The starting point for any audit is the disclosures made in the income tax returns (ITR14s). Taxpayers must indicate in their ITR14s whether they form part of a multinational enterprise (MNE) and provide relevant details of the intercompany transactions that were concluded during the year of assessment. Making an incorrect disclosure could amount to a "non-disclosure of material facts", which results in a waiver of prescription. This means that SARS would be free to audit a year of assessment even beyond the normal three-year prescription period. It may also place you in a difficult position regarding the imposition of penalties, should the audit result in an adjustment to taxable income. It is therefore prudent for taxpayers to provide proper disclosure in their ITR14s. However, this declaration, coupled with National Treasury's and SARS' collective efforts in addressing Base Erosion Profit Shifting (BEPS) (which have intensified in recent years due to South Africa's slow economic growth and poor tax revenue collections) make it essential for multinationals to adequately prepare for a potential audit of their transfer pricing practices.
Unfortunately, there is no way of guaranteeing that your business will never be audited. However, in this article, we discuss ways of preparing for and navigating SARS' investigation process to reduce the risk of a protracted transfer pricing audit and a potential adjustment.
- Ensure you are compliant
In terms of the BEPS Acton Plan adopted in 2013 by the OECD and the G20 countries (including South Africa), Country-by-Country (CbC) reporting was developed. South Africa adopted these guidelines and has brought in compulsory transfer pricing documentation requirements where the aggregate of a resident company's transactions value (without set-off) with offshore connected parties amounts to ZAR 100 million or more. The documentation provides SARS, and other tax authorities with which it shares this information, with the basis to conduct thorough transfer pricing risk assessments. It is therefore imperative that such documentation is prepared and filed.
- Put your best foot forward
Transfer pricing documentation prepared by a MNE, with or without the assistance of a transfer pricing advisor, should be kept and filed in terms of South Africa's domestic regulations. However, such documentation should not be viewed as a simple compliance process. The documentation is essential for supporting the arm's length nature of these transactions.
If not already filed, your transfer pricing policy will be one of the first documents that SARS will request in a transfer pricing audit. To avoid having to respond to irrelevant questions and a protracted investigation process that is likely to absorb significant time and resources, the policy must adequately delineate the factual arrangements and information related to transactions with offshore connected parties in line with the underlying legal agreements.
Fundamentally, the documentation provides the context for how each party fulfils its contractual obligations stated in the underlying agreements. From this information it is possible to ascertain who does what, how the risks associated with the transactions are shared and what, if any, valuable assets are utilized. Getting this wrong may not only undermine your position in an audit, but also increases the risk of penalties being imposed should an adjustment be made.
Multinationals must ensure that the adoption of the preferred transfer pricing methods is sufficiently substantiated in the documentation; that the benchmarking and economic analyses are recent; and that the functional analyses are still relevant. The simpler and more user-friendly the transfer pricing document is, the better.
- Importance of legal agreements
Although it is not essential, it is good business practice to have intercompany agreements governing the transactions. Make sure that these agreements are well-documented and accurately reflect the nature of the transactions and the roles and obligations of the parties. The agreements, when read in conjunction with the transfer pricing documentation, should provide the full picture and allow the reader to fully understand the nature of the transaction, the shared functions, risks, and assets used, as well as the contractual obligations of the parties.
We urge multinationals to make sure that the legal agreements are up to date and that the transfer pricing document aligns with those agreements. If there is a disparity between the agreements and the transfer pricing document, it will inevitably lead to increased scrutiny by SARS.
- Be proactive in managing your transfer pricing policy
A regular assessment of your intercompany transactions, the pricing structure and allocation of related risks and functions is important to ensure compliance with South Africa's domestic transfer pricing rules.
Check that the documented analysis aligns with the related legal agreements and that both accurately reflect the pricing, terms, and risks of the affected transactions. If the document analysing and supporting the transfer pricing differs either from the legal agreements in effect, or the conduct of the parties, SARS is likely to disregard the analysis and draw its own conclusions.
Make sure your policy is up to date, the benchmarking is relevant and that you have checked the results to ensure the pricing or outcome fall within the ranges identified. It is much harder to justify results three or four years after the fact in an audit situation than proactively correcting the position in real time.
If a possible risk is detected through a self-assessment, a voluntary self-correction is always preferable to an adjustment being made by SARS with penalties and interest at the conclusion of an audit.
- Hot topics
Certain areas tend to attract greater scrutiny from tax authorities. However, the absence of these does not mean you are not at risk. Vanilla buy-sell arrangements can also be subject to transfer pricing audits.
Any form of restructuring or reorganisation within a corporate group (which has especially become necessary in this economic climate) is likely to be scrutinised, as this inevitably results in the reallocation of significant functions and risks. Such reorganisations must be driven by sound business principles and may be challenged by SARS if the reallocation lacks economic substance. It is therefore essential that MNEs make sure that their transfer pricing policies still accurately describe and support the economic substance of the allocation of risks after a restructure. If a function is moved, ensure that the people responsible for that function and for managing the risks around that function are also moved. When there has been a transfer of something of value, the transferring entity should be rewarded on an arm's length basis.
SARS recently released its new Draft Interpretation Note on the Determination of the Taxable Income of Certain Person from International Transactions: Intra-Group Loans. This note clarifies that there are no longer any safe harbours to rely on in terms of the level of debt funding that SARS will accept, or the interest rates charged. SARS has confirmed that both the quantum and the pricing of an intra-group loan must adhere to the arm's length principle. Now is an opportune time for you to review all cross-border intragroup loan arrangements and prepare support for these arrangements being at arm's length, from both the lender's and the borrower's perspective.
Intellectual property transactions are becoming one of the key hot topics for tax authorities globally, with several key multinationals facing significant tax adjustments following audits. SARS will not be far behind on this trend. Key considerations are that development, enhancement, maintenance, protection and exploitation (DEMPE) activities relating to the intangibles are reviewed and should be carefully documented. The important take-away from recent transfer pricing case law on intercompany transactions relating to intangibles is that intercompany agreements must support the taxpayer's position on the ownership, marketing, and licensing of intellectual property, and that these agreements must be aligned with the group's transfer pricing analysis and the conduct of the parties.
In determining an arm's length profit allocation, the OECD recommends investigating which entity performs the DEMPE functions. The entity that legally owns the intangibles, assumes the DEMPE functions, and bears all the operational and financial risks, should be allocated a significant portion of the profits earned from those intangibles, while the more routine activities would only be awarded routine returns. Intangible returns should therefore be based on each entity’s contribution. The internal management and governance of intangibles within a multinational group is imperative — transfer pricing documentation must accurately describe the transaction, define the intangibles involved and demonstrate that the profit allocation is aligned with the entities that own the intellectual property, contribute mostly to the DEMPE functions, and assume the most risk. If the entity assuming the risks differs from the entity that performs the DEMPE functions, a clear explanation must be given in the transfer pricing documentation. Tax authorities have also expressed a special interest in royalty payments that are linked to the leasing of intangible assets. Therefore, licensing arrangements must be correctly priced and benchmarking to support this must be held. Moreover, the ownership and transfer of intangibles between related parties, where one party is in a low tax jurisdiction, as with all transactions, remains a significant audit focus.
- Respond comprehensively to any initial queries
Even before you receive a notification of audit, SARS may well send information requests to get a better understanding of the transactions. Despite all the preparation that you do to ensure audit readiness, these initial requests for information are likely to be fairly wide-ranging and may include questions that you may consider to be irrelevant. However, we would urge multinationals to provide comprehensive responses to SARS' requests for two reasons:
Preparing for an audit requires putting your ducks in a row, having the correct documentation, and doing everything possible to support your transfer pricing practice as arm's length. While we cannot guarantee a complete avoidance of a transfer pricing audit, our experience in assisting multinationals to assess their transfer pricing risk and, if necessary, responding to transfer pricing queries from SARS, has provided us with invaluable insights on how to guide and advise to ensure the best possible outcome.