation gave and still gives SARS the authority to make adjustments. SARS had based its justification for the adjustment on the OECD Guidelines and Practice Note 7 (PN 7), released by SARS to provide TP guidance. The company requested that the issue of whether SARS’ conduct fell within the specific TP provisions be separated from their appeal of the assessment.

Of course, this did not go well for the company as all SARS had to do was argue that the arm’s length nature of a transaction is an overriding principle in TP and the manner an adjustment is determined. SARS argued it was well within its remit to calculate an adjustment using a method accepted by the OECD Guidelines, and ultimately the Judge agreed.

Furthermore, the company could not provide evidence that it had tested the transaction in its TP documentation, which the Judge confirmed, based PN 7 is very risky: It is always in a taxpayer’s interest to be able to demonstrate that transfer prices are at arm’s length in adequate TP documentation. If there is no documentation in place and SARS adjusts the arm’s length amount, it will be difficult for the taxpayer to justify an alternative method.

South Africa now has legislation that brings the international tax standards, including those set by the OECD, within its laws. However, the case made clear that even without this law, though SA is not a member of the OECD (it only has observer status), it must align to the OECD standards.

It will be interesting to see what happens when the case gets to court on its merits. What is, however, clear is that TP remains the significant focus area for SARS and taxpayers need to prepare appropriate documentation to support their arm’s length price. Contact us to discuss your specific situation.

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