Alleged base erosion and profit shifting activities of multinational enterprises (“MNEs”) have been a hot issue globally and therefore the chances of an MNE being confronted with a transfer pricing audit have increased substantially over the last few years. Owing to the intense focus on transfer pricing by almost all tax authorities around the world, together with a growing focus on international exchange of information, it seems only a matter of time before any MNE will be subject to transfer pricing audit scrutiny.

Steps taken in preparation of a South African transfer pricing audit

Taxpayers need to proactively adopt strategies that will enable them to manage the risks associated with the transfer pricing audit.

• Performing a self-assessment: A regular assessment of your inter-company transactions, the assessment of functions, assets and risks as well as the pricing structure is key. Check that your policy is up to date, ensure validity and relevance of benchmarking studies and ensure that your results fall within the interquartile range identified. If a possible risk is detected, a voluntary self-adjustment is always preferable to an adjustment being made by the South African Revenue Service (“SARS”).
• Reporting requirements: South Africa follows the three-tiered approach as implemented by the Organisation of Economic Cooperation and Development (“OECD”), ie, country-by-country reporting (“CbCR”), including the Master File and the Local File. South African parented multinationals who have an aggregate of potentially affected transactions of more than ZAR100-million annually need to prepare and submit a Master File and Local File. Such documentation should not be viewed as a simple compliance exercise as such documentation provides SARS (and other tax authorities with which it shares this information) with the basis for conducting thorough transfer pricing risk assessments. It is therefore imperative that such documentation is simultaneously prepared and filed.

• Preparation of robust documentation: Without substantiation of transfer prices, you open the door to a thorough investigation, because it allows tax authorities to formulate their own views on the situation, which is extremely harmful and immediately puts you on the back foot. In one transfer pricing case, a Danish court ruled in favour of the tax authority, entitling them to make a discretionary assessment of the taxable income. This permitted the tax authority to benchmark the manufacturer (taxpayer) as opposed to the related party sales companies, arguing that the taxpayer had failed to furnish it with robust information concerning the sales companies and therefore could not perform a reliable benchmarking study. In contrast, in another transfer pricing case the Danish court judged in favour of the taxpayer. The court ruled that the transfer pricing documentation provided adequate justification for the benchmarking applied, thus preventing the revenue authority from applying the Transactional Net Margin Method (“TNMM”) to assess the income of a company making losses. 

It is evident that well-prepared and robust documentation enables you to defend your policies and provides context for how each party fulfils its obligations.

• Alignment of facts and evidence: Check that the transfer pricing analysis aligns with the legal agreements and the actual conduct of the parties. It is critical to provide a consistent picture and allow the reader to fully understand the nature of the transactions. If there are inconsistencies, the chances are that SARS will disregard the analysis and draw its own conclusions. Therefore, always ensure that you provide consistent information and a cohesive story across CbCR, Master File, Local File, legal agreements and supporting evidence.
• Respond systematically to SARS’ requests: Section 46 of the Tax Administration Act, 2011 (“TAA”) gives wide powers to SARS to request information which it considers to be relevant. We advise you to provide comprehensive and timely responses to SARS’ requests as this will create a cordial working relationship with SARS which will go a long way when it comes to granting extensions or penalty mitigation.

• Interview readiness: Ensure that the individuals (key strategic decision makers) are fully briefed in advance. When it comes to the field audit interviews it is imperative to ensure that the individuals respond appropriately and understand the context of the questions raised by SARS. Interviewees should only respond when they know the answer and avoid speculating. A good idea is for the potential interviewees to refresh their memories by reviewing all relevant material in advance. It is also worth having 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.

Common risk areas faced

One of the most common reasons for disagreements between taxpayers and SARS relates to whether the entity under investigation is doing what it claims to do. This is the limited risk versus full risk predicament. This would generally be caused by a disagreement over the functional profile of the parties, ie, marketing agent versus service provider. In such cases, the best line of defence is to ensure you have as much factual evidence to support the functional profile of the entity under audit.

The selection of comparables also plays a significant role as SARS will question the taxpayer’s comparable data put forward and provide their own comparability analysis. Don’t just accept that SARS’ analysis is correct. It is essential to thoroughly dissect SARS’ analysis, request additional information where necessary and keep asking questions.

Conclusion

The increasing sophistication of transfer pricing audits incentivises taxpayers to take their transfer pricing seriously. Being proactive, cooperative and implementing strategic measures to ensure a more favourable outcome in the long run.  

Reviewed by Peter Dachs, Head of ENSafrica’s Tax department.

Robyn Kantor

Tax Manager

[email protected]