Transfer pricing audits can be onerous, but taxpayers can achieve a more successful outcome by providing all information requested, anticipating areas of concern, and engaging openly with SARS
The South African Revenue Services’ (SARS) recent issue of seemingly arbitrary questionnaires to multinationals on the provision or receipt of intra-group services has encountered much criticism and complaint.
Although I agree that there appears to be a lack of coordination at SARS, with many taxpayers receiving these questionnaires while already under a transfer pricing audit, it demonstrates that SARS is serious about tackling the perceived use of transfer pricing to shift profits and contribute to base erosion in South Africa.
SARS is not the only tax administration taking this view. Transfer pricing featured heavily in the BEPS1 program and continues to be a focus of the G20/OECD2. Taxpayers should be prepared for an increased focus on transfer pricing practices and more questionnaires and requests for information from SARS.
How should you navigate this to achieve a liveable outcome? Below I explore some of the challenges and possible approaches that could ensure that taxpayers facing audits into transfer pricing practices emerge relatively unscathed.
The notification of an audit can quickly throw tax managers into a mood of frustration. Firstly, because in many cases SARS has already been provided with comprehensive transfer pricing documentation supporting the policies in place and seems to be asking for more irrelevant information. Secondly, because the tax manager is aware that this is the start of a long and difficult process which will tie up their already-stretched resources and detract from dealing with the day-to-day operations of the business. It is important to remember that SARS only has a snapshot of the transactions from the annual financial statements, the tax return and the transfer pricing documentation (if submitted). Obviously it does not have the same level of understanding of the business as the taxpayer does.
The request for additional information accompanying SARS' notification of the audit aims to bridge that knowledge gap. While some of the questions raised may appear pointless or irrelevant, that may indicate SARS is unsure what questions to ask and is trying to make the first request as comprehensive as possible. This is largely why the first request leads to a second request and so on. Section 46 of the Tax Administration Act (TAA) gives wide powers to SARS to request information which it considers to be relevant in order to apply the Income Act (in this case section 313).
Clients often ask us whether they should provide information which they consider irrelevant to the audit. Our response is always the same: "What is the downside of providing the information requested?" In some cases, it is the time and resources needed to collate the information for SARS. However, if SARS considers it relevant and it is not supplied, SARS will invariably ask for it again and may view the taxpayer as being obstructive. Being co-operative in providing the information not only ensures an amicable working relationship with SARS, but may result in SARS being more amenable to granting extensions to provide that information as well as the greater possibility of penalty mitigation if the audit results in an adjustment. It is therefore worth considering this when dealing with SARS' frustrating requests.
Being prepared is being forearmed. While the initial information requests may not indicate where SARS' concerns are, it is certainly worth taking a step back and undertaking an internal risk assessment for the years under audit. This will help to determine the best strategy to adopt throughout the audit. Revisiting the transfer pricing analysis is key. Question whether the transfer pricing analysis raised any potential problems. Touching base with the advisors who prepared the documentation could provide insight into any issues identified when the analysis was undertaken.
Checking that the documented analysis aligns with the related legal agreements and that both accurately reflect what was actually happening in the audit years is also critical. If the document analysing and supporting the transfer pricing differs either from the legal agreements in effect, or the conduct of the parties in those years, the chances are that SARS will disregard the analysis and draw its own conclusions. Being aware of these risk areas enables you to ascertain how to manage the rest of the audit and perhaps start to prepare for a likely adjustment at its end. If you know there is a problem and some of the transfer pricing practices were incorrect, it might be better to "fess up" early and bring a quick resolution to the audit. SARS would no doubt appreciate a quick win and walk away. Trying to cover an issue up is likely to lead to a long-drawn-out audit which will end the same way and possibly result in other issues being identified.
Understanding SARS' area of concern will also enable you to effectively manage the audit better. It may not be possible to identify SARS' thinking from the early correspondence, but as the audit progresses this should become clearer. It is better to be prepared for the letter of findings than be taken by surprise. For instance, if the transfer pricing analysis highlights that the tested party assumes risk and is classified as a full risk entity, but in reality the risks are minimal or unlikely to occur, this could be a possible area of risk in the audit.
SARS will want to interview key individuals during the course of the audit. These individuals will include operational as well as tax and finance people. Ensuring that the non-tax individuals are briefed in advance is important to ensure they respond appropriately and in context to the questions raised by SARS. Common issues we encounter are the use of
hearsay. The individual is asked a question outside his or her area of expertise but responds based on an understanding or belief of what happened, rather than from first-hand knowledge. Interviewees should
remain in their lane and only respond when they know the answer, avoid speculating and be prepared to say
I don't know, or
you need to ask…..
A good strategy is to interview the individuals internally first. Potential interviewees must refresh their memories by reading through relevant contemporary documents. Not only will this ensure they are prepared, it will also enable you to be sure SARS is interviewing the correct people with the requisite knowledge to respond to the questions. In some instances, SARS may be prepared to share a broad outline of the questions they will ask in advance to enable you to ensure the most experienced individuals within the right fields are interviewed. It is also a good idea to have someone present at the interview to moderate the discussion, if required, and to record the interview so that there is a clear record of what was said.
Throughout the course of the audit, large volumes of documents will be shared with SARS and there may be several meetings with SARS. Ensure you maintain a file which includes everything provided, minutes of all meetings held, copies of all interviews held and the dates these were provided/undertaken. On several occasions our clients have had to search for a document which was provided to SARS during the audit and on which SARS was now relying for its findings.
Information will also be shared with SARS electronically. The use of data rooms is useful to maintain the log of information shared. However, the management of these data rooms and the access is important and needs to be carefully monitored.
SARS will generally indicate once they have the information they need to reach their findings. It is also important that you are comfortable that all relevant information has been provided. It is preferable to extend the audit period to clear any outstanding items rather than leave SARS to establish its findings on part-fact and part-assumption.
Responding to the letter of findings will set the scene for how the likely adjustment is to be defended. This letter sets out SARS' position based on the facts it has analysed. Look closely at the position put forward by SARS and determine how best to respond. The period between the letter of findings and the letter of assessment provides a window to correct any misunderstandings which may exist and ensure SARS makes any adjustment based on the correct facts. We have been involved in audits where facts are still being clarified at the ADR4 stage.
Sometimes it may be preferable to engage with SARS by presenting the facts to them and allowing additional questions and discussion in a face-to-face meeting. This can help to deal with misunderstandings effectively. If this approach is chosen, it is important to agree with SARS who will minute the meeting and both the taxpayer team and the SARS team must agree on the final minutes recorded.
Ensuring that you and SARS are working from the same hymn sheet is paramount to achieving an acceptable outcome.
Are there any easy wins? By analysing the letter of findings, the facts surrounding the transactions and the transfer pricing support it may be possible to identify early wins. One area which often trips up clients and SARS alike is the application of the “connected person” definition to the entities who are party to the audited transactions. SARS has provided comprehensive guidance on the definition of “connected person” in its recently-updated interpretation note5 which also includes useful examples. If the parties are not connected, then section 31 (in its current form) does not apply - and that's the end of it. Having been through two matters where this was the case, it may frustrate SARS, but at the end of the day
the law is the law.
One of the most common causes of disagreement between taxpayers and SARS in a transfer pricing audit relates to the fact pattern and notably whether the entity under investigation is factually doing what it is purported to do.
This is the age-old limited risk versus full risk dilemma.
The OECD Transfer Pricing Guidelines6 provide exhaustive guidance on analysing the assumption of risk, but
the facts are the facts. Although it is important to evidence the functions undertaken, risks assumed and assets used by the entities in the transaction under audit, the situation needs to be considered in the context of the findings. Look at the other findings from SARS. Does SARS agree with the transfer pricing method adopted and/or the comparable data used to support the position? If this is the case, and it is simply a dispute over the functional characterisation, then it is important to focus your energy on defending this. If, however, a move between full risk and limited risk is not going to make a significant impact because SARS has disregarded the transfer pricing technical support, then arguing the facts may not affect the outcome and your energy might be better served by focusing on the transfer pricing technical aspects.
An example of this could be where the transfer price for the transaction is supported using a comparable uncontrolled price method which focuses on the price charged for the goods or services as opposed to testing the profitability arising from the transaction. If SARS argues that the more appropriate method should be profit-based, the impact on the adjustment could be significant. This would not necessarily be influenced by a disagreement over the functional profile of the parties. In this case, it would be more important to refute the appropriateness of adopting a profit-based method and do extra work to support the argument that a comparable uncontrolled price method is the correct approach.
Similarly, the selection of comparables also plays an important role. Without doubt SARS will scrutinise the comparable data put forward in the analysis and probably argue that one or more of the comparable entities used to source the data should be removed. It might be necessary to argue this to some extent, but you should also consider the impact of removing the disputed comparables. We have seen instances where SARS has removed entities from the comparable set but the result has been in favour of the taxpayer.
With comparability analysis where profit-based methods are used, the key area of negotiation is more likely to be the arm's length point in the comparable range. The functional profile of the tested party will play a role in determining this but ultimately this will probably be the negotiation which leads to the final settlement on the adjustment. Experience has taught me that being open to discussions around this can bear fruit when trying to get to a point of agreement.
Determining your strategy should be considered right from the start. Only one transfer pricing matter has gone to court so far. Most are resolved through settlement negotiations or mutual agreement procedure (MAP)7. The three different approaches to settling the dispute have different implications and should be considered as the audit progresses.
Settlement negotiations are still the most common way to resolve a transfer pricing dispute. In a settlement it should be borne in mind that no precedent is set, leaving future years vulnerable to another audit if the transaction remains in place. Settlement may, however, result in a reasonable outcome that both the taxpayer and SARS are prepared to live with (mutually unsatisfactory) and can often be negotiated to encompass later years on an informal basis8. Settlement will lead to an incidence of double taxation which is often unrelievable as SARS usually requires the taxpayer to agree not to pursue MAP in settlement cases. Having said that, some countries offer unilateral corresponding adjustments under their domestic law where it can be proven that economic double taxation has been suffered.
Surprisingly, the use of MAP is not as widespread in South Africa as other countries, probably because none of South Africa's double tax agreements has an arbitration requirement to ensure the speedy resolution of MAP cases. Entering into MAP is, however, similar to the domestic objection and appeal process and should be considered as a serious alternative to domestic remedies. The benefit is that another tax authority is involved. This could be particularly useful where the same transaction has already been audited by that tax authority and signed off as arm's length. In such cases, the foreign tax authority is unlikely to change its position, making SARS' case difficult to win. The downside is that the MAP process is closed to the taxpayer so there is limited opportunity to influence the decision. SARS has issued comprehensive guidance9 on the process which includes the following statement:
"A person can pursue the MAP and domestic legal remedies simultaneously. SARS may concurrently consider a case presented to the competent authority for MAP and the objection lodged by the taxpayer under domestic tax provisions against the assessment. Depending on the circumstances, the competent authorities may defer the MAP until a decision has been reached on the objection or if a taxpayer has requested a settlement."
It is useful to commence discussions with the group tax manager or tax manager overseeing the transfer pricing for the other entity to the transaction, especially where the location of that entity is in a treaty country. This would assist in deciding whether the MAP process is a contender. Also, reaching out to the group tax and transfer pricing manager may throw up instances where another entity in the group has faced a similar audit from its tax authority, providing valuable insight and ammunition in dealing with your audit.
I think the MAP process is underutilised for transfer pricing adjustments and, if used more often, could not only benefit taxpayers by providing greater certainty, but also help to improve SARS' skills.
Taking a transfer pricing matter to courtsignificantly changes the approach. Taxpayers tend to forget that part of the process is to go through "discovery". This is often where some of the skeletons start to come out of the closet. Additional witnesses may be interviewed and their testimonies can often throw up some red flags which until now had not been identified. If there is any chance that the matter will go to court, it is good practice to check all documents likely to be picked up in the discovery process and interview witnesses early on. This may well determine the preferred route to resolution. A decision by the court will, however, be binding on both parties which, if favourable to the taxpayer, will create certainty in future years.
In conclusion, managing a transfer pricing audit is time-consuming and requires resources both locally and overseas to collate all the information needed. Even when transfer pricing analyses are undertaken every year and documentation is meticulously maintained, this cannot guarantee that a transfer pricing audit will be avoided. Ensuring that certain steps are taken and strategic thinking is applied throughout the audit process can make it less arduous and potentially lead to a more favourable outcome.
1 - Base Erosion and Profit Shifting program - G20/OECD
2 - Organisation for Economic Cooperation and Development
3 - Section 31 of the Income Tax Act no 58 1962 as amended - Transfer Pricing
4 - Alternative Dispute Resolution Process
5 - Interpretation Note 67 - 28 Jan 2020
6 - Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations - OECD 2017
7 - Negotiation for the relief of double taxation under a relevant Double Tax Agreement
8 - Currently obtaining advanced rulings or Advanced Pricing Agreements is not possible for transfer pricing matters.
9 - LAPD IT G24 - 20 March 2020