A precedent-setting case between a South African multinational company and the South African Revenue Service (SARS) underscores the intricacies of arm’s length pricing between a parent company and its subsidiaries in disputes over transfer pricing.
Transfer pricing is an accounting practice that represents the price that one division in a company charges another division for goods and services provided.
The multi-billion-rand dispute between ABD Limited, a South African telecom company, and SARS is the first to end up in court. The Tax Court found in favour of the taxpayer after a protracted and highly contentious legal battle. SARS is taking the judgment on appeal.
ABD’s subsidiaries are operating companies with shareholders worldwide, with ABD being a significant shareholder. It licenses its intellectual property (IP) to the companies, which pay ABD a royalty. ABD charged 14 of its subsidiaries the same royalty rate of 1% for the right to use its brand.
Eyewatering additional assessment
SARS initially accepted ABD’s royalty calculations in 2009, but in 2014 it undertook a transfer pricing audit. The relevant period was 2009 to 2012. The audit resulted in an eyewatering additional assessment of R7.5 billion for the four years, adjusted down to a still staggering R1.2bn and eventually set aside by the court.
Daniel Erasmus, a partner at Pieterse Sneller and Erasmus and lead counsel for ABD, said they were all “arguing from the same page” when SARS booted its expert witnesses a month before the trial. SARS introduced a new expert with an entirely new methodology to calculate the royalty rate, Erasmus explained during the recent Tax Indaba.
The core issue was to determine an arm’s length price for the royalty payments, which is crucial for “fair taxation and preventing tax evasion” through transfer pricing manipulation.
In his judgment, Judge Norman Manoim remarked on ABD’s point that the company had no incentive to charge a lower royalty to avoid paying higher taxes in South Africa. Evidence presented to the court showed that for most of the jurisdictions where the subsidiaries operated, the tax rates were equal to or higher than the South African tax rate.
“ABD also has minority shareholders in most of the operating companies (Opcos). If it were to undercharge the Opcos through the royalty, this would mean it inflated its profits in the Opcos. The result of this is that the minority shareholders would be rewarded with profits that exceeded their shareholdings,” Judge Manoim observed.
Short-changing the fiscus
Okkie Kellerman, transfer pricing expert at Middlesex University and part of ABD’s team of experts, said at the Indaba that SARS cannot argue that because there is a tax saving, it is by default illegal, or there is inherent planning to pay less tax.
“The mere fact that there are different tax rates cannot be taken as an automatic sin. You must understand the transaction to see whether there is a sin.”
The “sin” that transfer pricing rules address is the transfer of profits from a high-tax jurisdiction to a low-tax jurisdiction, which was clearly not the case in ABD’s business model.
Judge Manoim said he appreciated that the outcome of the case would be a great disappointment to SARS, which expended extensive resources to create a precedent in a seldom litigated field of tax law.
“But this not only meant it running contrary to the opinions and approach of its initial expert (which meant effectively dispensing with his views without explanation and engaging a new expert) but fighting a case where there appeared to be no rationale for the taxpayer to have any motive to short-change the South African fiscus.”
Digging deep
Erasmus says the dispute highlights the complexities of multinational companies’ IP royalty assessments.
“The strategy and the way that you piece your case together, the experts that you use, and what you have them testify to is a fine art to ensure that you are not tripping yourself up,” he said.
SARS will dig deep during its audit, which can be years down the line. “They will challenge you on the research that was done and the surveys that were conducted to back up the methodology you are relying upon,” Erasmus warns.
“You must have the information at your fingertips, otherwise I can assure you eight years down the line (when the case eventually ends in court), it will be difficult to find the people that gave the advice or were involved in putting the methodologies together. If you can find the witnesses, they will be challenged at every single level.”
Kellerman says companies that charge their foreign subsidiaries nothing for their brand (IP) can find themselves in a “very dangerous place”.
Companies often argue their brands may be well-known in South Africa, but they are not worth anything in the United Kingdom, Australia, or Asia. “That is not the case. You must make sure that none of the profits of the operating company is at all generated by that ‘unknown brand’ of yours.”
If a company is big enough to face transfer pricing audits, it should have a tax risk steering committee that meets every quarter and reviews the risks, Erasmus advises.
Amanda Visser is a freelance journalist who specialises in tax and has written about trade law, competition law, and regulatory issues.
Disclaimer: The views expressed in this article are those of the writer and are not necessarily shared by Moonstone Information Refinery or its sister companies. The information in this article does not constitute financial planning, legal, or tax advice that is appropriate to every individual’s needs and circumstances.
