Transfer pricing in a state of flux

South African developments

In this article we discuss the recent changes in the transfer pricing landscape in South Africa, current developments and areas where certainty remains a challenge for Multinationals currently invested in, or considering investing in South Africa.

South Africa is not a member country of the OECD but, with its observer status, is a participant and regularly provides input at the various working party meetings.  Perhaps one of those were it has had significant input is Working Party 6 dealing with the Taxation of Multinational Enterprises, the working party which formulates most of the policies behind transfer pricing and the OECD Guidelines thereon.  As such South Africa has always subscribed to the OECD approach and generally adopted the Guidelines.

This was even more evident with the recent changes to the transfer pricing rules which came into effect for tax years commencing on or after 1 April 2012.  Prior to the change, the legislation had focused too narrowly on price, so that the legislation was in some ways restricted to only adjusting the consideration paid or received in terms of a cross-border transaction between connected persons.[1]  This meant that, provided the pricing could be supported as arm’s length, the transaction could not be attacked even where certain of the terms or conditions, other than the price, may not have been arm’s length.  The 2012 change extended the legislation to allow any term or condition to be adjusted in the event that they were found to be non-arm’s length.  This in fact aligned the legislation closer to the wording of Article 9 of the Model Tax Convention.

However, this change brought a certain degree of uncertainty to the transfer pricing rules.  Firstly it abolished the long standing safe harbour provisions for thin capitalisation.  Previously, provided inbound financial assistance fell within the safe harbour provisions of a 3:1 debt to fixed capital ratio and had an interest rate in line with South African prime lending rate plus 2%, or the relevant inter-bank lending rate plus 2%, the South African Revenue Service (SARS) considered the arrangement to be arm’s length.  Under the new legislation inbound financial assistance falls into the general transfer pricing provisions which require the amount of debt and associated interest rate to be substantiated as being arm’s length in the same way as all other transactions.

This has placed a significant onus on taxpayers to be compliant in respect of these transactions.  It also creates some degree of confusion as the Practice Note[2] which governed SARS interpretation of thin capitalisation, and which advocates the formulaic debt to equity ratio, has not been withdrawn and thus remains in force.  The thin capitalisation rules were further complicated by the introduction of debt restriction rules effective from 1 January 2015.  These rules will in fact limit interest deductions on debt from foreign connected parties to the extent that such interest is considered to be excessive.  What creates the confusion is that these new rules and the thin capitalisation rules appear to stand separate. Therefore understanding the hierarchy of how the sections will interplay is a challenge.  What we do know is that SARS is grappling with completing a revised Interpretation Note (IN) on thin capitalisation which will eventually replace the old, outdated Practice Note.  The draft IN was released for comment over 12 months ago and as yet there is no news as to when taxpayers can expect to see the final version.

South Africa is also introducing a withholding tax on interest with effect from 1 January 2015.  Based on the current wording, it appears that, where there is a foreign recipient of interest (paid from South Africa) who is subject to withholding tax (even at a reduced rate by virtue of a tax treaty), the excessive debt rules will not apply to the South African borrower. However, this is not altogether clear – creating further uncertainty.


The second key change creating challenges for taxpayers was the introduction of a revised secondary adjustment mechanism.  Under the old transfer pricing rules and primary adjustment resulted in a secondary adjustment which deemed the primary adjustment to be a dividend.  This deemed dividend was subject to the then Secondary Tax on Companies (STC).  Whilst simple to administer this did create some burden from a cash flow perspective.  Where a primary adjustment had the effect of reducing a loss, the secondary adjustment would nevertheless result in a cash payment of STC.

Under the revised legislation, the secondary adjustment is deemed to be a loan which attracts a market related interest rate.  Whilst reasonable in theory in that it removed the cash burden associated with the STC charge, this provision opened up a whole host of practical problems, from the need to retain separate tax accounts to deal with it, to timing issues on how to correct it.   As a consequence the 2014 Budget announced the arrangement would be reconsidered and the likelihood would be a return to deeming the primary adjustment to be that of a dividend.  The question which will then need to be addresses is whether this deemed dividend will be subject to the dividend withholding tax, and if so, whether the relevant Article of the Double Tax Agreement will apply. (It seems likely that the secondary adjustment will be a tax imposed on the South African company – rather than the foreign related party – and therefore that no DTA relief under the Dividend Article will be available)

But by far perhaps one of the most significant changes was the move from a discretionary section to a self-assessment mechanism.  Under the old regime, the Commissioner for SARS would first have to evaluate the taxpayers transfer pricing practices and if as a result of this, he considered that the pricing was not arm’s length, he would then exercise his discretion and make an adjustment to an arm’s length position.  This in effect created an initial burden of proof on the Commissioner, or SARS.  It also enabled the taxpayer to query the basis of the adjustment.  But perhaps more importantly it permitted taxpayers to play the “audit lottery” and wait until a challenge before testing the pricing and undertaking the required analyses to support the arm’s length nature of the pricing policies.

Under the new legislation this is no longer possible.  The legislation now requires taxpayers to file returns on the basis that any transactions falling within the ambit of the transfer pricing rules are conducted at arm’s length.  Therefore, to the extent that transfer pricing adjustments are required, the taxpayer must do such adjustments itself in preparing its tax return. To enforce this further, significant changes to the annual tax return have been implemented requiring additional disclosure on all transactions with both connected and independent parties both domestic and foreign.  In many cases this increased level of disclosure is creating problems for many companies who simply do not have systems which provide the level of data breakdown to enable this information to be provided.  One can only hope that as with so many of the other recent changes, we see a more reasonable approach being taken in time and some revisions made to the level of data required.

In addition to the legislative changes discussed above, we have also seen some administrative changes.  The movement of most of the administrative provisions to the new Tax Administration Act also heralded some interesting developments.  One of these was a short lived extension of the prescription rules (statute of limitation) for transfer pricing from 3 to 5 years.  Prior to the final enactment of the Act however, this was removed on the basis that transfer pricing is in itself complex and 5 years may not be the right timeframe to ensure that SARS has time to monitor and implement an effective compliance program.  So at the time of writing the prescription period remains at 3 years.

What is also of interest is that SARS is actively involved with many of the OECD WP6 current projects, most of which stem from the BEPS action plans released in 2013.  Key concerns facing the OECD countries which lead to this 15 point action plan largely stems from a need to protect fiscal base, ensure sharing of information and rally together against attractive low tax jurisdictions.  The proximity of the European countries has led to efficient global structures centralising value and talent and minimising costs through low risk manufacturing and distribution arrangements.  IP holding companies, commissionaire structures and toll manufacturing arrangements around centralised principal entities are common in such a close economic environment.  Further afield, hybrid entities and look through companies provide other opportunities for multinationals to organise operational gearing in a tax efficient manner.  But will BEPS be the solution to all this? And more importantly does it really have application in South Africa?

Countries appear to continue to create tax advantages and incentives for investment, the UK patent box regime being an example in point.  South Africa is no different, - accelerated depreciation and high deductions for R&D activities are two examples.  Could South Africa find itself labelled as a tax haven for R&D activities?  It begs the question how governments balance attracting foreign investment through such incentives against partnering with their OECD members against base erosion.  South Africa finds itself in an interesting position, juxtaposed between the developed countries of the OECD and its role in Africa.  It is interesting to see what impact this will have on South Africa tax policy.  It is likely that we will start to see an African or UN BEPS program emerge in time which addresses base erosion and profit shifting in the developing world.  That program is most likely to identify a somewhat different set of action plans to the OECD.  We have already seen India and China express the need for Location Saving Advantages to be addressed through transfer pricing and, with the high levels of growth set for Africa, more and more African tax policy will seek to protect its taxing rights.

But in reality does Africa need more measures?  With already high withholding tax rates coupled with a low incidence of Double Tax Agreements and aggressive Exchange Control/central bank restrictions, Africa has to some degree already got strong protection against base erosion and profit shifting.  In fact, arguably many African countries should consider the liberalisation of their regulatory environments in order to be more investor friendly.

South Africa through its hybrid debt rules, debt restriction rules, round tripping and exchange control rules and stringent transfer pricing rules has already dealt with many of the BEPS actions through domestic legislation.  The move to bring in withholding taxes on interest and management fees completes this.  Arguably South Africa is playing both its jokers.  Following the approach of the UN and BRIC countries through aggressive tax protection policy as well as playing nicely with the members of the OECD.

The one area South Africa continues to shy away from, and one area its OECD fellow members would expect to see happening soon, is the need for an Advanced Pricing Agreement (APA) regime.  South Africa has an advanced tax ruling regime but has specifically excluded transfer pricing from this.  Increased investment into South Africa keeps bringing this to the fore.  Not only would this be a very welcome development, but without it, South Africa runs the risk of falling behind its African cousins with many opting to bring in an APA program together with transfer pricing rules.  South Africa hopes to retain its investment attractiveness for the continent through its Headquarter regime and infrastructure advantages, but in reality this is at risk.  Tax uncertainty will still play an important role for Multinationals wanting to expand into Africa.  Already we are seeing increased interest in using other countries as the springboard into the Continent. Possibly South Africa could consider an interim step of granting tax rulings to SA taxpayers  in respect of transfer pricing matters (unilateral APA’s) and could then progress to bi-lateral APA’s at a later stage.

So as South Africa continues to bring in more complex tax legislation and greater enforcement around transfer pricing, the question is whether it has the resources to implement this.  Without doubt SARS has geared up in this area of taxation and employed many professionals from big-four firms into its specialised practice.  However it is still resource constrained and is limited to picking its audits with care and limiting itself geographically.  What is missing is the separation between operational implementation and legal and policy around this area of taxation, which is the norm in most other countries with mature transfer pricing rules in place.  Until this happens, the ability to manage and implement a successful transfer pricing legislative policy including a successful APA program remains a challenge.

Comments and conclusions

South Africa has seen some significant changes in the legislation relating to transfer pricing over the last two years.  The problem however is that these changes remain in flux and need bedding down to create some certainty to investors.  This coupled with other complex changes and increased disclosure requirements have had the effect of increasing the compliance burden for any company doing business in South Africa.  The absence the certainty provided through an APA or advanced ruling program creates further pressure on Multinationals in managing their global business and effective tax rate.

While we continue to see focused, albeit limited, transfer pricing audit activity from SARS, capacity constraints inevitably lead to a lack of momentum around legislative progress and policy advancement.  Delays in providing clarity around legislative changes and the ongoing delay in addressing an APA program are symptomatic of this.

What can we expect to see now?  Hopefully some bedding down of the new legislation through improved guidance, most likely coupled with an Africa focus look at BEPS and some variants to the action plan proposed by the OECD.  As for an APA program, we will just need to wait and see.


[1] The connected person definition is broad but in essence refers to companies which form part of the same group.

[2] Practice Note 2 issues in 1996

Karen Miller
Tax: Transfer Pricing
Tel: +27 21 427 5484

Billy Joubert
Tax: Transfer Pricing
Tel: + 27 11 806 5352



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