All you need to know about TP adjustments

Finding Transfer Pricing a Headache? TP Adjustments are even worse…

Transfer pricing (TP) adjustments occur when a transaction between connected persons or associated enterprises has been found to be non-arm’s length, and an adjustment is made to the taxable income to either disallow a deduction or include a taxable amount, and therefore “correct” the taxable income. TP adjustments are complex and have other tax implications, not just in terms of the additional corporate tax due.  A TP adjustment can also have dividends tax, withholding tax, and even VAT consequences.  Moreover, TP adjustments comprise both a primary adjustment (i.e. the “correction” to taxable income) as well as a secondary adjustment (i.e. a further tax that is payable as a direct consequence of the primary adjustment).

Timing of TP adjustments is key

In a recent South African tax court case, (CBA (Pty) Ltd v Commissioner for the South African Revenue Service (Case No. 24674)), the verdict reaffirmed that tax is an annual event and therefore expenses and/or allowances claimed must match the year during which such expenses or assets are actually incurred. This principle is also applicable to TP.  Thus, a taxpayer engaging in cross-border intra-group transactions must do so at arm’s length in respect of each year of assessment. If the arm’s length test is not satisfied and there is a tax benefit for one of the parties to the transaction, then a TP adjustment may be necessary. To achieve an arm’s length result, taxpayers often make use of retrospective TP adjustments. For example, if the taxpayer overpaid its foreign connected person supplier during the year and does not meet the arm’s length operating margin set in terms of the TP policy, the supplier would need to issue a credit note to retrospectively adjust the operating margin to the arm’s length level.

Applying the principle followed in the tax court case, it is doubtful that the SA Revenue Service (SARS) would agree with a taxpayer performing a retrospective adjustment in terms of a catch-up adjustment in a subsequent year and treating it as part of the calculation of the taxable income of the subsequent year. It is therefore critical for taxpayers to not only document their TP policy but also to ensure that TP adjustments are made throughout the year (as opposed to posting retrospective year-end adjustments to the accounting records).

TP adjustments and Dividends Tax & penalties

A taxpayer is obliged to make a TP adjustment in their income tax return to reflect the arm’s length fee that should have been earned for providing/receiving inter-company goods and services. This will give rise to normal tax at the standard rate. In SA, there is also a further consequence in the form of dividends tax at 20% on the TP adjustment.

Should the taxpayer fail to make these adjustments in the tax return, there is a risk that SARS could make an adjustment for the income tax and dividends tax payable and seek to levy understatement penalties and interest.

Based on the views expressed in the judgment of Volkswagen of South Africa (Pty) Ltd v C: SARS 70 SATC 195, dividends tax payable by a company on a dividend in specie or a deemed dividend in specie falls outside the ambit of the dividends article of a tax treaty. The importance of this statement is that the rate of 20% on the deemed dividend cannot be reduced in terms of the dividend article of a treaty.

TP adjustments and VAT 

TP adjustments are usually done at year-end and may be either prospective or retrospective, and upward or downward depending on the circumstances.  In relation to prospective adjustments, no action would be required from a VAT perspective since an increased transfer price for future supplies will be reflected on the relevant future invoices and VAT will be accounted for accordingly.

In relation to retrospective adjustments, if a foreign group company effects a year-end TP adjustment, a VAT liability (and customs duty) can arise if the price of goods imported is increased retrospectively. The same can apply to imported services. Exported goods and services will typically qualify for zero-rating, as long as the correct documentation is obtained.

In February 2022, the Italian tax authorities addressed the VAT treatment of TP year-end adjustments. In summary, a TP year-end adjustment will only have VAT consequences if there is a direct link between the TP adjustment and the consideration paid for the goods.

Next Steps

So TP is never simple, adjustments add an extra layer of complexity. If you are scratching your head about TP adjustments, please reach out to us.