I wrote an article on the IBOR transition from a South African perspective about a year ago. The article focused on what “IBOR transition” means and on how to get ready for it should you have active arrangements referencing IBOR. You can find the article here.
From earlier this year some IBOR rates are no longer published. The big example is USD LIBOR, which many have referenced to provide for an interest rate in their agreements. Let’s assume we still have agreements in place as of right now that reference USD LIBOR but as this is no longer published, how do I determine my interest rate. This also assumes the agreement does not have another rate to use in case USD LIBOR is no longer available. The below are some points to consider from a transfer pricing perspective. There are potential other tax consequences that may also arise from this but I have tried to stay clear of those, as it can be a lot to digest in one blog post.
Similar to most transfer pricing enthusiasts, I was looking forward to the 2022 OECD Guidelines which were published in January this year. Honestly, I am not sure what I was expecting, it’s not like a new method was on the horizon or that there was going to be a substantial change to the arm’s length principle, but one can always hope for some excitement?
It was not to be, and that is probably a good thing, could you imagine transfer pricing professionals trying to deal with another shock on top of Pillar 1 or 2? But back to the topic, what has actually changed?
Businesses are struggling to survive during the COVID-19 global pandemic and are considering many different options, especially around cash management. Transfer pricing should not be overlooked, and this is not only for compliance reasons. Transfer pricing can assist with alleviating some of the pressures that businesses are currently dealing with. Below is a summary of transfer pricing matters that should be on every multinationals (MNEs’) radar:
I have spoken a lot about the arm’s length range and when we should use a statistical tool such as the interquartile range (IQR) to derive an arm’s length range. But how do we calculate the IQR practically?
The easy answer is, Microsoft Excel or Numbers (for Mac) will do it for you, you just have to use the right formula. For Numbers this is a little easier as there is only one formula (=quartile) but for Excel users this can become a little more confusing as there are two formulas. Originally, Excel also only had one formula but now you have the option of either using =quartile.inc or =quartile.exc. The previous formula within Excel was equivalent to =quartile.inc, in case you were wondering.
So the questions are: Which formula should I use? Does it make a difference in the range? Will the tax authorities care?
Transfer pricing and the inherent arm’s length principle has been around for some time now and many African countries have implemented transfer pricing regulations. In Africa, only about five countries had transfer pricing legislation in place before 2000, now in 2019, only about five countries do not have any arm’s length or anti-avoidance provisions in place dealing with transfer pricing. Out of these countries approximately 40 countries in Africa have some sort of formal transfer pricing documentation requirements, be it in the form of formal submission or retention requirements.
The South African submission requirements for a master file and local file have been finalised. The only change to the previous draft submission requirement is the effective date, which is now set as financial years starting on or after 1 October 2016 (instead of 1 January 2016). The master file and South African local file will have to be submitted to SARS 12 months after financial year end, meaning the first reports (files) are due to be submitted on 30 September 2018.
The overall threshold for master file and local file requirements stayed at R100 million. Please keep in mind the R100 million is the gross amount of all cross border related party inbound and outbound transactions added together and includes capital loan balances. In addition, there are also separate transfer pricing documentation retention requirements which should be considered together with the master file and local file requirements.
It may seem that there is still ample time to meet such deadlines, but a master file and local file project (and potentially additional info as per the transfer pricing documentation retention requirements) is time consuming. We recommend to start planning for such a project as soon as possible, especially, where no transfer pricing policy or previous transfer pricing report (file) is in place and this may be the first time you are undertaking such an exercise.
The conference overall was very insightful and I am glad I could participate. I hope to be back next year, and maybe see more of you guys there? As promised herewith the juicy bits from day 2. Just to reiterate, these are not necessarily my views, but I find some of the thoughts interesting so I had to share them:
Tax authorities, including SARS, use analytical tools to determine a risk rating for taxpayers
SARS would not only go after specific transactions but also after certain industries, including aggressive schemes/structures (marketing hub was mentioned)
Initially tax authorities like SARS are just trying to understand your business and taxpayers don’t always provide adequate information. Taxpayers should provide correct and detailed responses, which will help the tax authorities with a ‘better’ audit (correct), less back and forth re information requests, and should an audit go to court the initial information will be under scrutiny
Taxpayers should keep in mind that tax authorities have no ‘real’ understanding of what is going on and are just trying to get this understanding
When giving additional information, a taxpayer should reference this back to the TP Document and other info where relevant
SARS automatically will look at historic tax returns, up to 10 years
If a taxpayer states there is a TP Document available, SARS will only give 7 days to provide said TP Document
It isn’t certain that SARS will accept the low value adding services section of the BEPS Action Point 8 – 10
Should a transaction not be at arm’s length as per s31, could that threaten a CFC’s business establishment exemption?
If you are using IP, do you know what the actual value of it is? This should form part of the new/overall thresholds re TP Documentation requirements or other BEPS thresholds
The draft thin cap interpretation note does not seem to be relevant and assumptions are made that it will be revisited before it is finalised
There is an assumption out there that before BEPS everyone was safe, and no you are no longer – not really true, the arm’s length principle has been around before BEPS
The fact that a taxpayer is transacting from a tax heaven is not the issue, the issue arises where a taxpayer cannot support a transaction from an arm’s length perspective – would a third party transact that way
The arm’s length principle is not about being ‘fair’ but rather what is market related – is the market fair?
If you have any thoughts or questions, please share them below. And don’t forget to share the posts so other transfer pricing enthusiast can discover my blog too.
As my vivid followers will know, I promised I would provide some insight into the Transfer Pricing Summit 2016 hosted by the South African Institute of Tax Professionals (known as SAIT). Instead of giving minutes of each session I thought I give a list of the juiciest comments/moments. Obviously if you would like to elaborate on any of them, let me know via the comment section below.
Just documentation is not enough anymore in transfer pricing, [we] must get to the substance
Knowledge is key and in the digital age it is easy to get – for both taxpayers and tax administrations
Are leading MNEs paying their fair share of tax? If not, our tax systems are not working as most [tax] should come from these MNEs
Days of pleading ignorance are over (example of the Australian Parliament), you have to know what is happening in your business
Most African countries follow OECD, but is there enough skills? Maybe not yet, but we have auditors with no borders and funding is pledged by certain organisations like the World Bank to assist with skills development
Assumption is that illicit funds only flow out of developing countries to developed countries, this does not seem to be the case
Is there a difference between evasion or avoidance in relation to transfer pricing. It is uncommon that MNEs try to miss-price (i.e. be fraudulent) but rather, transfer pricing is not an exact science. There may be some bad apples but that is not the norm
Some countries apply transfer pricing to any cross border transaction, the reason for this is that countries are not always able to proof a relationship (connected person) and this way the tax authorities can put the onus onto the taxpayer to provide support that a transaction is with third parties or related parties
Most countries in Africa not yet doing a lot of work around IP, trying to focus on other transactions first, such as services.
ATAF has released a toolkit that the Nigerian tax authority is using. The feedback from FIRS has been that this is a game changer and ATAF will release this tool for other tax authorities to use towards the end of 2016
Question remains, how to deal with comparability studies. Usually, no local comparables are available and how can tax authorities/taxpayers get around that. Introduce a safe harbour? Maybe use less comparable companies or do geographical adjustments. A question was raised, why don’t tax authorities provide a number that should be used as an adjustment for geographical differences and taxpayers can use European comparables.
Africa may be looking into APAs but generally speaking, the focus is on audits as tax authorities do not have enough transfer pricing specialists/skills
Information should be readily available, but that is not really the case. Companies within a MNE are using different accounting systems and so forth. Difficult to just get the information. MNEs should try do a dry run to make sure there are no snags
Making CBCr reports public has added pressures and may result in reputational risks
NGOs can make more damage to a business than a tax authority can
Should a tax authority use a CBCr in bad faith, there is a way to stop submitting the report by a MNE, but it is unlikely that it will happen. The CBCr process is based on trust
MNEs need to consider the risk of ‘low valuable’ IP which a tax authority deems to be of high value
When analysing transfer pricing, the economies in which the related parties transact in must be considered. As such, it comes to no surprise that a change of an economy will have some sort of transfer pricing knock-on effects. The latest example of such a change is Brexit (British exit – referring to Britain leaving the EU). For those of you who do not follow the Brexit discussion closely here is a quick wrap up of what is likely to happen to the UK economy should the UK exit the EU:
The Pound may lose value
Stock markets are likely to lose value with multinationals and banks hit hardest
Debt interest rates in the UK are likely to rise
As this is likely to put the UK economy under strain this is not too different from what would happen if an economy is downgraded from investment grade to non-investment grade (i.e. junk status). To refresh your memory on that discussion click here.
But additionally, countries that transact with the UK, for example South Africa will also feel the knock-on effects. Firstly, there is likely to be a renegotiation of trading terms between the UK and EU which are less favourable. This could mean that countries, especially South Africa, which trade with the UK (or use the UK as a gateway into the EU) have less favourable trading terms too. South Africa is the UK’s largest African trade partner.
Secondly, where trade is more difficult and likely to result in increased prices, demand from the UK for South African goods (and vice versa) may decrease, even more so where the economy is strained.
…other taxes such as import duties and VAT will be much more concerning for multinationals.
Thirdly where the Pound decreases in value this will result in foreign exchange losses for UK multinationals. This may sound positive for other countries such as South Africa, but keep in mind that other currencies are likely to increase in value as these are more sought after, such as the USD. This means that countries like South Africa may also face a foreign exchange risk (unless transacting only in Pounds).
Ignoring the economics above, other taxes such as import duties and VAT will be much more concerning for multinationals. Should there be a Brexit, I believe that the UK would maintain the arm’s length principle, meaning that transfer pricing in the UK will remain the same. Especially since the UK is part of the G20/G7. This at least would be some good news.
To my international readers, this post uses South Africa as an example, but the analysis is generic and could be applicable to any country that faces a downgrade.
South Africa’s credit rating could be downgraded to “junk” at the end of the week (3 June 2016). In simple terms this would mean that South Africa will have to pay a higher interest rate for its debt as South Africa is seen as a riskier investment by lenders. This will have knock on effects on the economy and in short, it may play out as follows.
This ultimately may require a different funding strategy altogether…
Investors may stop investing in South Africa which means prices of South African assets will drop due to the lack of demand for South African debt and shares listed on the JSE. This will weaken the Rand‚ inflation will increase and South African companies will have to endure higher costs and interest rates.
South Africa’s GDP is only marginally growing and a downgrade may push South Africa into a recession. Considering all this (and this is by no means a detailed picture) I would like to explore how this could affect transfer pricing? Transfer pricing is very fact dependent but I will try explore this topic on a generic basis.
The first thing that comes to mind is that companies are less likely to make profits in an economy that is in a recession. Companies that make losses are generally seen by tax authorities of greater risk as they are perceived to shift profits. So the questions here is whether the losses are due to commercial activities or due to transfer pricing arrangements. Most likely the losses are linked to the economy/downgrade but there may be additional scrutiny from tax authorities and it is up to the companies to support their losses. Again, transfer pricing studies are very fact dependent, but where a company uses benchmarking studies to support the arm’s length principle it will be difficult to support losses. This is due to the fact that benchmarking studies usually provide positive interquartile ranges, and where a company is loss making it may not be able to support its pricing unless it looks towards the minimum which is an outlier to the range and is usually not seen as a good comparable. There are different solutions to this issue depending on the facts and circumstances, one of the more obvious solutions would be to select comparables from a comparable economic environment. But will this solve the issue?
Many South African companies already see their profits reduced/eliminated by foreign exchange losses. This causes similar issues as the above, and with a downgrade this is only likely to get worse.
Moving away from loss making entities, a downgrade in the economy will also affect the credit ratings of borrowers within the economy, which results in higher interest rates payable. This in turn may have a knock on effect on a company’s thin capitalisation. Increased expenses will have an affect on the company’s debt capacity which means it is not able to borrow as much as previously. Companies which previously had acceptable amounts of debt now may be thinly capitalised and therefore may not be allowed to deduct the full interest expense as a tax deduction. Additionally, the increase in the interest rate may also receive additional scrutiny from tax authorities.
One must also keep in mind that South Africa has exchange controls in place to monitor cross border payments. Where a company is seen to be of higher risk, it will have to pay a higher interest rate. It is likely that a higher interest rate requires a more stringent approval process from the South African Reserve Bank (or authorised dealer) and the approval may even be disallowed. This ultimately may require a different funding strategy altogether, such as using equity over debt.
Another point to mention is where South African companies are remunerated on a cost plus basis, be it on a gross cost or return on total costs (see differentiation here), these companies are now becoming less competitive as doing business in South Africa overall is becoming more expensive. So the question here is whether from the other related parties side, the transactions overall still make commercial sense or are we potential causing a transfer pricing problem in the other jurisdiction?