A recent transfer pricing case raised a number of interesting issues about procedure in the event that a taxpayer disputes SARS’s findings following an audit
South Africa has seen its third "transfer pricing" case which, once again, does not actually deal with the merits of the transfer pricing analysis. Following on from Crookes Bros1 and the ABC case,2
United Manganese of Kalahari (Pty) Ltd v The Commissioner for the South African Revenue Service3 considers the merits of procedure as opposed to the merits of the transfer pricing analysis under audit.
UMK made an application to the High Court to review and set aside SARS's decision to raise additional income tax and dividends tax assessments and make a declaratory order. UMK approached the High Court directly without first exhausting its remedies of objection and appeal to the Tax Court. The High Court believed that the Tax Court was better suited to adjudicate the dispute. UMK had to exhaust its internal remedies before approaching the High Court unless it could show that exceptional circumstances existed. UMK tried to argue that the exceptional circumstances existed as set out in more detail below. The High Court disagreed and held that where the Income Tax Act or Tax Administration Act prescribes a method of achieving a particular goal in stead of having to approach the High Court, there are no exceptional circumstances. UMK's application was ultimately dismissed.
However, the case does raise some interesting aspects worth keeping in mind in the event you find yourself in the unenviable position of being under audit.
The facts in brief
The taxpayer was notified of a transfer pricing audit in 2017. SARS issued a letter of audit findings in April 2019 informing UMK of the outcome of the audit. After further correspondence between the parties, UMK responded to the letter of audit findings in 30 August 2019. The parties then agreed to extend the period within which SARS could raise additional assessments to 31 January 2020. On 31 January 2020 SARS issued a Finalisation of Audit Letter resulted in an adjustment to the taxpayer’s taxable income for the 2011-2013 years of assessment in terms of section 31(2) of the Income Tax Act (the Act) and a dividends tax assessment for the 2013 year of assessment under section 31(3) of the Act.
The taxpayer took SARS’s decision to issue additional assessments on review. It argued that SARS changed the basis of the assessment without affording the taxpayer the opportunity to consider the changed basis of assessment and as such unlawfully issued additional assessments in breach of section 42 of the Tax Administration Act (TAA). SARS disputed this, on the basis that the taxpayer had not followed due process in line with Chapter 9 of the TAA by lodging an objection against the additional assessments, specifically section 104 of the TAA.
SARS maintained the taxpayer was simply "forum shopping" in taking the decision on review, rather than following the correct procedures under Chapter 9 of the TAA. These procedures would ultimately lead the dispute to the Tax Court and, if appealed, to the High Court.
What constitutes adhering to section 42? What is reasonable to keep the taxpayer informed?
While PAJA was also a bone of contention for the taxpayer, in this article I am staying away from that thorny issue and instead considering whether the taxpayer had grounds to argue that SARS contravened section 42 of the TAA.
Section 42 of the TAA requires the SARS official involved in the audit to keep the taxpayer informed about the process of the audit, including the initial notification of commencement of the audit and, more importantly, on conclusion of the audit "a document containing the outcome of the audit, including the grounds for the proposed assessment". In transfer pricing cases this typically takes the form of a Letter of Audit Findings, setting out SARS’s findings and generally inviting the taxpayer to respond. After considering the taxpayer’s response (or not, which is often the case), SARS will issue a Finalisation of Audit Letter accompanying the additional assessments.
The taxpayer argued that SARS was in breach of Section 42 of the TAA because it changed the basis of its assessment without informing the taxpayer, making a material error in the application of the connected person definition to the facts.
SARS issued its Letter of Audit Findings on 17 April 2019, after several requests for information and conducting interviews with employees of the taxpayer. In my experience, this is SARS’s normal approach to transfer pricing audits. SARS also afforded the taxpayer 21 days to respond to the letter. The case notes that SARS indicated in its Letter of Audit Findings that it proposed to raise additional assessments under section 31(2) of the Act for the 2011-2013 years of assessment. Correspondence followed between SARS and the taxpayer which culminated in a Finalisation of Audit Letter issued on 31 January 2020, accompanied by the additional assessments.
Two aspects are clear. Firstly, the initial notification of audit letter in March 2017 stated that the scope of the audit was "transactions between the taxpayer and its offshore connected parties". Secondly, the Finalisation of Audit Letter stated: "This letter follows an audit of the transactions between UMK's and its offshore related parties". In the Letter of Audit Findings SARS stated: "SARS is of the view that the provisions of s 31 of the Income Tax Act 58 of 1962 are applicable to UMK's 2011 to 2013 years of assessment".
The court held, and I must agree, that both the Finalisation of Audit Letter and the Letter of Audit Findings stipulated the basis of the assessment and gave the taxpayer the opportunity to object to SARS’s findings and correct any errors SARS may have made in arriving at its view.
Jumping directly to litigation, as the taxpayer sought to do, also eliminated the opportunity for the matter to be resolved without litigation. SARS argues this undermined the administrative process set out in Chapter 9 of the TAA.
The timeline suggests that the taxpayer requested an extension on 16 July 2019 to respond to the Finalisation of Audit Letter and responded on 30 August 2019.
Whether SARS needs to expressly indicate in its findings
how the parties to the transaction are connected is discussed below. However, I believe the Judge ruled correctly that the taxpayer erred in its argument that SARS contravened section 42 of the TAA. SARS issued multiple letters, including the Finalisation of Audit Letter and the Letter of Audit Findings. These two letters, plus the other correspondence, would satisfy the requirements of section 42 of the TAA.
Does SARS need to state explicitly why it views the parties to be connected in its findings in order to legitimise any adjustment under section 31 of the Act?
The taxpayer argued that SARS made materially errors in interpreting the application of section 31 of the Act, notably the connected person requirement. SARS relied on paragraph 1(d)(vA) to connect the two parties to the transaction, which was adjusted in terms of section 31(2) of the Act.
Paragraph 1(d)(vA) relies on management and control, a specific test. SARS maintains that the two entities had common management and control, making them connected persons. The taxpayer argued that SARS erred in making this connection.
Although this article does not go into the merits of the "managed and controlled" argument, suffice it to say the interpretation of paragraph 1(d)(vA) is fact-specific. It hinges on de facto management and control as opposed to de jure management and control, a point on which both parties agreed. The parties did, however, disagree on how de facto management and control should be interpreted.
The question arises whether SARS, in making an adjustment under section 31 of the Act, is required to stipulate the basis for the parties being connected as defined. Arguably SARS did provide its basis for the connection in its Finalisation of Audit Letter, but the detail may have been lacking in the earlier Letter of Audit Findings. Was section 42 of the TAA contravened because both letters did not provide the same detail?
Counsel for SARS maintained that there was consistency in the two letters, as they both concluded the parties were connected as defined in section 1 of the Act. The Judge accepted this.
I agree with the Judge. If SARS raised additional assessments under section 31 of the Act, the requirement for the parties to the transaction to be connected is implied, even if it is not clearly stated. The taxpayer had the opportunity to: (1) dispute the parties were connected in its response to the Letter of Audit Findings; (2) ask SARS for its reasons for concluding the parties were connected under section 103 of the TAA, following the issue of the Finalisation of Audit Letter; and (3) raise its objection to the application of paragraph 1(d)(vA) of the connected person definition through a formal objection under section 104 of the TAA.
Although arguably SARS should be clear on how the parties are connected when applying section 31 of the Act to legitimise the application of the section, the taxpayer was afforded several opportunities to clarify or contest this.
Whether SARS's witness interviews constituted functional analysis
A side point of interest in this judgement relates to the discussion about the interviews SARS held with employees of the taxpayer.
I have been involved in several transfer pricing audits, and, in most cases, SARS conducts interviews with operational personnel to understand the functions undertaken and risks assumed and how these are managed. This is commonly referred to as a functional analysis.
SARS will usually start its analysis with any transfer pricing documentation provided by the taxpayer. The case did suggest the taxpayer provided a transfer pricing document, but it is not possible to determine whether that document provided a comprehensive functional analysis for each of the parties to the transactions under audit. Irrespective of this, section 46 of the TAA gives SARS wide powers to obtain information it considers relevant to the audit. This can be provided in written form or orally.
The taxpayer maintained that the interviews held could not be regarded as functional analysis interviews because no list of questions was provided in advance.
The OECD Transfer Pricing Guidelines define a functional analysis as "an analysis aimed at identifying significant activities and responsibilities undertaken, assets used or contributed, and risks assumed by the parties to the transactions". Section D.1.2 of the Guidelines recognises the importance of undertaking a functional analysis to accurately delineate the controlled transactions and identify comparability between the controlled transactions and uncontrolled transactions (arm's length transactions). The analysis focuses on what the parties do and the capabilities they provide. The Guidelines do not prescribe how a functional analysis should be conducted and certainly do not prescribe the need for questions to be provided in advance of any meetings with the parties being analysed.
SARS’s Practice Note 7 describes a functional analysis as "a tool assisting in the selection of a transfer pricing method and the proper determination of the arm's length price". The Practice Note provides guidance on the characteristics of a functional analysis but does not prescribe how it should be conducted.
I agree with the Judge that there is little merit in this argument. It is well known that SARS commonly uses interviews in undertaking a functional analysis. Advisers assisting their clients to complete a detailed functional analysis for the purposes of their transfer pricing documentation employ the same approach. For this reason, taxpayers should ensure all employees are sufficiently briefed before such interviews to ensure they remain within their area of expertise and knowledge, assist SARS concisely and correctly and do not wander into the realms of self-promotion and hearsay.
This case presents a good example of how not to fight a transfer pricing dispute. The TAA provides a solid process for navigating a transfer pricing audit, from the initial notification, through to the information requests in terms of section 46 and managing the dispute resolution process in Chapter 9 in the event that additional assessments are raised.
Any taxpayer facing a transfer pricing audit needs to ensure it fully understands the information being requested and provided to SARS and the section of the Act that SARS is applying to the facts. I have seen transfer pricing audits succeed and fail over the correct application of the connected person definition, which is vital to the application of section 31. As the Judge stated, "absent this requirement section 31 of the Act will not find application". It is perhaps more important to understand the basis for any adjustment being proposed by SARS under section 31, the characterisation of the entities to the transaction arising from the functional analysis, the appropriateness of the transfer pricing methods used and the availability of robust comparable data. These are the tools which enable a taxpayer to mount a defence against any adjustment, whether that be through the domestic dispute resolution provisions in Chapter 9 of the TAA or through the relief afforded by a Double Taxation Convention.