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Analysis of Case Studies in Africa Following the Introduction of Transfer Pricing Regulations

By Prof. Dr. Daniel N. Erasmus
Posted: 18th June 2015 14:43
More African countries are introducing transfer pricing regulations.  We have seen an increase in the number of TP controversies.  Here are some case studies of TP controversies we have been involved in, in Africa:
Case Study: Malawi

Sourcing fees to a procurement intermediary
Technical fees for technical services including technical guidance from engineers

Section 127(2) of the Taxation Act (Chapter 41.01) states:

“Where the Commissioner is of the opinion that the main purpose for which any transaction or transactions was or were effected (whether before or after the passing of the Act) was the avoidance or reduction of liability to tax any year, or that the main benefit which might have been expected to accrue from the transaction or transactions was the avoidance or reduction of liability to tax, he may, if he determines it to be just and reasonable, direct that such adjustments shall be made as respects liability to tax as he considers appropriate to counteract the avoidance or reduction of liability to tax which would otherwise be effected by the transaction or transactions.”

Investigations conducted by MRA on the Malawi Co were based on a tax dispute between Holdco and a Revenue Authority in a foreign country.  The MRA investigations through this dispute were influenced by pre conceived ideas on the relationship between Malawi Co and its Holdco.  A meeting which was hurriedly arranged by MRA and chaired by an MRA outside consultant, without first circulating the MRA findings letter on the audit to Malawi Co, seemed to be calculated to intimidate Malawi Co’s management to submit to findings that were being communicated to them for the first time, without the opportunity to respond properly. 
It is clear from the investigations findings that no attempt was made during MRA’s investigations to separate facts from hearsay.  The allegations raised in the findings letter had no basis apart from a media report on a tax issue that has no relevance to Malawi Co’s operations.  In addition, there was no attempt on the part of MRA investigators to thoroughly check the media report facts with appropriate senior management staff on issues pertaining to Malawi Co’s business.  Information (unlawfully) obtained from the foreign Revenue Authority was deliberately twisted to support pre-conceived findings that were not verified or validated with available information and documents.
For the sake of good order, fairness and transparency, it was suggested that the investigations be redone so as to validate information collected and obtain accurate documentation on the relationship between Malawi Co and its Holdco. 
Additional tax assessments were hurriedly raised, but then suspended after a successful interdict in the High Court was obtained.  A year later the Commissioner withdrew the additional tax assessments.
Case Study: Kenya

Sourcing fees to a procurement intermediary
Disallowance of royalty expenses

Section 18(3) of the Income Tax Act (1973) (read with the Income Tax (Transfer Pricing) Rules 2006) states:
“(3) Where a non-resident person carries on business with a related resident person and the course of that business is so arranged that it produces to the resident person either no profits or less than the ordinary profits which might be expected to accrue from that business if there had been no such relationship, then the gains or profits of that resident person from that business shall be deemed to be the amount that might have been expected to accrue if the course of that business had been conducted by independent persons dealing at arm's length.”

The taxpayer objected in terms of section 84(2) of the ITA.
The additional assessment was based on two types of adjustments to the taxable income of the taxpayer:
In the first instance, a transfer pricing adjustment concerns the import of raw materials from a related party was made to the Earning Before Interest and Tax (hereafter referred to as “EBIT”) of the taxpayer.  This adjustment was made in terms of section 18(3) and the Income Tax (Transfer Pricing) Rules, 2006.  No legal framework was included in the Letter of Assessment (“LOA”) issued by the KRA (an administrative defect giving rise to unconstitutional conduct by the KRA);
In the second instance, a deduction of a royalty payment related to technical know-how was disallowed, which disallowance was based on section 16(1)(a) of the ITA.
The grounds for the transfer pricing adjustment by the KRA included the following as set out in the LOA:
the primary methodology (Resale Price Method (“RPM”) applied by the taxpayer for the years under review, as presented in the taxpayer’s Transfer Pricing Policy, (the “TP Policy”), was rejected by the KRA based on the alleged lack of information to verify the functional profile and characterisation of the tested party;
the secondary methodology (Transactional Net Margin Method (“TNMM”)), as applied by the taxpayer and presented as an alternative to the primary methodology in the TP Policy, was also rejected by the KRA, based on a rejection of 5 of the 7 comparable entities included in the sample.  The rejection was based on alleged independence issues (3 entities), alleged comparability issues (1 entity) and an alleged lack of information (1 entity).  That left 2 entities that do not form a proper sample.  However, it was found that at least 3 comparable entities were applicable, and the KRA were incorrect in their analysis, after carefully checking the comparability issues raised by the KRA;
the KRA, due to the 2 entity sample not providing an appropriate comparable, then performed a TNMM study of their own, the results of which were shared with the taxpayer.  However the taxpayer’s advisors questioned the validity of some of the comparable entities included in the sample and the time periods used.  The KRA then made certain adjustments to the study based on these comments.  The final TNMM study used by KRA included a set of 10 comparable entities and covered the periods in question.  The evaluation of the taxpayer’s EBIT was based on the interquartile range of 10.85% to 13.17%, that resulted from the study;

The taxpayer’s EBIT as presented in the Audited Annual Financial Statements (“AFS”) was adjusted by the KRA by deducting “other income” as presented;

the KRA disregarded the adjustments to the EBIT of the taxpayer related to “non-recurrent items” and the effect of foreign exchange differences, as proposed by the taxpayer for comparability purposes.  However, this disregard was not explicitly stated in the LOA and was omitted in the methodology applied by the KRA in the LOA;
Finally, the KRA made the transfer pricing adjustment by adjusting the EBIT (already adjusted to reflect the amount before “other income”) of the taxpayer to a 11.93% EBIT margin, which was the median of the TNMM study performed by the taxpayer.
The grounds of the disallowance of the royalty expense included the following:
the failure to present the information requested resulted in an inability by the KRA to benchmark the transaction; the expense was disallowed based on the provisions of section 16(1)(a), which states that: “16.  (1) Save as otherwise expressly provided, for purposes of ascertaining the total income of a person for a year of income, no deduction shall be allowed in respect of – (a) expenditure or loss which is not wholly and exclusively incurred by him in the production of the income….”[underlining added]
The taxpayer objected to the additional assessments raised by the KRA on the following grounds:
 - the reasons advanced for the rejection by the KRA of the primary methodology used by the taxpayer for the period under review are not supported by the transfer pricing principles in terms of the TP Rules and OECD TPG;
the reasons advanced for the rejection by the KRA of the secondary methodology presented by the taxpayer as an alternative to the primary methodology are not valid and are not based on sound transfer pricing principles in terms  -  - of the TP Rules and OECD TPG;
 - the TNMM study performed by the KRA and used as the basis of the additional assessment are not based on sound transfer pricing principles in terms of the TP Rules and OECD TPG;
 - the application of the TNMM study used by the KRA as the basis of assessment and are not based on sound transfer pricing principles in terms of the TP Rules and OECD TPG;
 - the KRA erred in taking the royalty expense into account as part of the TNMM methodology to test the financial performance of the taxpayer;
 - the invalidity of the contention that the KRA was prevented from performing a benchmarking exercise of the royalty transaction, due to a lack of information on the relevant transaction;
 - the invalidity of the contention that the royalty expense was not incurred “wholly or exclusively in the production of income”;
 - the additional assessment for one year contravenes the provisions of section 79 of the ITA and the taxpayer objects pursuant to section 79(2) of the ITA.

In conclusion, the Commissioner was requested to set aside the additional assessments in terms of section 85 of the ITA, on the basis that the financial performance of the taxpayer, as adjusted to reflect comparable circumstances to the benchmarking entities, falls comfortably within the ambit of all indicators of arm’s length performance of similar independent entities; and the royalty adjustment is invalid as the financial performance of the taxpayer on a net basis, has already been shown fall within arm’s length standards, and the expense was incurred in the production of income.
Case Study: South Africa

An initial disallowance of interest expenditure that would otherwise be deductible due to transfer pricing adjustments
An upward adjustment of royalty charges from 1% to 3%

Section 31(2) (old version) of the Income Tax Act, 58 of 1962, read with Practice Note 7 issued on 6 August 1999 by SARS.(1)

In its one tax year, the taxpayer incurred an interest expense on certain loans obtained to finance the acquisition of shares in various subsidiaries acquired throughout Africa and the Middle East in an expansion of its activities.  The purpose was not only to derive profits by way of dividends from the acquired subsidiaries, but also to earn royalties and management fees.
The taxpayer sought to deduct a portion of that interest expense from its income for that year resulting in a reduced taxable income.  Subsequent to an original assessment that originally allowed the deduction (the same treatment applied to interest deduction in the earlier years of assessment), SARS disallowed the interest deductions in full by issuing a revised assessment. 
SARS entirely failed to consider what they had done in respect of that ONE year when they subsequently raised a further assessment for THE SAME year where they made significant transfer pricing adjustments.  No corresponding adjustment was made to the interest assessment to allow a portion of the interest expense as a deduction. 
The two revised assessments for the same year are irreconcilable. 
In the objection the following disputes exist: the fact that the transfer pricing principles applied by SARS are defective and not in line with the OECD TPG whether the conduct of SARS in the section 42 letter of findings process leading up to the second revised assessment was wrongful and reviewable; and at least 6 Mutual Agreement Procedures (hereinafter “MAPs”) with competent authorities in 6 other countries must still be finalised with SARS.  The various MAP processes are essential to eliminate any economic double taxation as required by the Double Tax Treaties (and binding international law) in respect of the transfer pricing adjustments SARS were looking to enforce when certainty does not exist that this is the final amount of tax due by the taxpayer.
The proposed royalty rate that is based on the weighted average calculation of brand contribution, results in a royalty rate that falls outside of the arm’s length range as determined by a consulting firm in their independent report, which is used by SARS as basis for the assessment.  The royalty charge is therefore not an arm’s length rate and cannot justify a transfer pricing adjustment.

Taxpayer’s royalty rate of 1% falls within the ambit of the alleged arm’s length range of 1% to 3% as determined by SARS’s independent consultant, and therefore, based on par 3.60 of the OECD TPG(2), no transfer pricing adjustment should be made.
Furthermore, the royalty rate as determined by SARS, is not based on arm’s length principles, as SARS did not provide any arm’s length benchmark as basis for the determination of this proposed charge. 
With regards to the adjustment for the 1% royalty charge, it was also explained that some royalties were paid as part of management fees.  These royalties were not taken into account by SARS, and the adjustment is, therefore, not accurate or valid.
Case Study: Zimbabwe

Management fees charged from subsidiary company in Zimbabwe, not the listed holding company, and no mark-up charged.

Royalties not charged into Zimbabwe for the R & D that actually took place in other country subsidiaries, where there is a conflation between the R & D and the use of the trade-mark and trade-name
The more detailed GROUNDS are as follows:
The legality of the conduct of ZIMRA in changing their reliance on the OECD Transfer Pricing Guidelines for Multi-National Enterprises, 2010 (hereafter referred to as “OECD TPG”) after the assessment; and the status of the in Zimbabwe.
The validity and accuracy of the application of section 98 of the Income Tax Act [Chapter 23:06] of Zimbabwe, to the specific facts and circumstances related to the revenue amounts included in the assessment. 
The arm’s length value of management fees and royalty charges included in the Assessment.
The legality, fairness and validity of the penalty charged by ZIMRA.
The validity of the conduct displayed by ZIMRA in the assessment by introducing new reasons after the additional assessment decision was taken, as well as the search and seizure activities related to the assessment; in light of the constitutional rights of the taxpayer with regards to fair, reasonable and lawful administrative justice.
Section 98 of the Income Tax Act [Chapter 23:06] states:
“Where any transaction, operation or scheme (including a transaction, operation or scheme involving the alienation of property) has been entered into or carried out, which has the effect of avoiding or postponing liability for any tax or of reducing the amount of such liability, and which in the opinion of the Commissioner, having regard to the circumstances under which the transaction, operation or scheme was entered into or carried out—

(a ) was entered into or carried out by means or in a manner which would not normally be employed in the entering into or carrying out of a transaction, operation or scheme of the nature of the transaction, operation or scheme in question; or
(b ) has created rights or obligations which would not normally be created between persons dealing at arm’s length under a transaction, operation or scheme of the nature of the transaction, operation or scheme in question;
and the Commissioner is of the opinion that the avoidance or postponement of such liability or the reduction of the amount of such liability was the sole purpose or one of the main purposes of the transaction, operation or scheme, the Commissioner shall determine the liability for any tax and the amount thereof as if the transaction, operation or scheme had not been entered into or carried out, or in such manner as in the circumstances of the case he considers appropriate for the prevention or diminution of such avoidance, postponement or reduction.”
The additional royalty fee charges were determined by applying a 3.5% rate to group turnover that is related to product sales.  The assessment was made in the light of the taxpayer not charging any royalty amount, based on the argument that the legal owner of the intellectual property, in this case, is not entitled to intangible related returns.  The rate used by ZIMRA was determined by using a royalty rate charged between related parties.  The taxpayer disputed the validity and legality of the basis used to determine the arm’s length rate, as well as the validity of applying section 98 of the Zimbabwean Income Tax Act (on anti-avoidance) in this case.
The additional management fee charges were determined by using the Group’s average for profit before tax of 20% as gross profit percentage, which translates to a 25% mark-up on costs.  This additional assessment was made in light of the taxpayer not charging any management fees, as it did not render such services.  The costs relate to management services rendered by another taxpayer, and member to the same Group of Companies.  The management subsidiary company was reimbursed by the operational entities at cost with no mark-up.  ZIMRA insisted that the head office function must be positioned within the listed company and may not be rendered by another group member; therefore the income on these services is taxed in the hands of the taxpayer, which is the ultimate holding company.  ZIMRA further contends that the services cannot be remunerated through reimbursement at cost and that a mark-up must be charged.  The taxpayer disputes this argument and the method and legal basis of calculating the arm’s length mark-up; as well as the validity of applying section 98 in these circumstances.
Certain conduct by ZIMRA is also disputed in light of the right of the taxpayer to administrative justice.
ZIMRA could have applied section 24 of the Income Tax Act, which states:
24 Special provisions relating to determination of taxable income in accordance with double taxation agreements
The Commissioner may—
if any person—

carrying on business in Zimbabwe participates directly or indirectly in the management, control or capital of a
business carried on by some other person outside Zimbabwe; or
carrying on business outside Zimbabwe participates directly or indirectly in the management, control or capital of a business carried on by some other person in Zimbabwe; or
participates directly or indirectly in the management, control or capital both of a business carried on in Zimbabwe by some other person and of a business carried on outside Zimbabwe by some other person; and
if conditions are made or imposed between any of the persons mentioned in paragraph (a) in their business or financial relations which, in the opinion of the Commissioner, differ from those which would be made between two persons dealing with each other at arm’s length;
determine the taxable income of the person carrying on business in Zimbabwe as if such conditions had not been made or imposed but in accordance with the conditions which, in the opinion of the Commissioner, might be expected to have been made or imposed between two persons dealing with each other at arm’s length.
Case Study: Uganda
The Issue:
Brand Expenses
The URA regarded 50% of the advertising, marketing and promotion expenses to be of a capital nature, and not deductible (but amortisable over 20 years as per the misquoted Group policy for the amortisation of intangible assets from Group financial statements – historically some goodwill was amortized over 20 years).
The following reasons were supplied as per the URA notice of assessment, read together with their letter of findings:
1. Section 31 of the Uganda Income Tax Act (Cap 340 as amended – “UITA”) is being applied to justify disallowing 50% of the expenditure as ‘ … incurred expenditure in acquiring an intangible asset having an ascertainable useful life …’, stating that TAXPAYER invested in the brand through ‘sponsorships, advertising and Corporate Social Responsibility activities’, thereby creating a marketing intangible.  Principles from case law (the DHL and GlaxoSmithKline case) were used as justification that a marketing intangible can be created through ‘investment in advertising, marketing and promotional expenditure’, and that ‘an associate/affiliate that invests in the brand has economic ownership of the brand although the legal ownership may reside with the parent company’.  The URA have effectively applied transfer pricing principles to justify the adjustment.
2. Tax treatment: section 22(2)(b) of the UITA (read with section 31) has been applied to actually disallow 50% of the said expenditure as: ‘… any expenditure … of a capital nature, or any amount included in the cost base of an asset’ that is ‘… incurred expenditure in acquiring an intangible asset having an ascertainable useful life …’;
3. The URA has not applied sections 90 and 91 of the Uganda ITA as the reason for the disallowance of the expenditure.  The URA however accept that the OECD Transfer Pricing Guidelines are applicable to any arm’s length transaction being questioned.
4. The URA has not accepted the IFRS treatment of the expenses as per the audited Annual Financial Statements, stating the accounting treatment does not determine or influence the tax treatment.
5. The URA has indicated in the letter of findings, that the 50% ratio applied is an assumption and may be adjusted if a breakdown is supplied by the taxpayer to justify a difference percentage allocation. 
6.The URA conduct above gives rise to the following issues:
6.1 has generally accepted accounting practice, such as IFRS, any bearing on the tax treatment of the expenses in terms of the UITA?
6.2 has the taxpayer ‘acquired’ an intangible asset by expending 50% of all advertising, marketing and promotion expenses for this purpose in terms of the UITA?
6.3 does the taxpayer have ‘an intangible asset’ that was acquired; and were the principles from the case law (DHL and GlaxoSmithKline) quoted by the URA, correctly applied to determine whether a marketing intangible was created?
6.4 if so (where the above questions give rise to a ‘yes’ answer), did the intangible asset acquired cost 50% of the expenditure each year for the audit periods 2003 to 2009, a total of 7 (seven) years, and recurring into the future?
6.5 if so, does the intangible asset acquired have ‘an ascertainable useful life’, and if so, is that ‘ascertainable useful life’ for the purposes of section 31 of the UITA 20 years as determined by the URA.
6.6 Information required by the URA for purposes of the mediation:
In order to convince the URA to allow all advertising, marketing and promotion expenses for the periods 2003 to 2009 and into the future, the taxpayer provided detail on the line expenses in a table handed to the URA on advertising, marketing and promotion expenses, to assist the URA in determining:
6.6.1 what expenses are of an enduring benefit and in excess of a year creating an ‘intangible asset’, giving rise to expenditure of a capital nature in terms of the Uganda ITA; and do these expenditure amount to 50% of the total marketing expenditure each year;
6.6.2 what expenses amount to ‘extraordinary efforts’ compared to industry averages as per the principles of the DHL and GlaxoSmithKline cases, resulting in joint economic ownership for transfer pricing purposes;
6.6.3 what is the ‘intangible asset’ that is created if joint economic ownership is, as recognised in English common law applied in Uganda, read with the Uganda ITA;
6.6.4 what is the ascertainable useful life of that ‘intangible asset’ in terms of the UITA (as influenced by IFRS).
6.6.5 In a letter provided by the URA after the arbitration process in the High Court of Uganda the following evidence was requested to enable the URA to make an informed decision on the issues raised: the transfer pricing document on the use of the trademark and intellectual property by the Group of Companies; a breakdown of the following components of marketing costs for each of the years under review:
                     outdoor advertising;
                     electronic media. a definition of its brand and its respective components.
6.6.6 It is noteworthy that in some cases, the OECD transfer pricing guidelines state that indirect charging may be unavoidable such as with centralised services, where the value for separate entities cannot be quantified, or where the burden of separate accounting is disproportionately heavy compared to the related services.  The taxpayer should not be expected to have prepared or obtained documents beyond the minimum needed to make a reasonable assessment of whether it has complied with the arm’s length principle.  Tax administrations should not require taxpayers to produce documents that are not in the actual possession or control of the taxpayer or otherwise reasonably available.  Moreover, the need for the documents should be balanced by the costs and administrative burdens, particularly where this process suggests the creation of documents that would not otherwise be or referred to in the absence of tax considerations.  Documentation requirements should not impose on taxpayers’ costs and burdens disproportionate to the circumstances.  Therefore, when indirect charging methods are unavoidable used, due to separate accounting being disproportionately heavy compared to the related services, the direct charging documentation will not be available and the taxpayer cannot be reasonable expected to produce such documentation.
Management Fees
As per the notice of assessment management fees paid by the taxpayer in Uganda to the management company supplying services were disallowed by the URA, and only expense claims equal to professional fees paid to staff seconded to the taxpayer, plus a 5% mark-up on costs were allowed.
1. The basis provided for the transfer pricing adjustment covers five basic issues.  Submissions against the transfer pricing adjustment are supplied in italics after each issue:
1.1 Alleged duplication of services between staff seconded to taxpayer, senior management and third parties.
Basis of charge of services (percentage of turnover) was not regarded as a valid method or arm’s length charge: Indirect charging is recognised by the OECD in centralised structures, especially when direct costing is not practical or too onerous. 
 - Internal Comparable Uncontrolled Prices (CUPs) were supplied as benchmarks for the charging of the services.  The URA regarded the CUPs as invalid:
Taxpayer’s argument was that comparability is determined by the OECD five comparability factors and not by the fact that the rate differs.
The URA argued that the transaction was not uncontrolled due to the fact that the parties were related at the date when agreement was entered into.  Taxpayer’s counter argument was that, the parties to the original agreement were not associates of the group.  Then control was changed to introduce the group.  The agreement was reviewed but not changed due to the necessity of the services, proving the arm’s length nature of the transaction when originally concluded.
Cost Plus method was regarded as the best method by the URA with a 5% mark-up as the appropriate arm’s length price, but only in respect of the seconded services to the taxpayer in Uganda: the cost plus method requires the availability of direct costing information, which is not available.  The services used as a basis (staff seconded to Uganda) does not relate to the support services.

After the mediation process in the High Court, Uganda, some of the abovementioned issues were conceded.  The taxpayer offered proof of an arm’s length price with the internal CUPs, verified by an independent TNMM study by an accounting firm and an independent expert witness. 
Due to a MAP processes initiated between two countries, further collection of outstanding tax assessments by the URA have been suspended.
Prof. Dr. Daniel N. Erasmus is an International Tax Attorney and US Tax Court Practitioner who is an acclaimed world-wide leader in tax risk management.  He advises and defends numerous national and multinational companies to protect them from the adversarial nature of tax controversies with tax authorities.  He has been lead Counsel in various Transfer Pricing controversies throughout Africa in Uganda, Kenya, Rwanda, Zambia, Zimbabwe, Malawi and South Africa.  His team have represented more than US$ 3.4bn in tax controversies where, on average, clients have paid out less than 3% of the taxes charges by Revenue Authorities.  This reflects a cautious approach in taking on Revenue Authorities in tax controversies where his team believe a client has a high prospect of success.  Many of these successes are as a result of his team getting involved in tax controversies at the tax audit stage.
For more information please contact Prof. Dr. Erasmus via email at or alternatively by calling +27 (11) 698 0329.

(1) The Davis Tax Committee (DTC) advised the Minister of Finance that the Practice Note should be updated. Since the current transfer pricing documentation guidelines, as contained in SARS Practice Note 7 (PN 7), are not that clear and are based on the 1995 OECD Guidelines, it is recommended that SARS revises PN 7 to be in line with the OECD revised Transfer Pricing Documentation Guidelines in Chapter V. For several years there have been indications from SARS and Treasury that an updated transfer pricing Interpretation Note is imminent. SARS published on its website a draft Interpretation Note on 3 April 2013 this draft Note needs to be finalised. SARS PN Note 7 is now 15 years old and has not been changed to keep pace with developments at the OECD. As mentioned above, currently preparing transfer pricing documentation is not compulsory in South Africa. It is recommended that documentation requirements should be introduced in line with the above discussed OECD Guidelines. Consequently, the OECD’s recommendation that countries should adopt a standardised approach to transfer pricing documentation that follows a three -tiered structure consisting of a master file, a local file and country - by -country reporting should be adopted in South Africa. This approach will encourage a consistent approach to transfer pricing documentation in different countries which will help contain the cost of global transfer pricing documentation. SARS PN 7 also makes references to certain provisions of the ITA which have been repealed and now form part of the Tax Administration Act 28 of 2011 (examples are provisions dealing with record keeping requirements and penalty provisions). It is therefore imperative that an updated Interpretation Note be prioritized. However, throughout the DTC December 2014 BEPS report, the DTC consistently refers to South Africa’s National Development Plan (NDP) and notes that while South Africa has a vested interest in combatting BEPS, South Africa should not adopt OECD measures without considering the country’s need to encourage foreign direct investment (FDI) in light of the NDP. The DTC also notes the general need to preserve South Africa’s international competitiveness by providing a tax environment conducive to economic growth.
(2)OECD TPG par 3.60 states: “ If the relevant condition of the controlled transaction (e.g. price or
margin) is within the arm’s length range, no adjustment should be made.


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