Transfer Pricing 101 - Why It Matters in a Global Economy

TRANSFER PRICING 101

📚What Is It?

Globalisation has led to increased access to international markets, broadening the scope of economic activities between countries. As nations engage in cross-border trade, they bring with them diverse tax systems and legal frameworks. This diversity often creates loopholes that multinational enterprises (MNEs) can exploit to maximise profits, often at the expense of national tax revenue.

This is where Transfer Pricing (TP) enters the picture. TP refers to the pricing of goods and services exchanged between related companies (where another company holds at least 20% equity and voting rights), such as those within an MNE. The point of contention here is not that these entities trade with each other, but rather the prices at which they do so. In South Africa, TP was previously governed by Section 31 of the Income Tax Act. While Section 31 still applies, it has been amended to align with Article 9 of the Organisation for Economic Co-operation and Development (OECD) Guidelines. The OECD guidelines require that transactions between related companies be set based on the arm's length principle, this means as if they were independent and unrelated entities. Depending on how a company chooses to price these internal transactions, TP can lead to either tax compliance or tax avoidance. 

The first major Transfer Pricing case in South Africa, Crookes Brothers Limited v The Commissioner for the South African Revenue Service, concerned an interest-free loan from Crookes Brothers Limited (Crookes) to its subsidiary, MML. While the loan was intended to qualify for an exception under Section 31(7) of the Income Tax Act, which exempts certain long-term loans from TP adjustment if they are not redeemable within 30 years. The agreement included a clause requiring immediate repayment in the event of insolvency, bankruptcy, or business rescue. Crookes argued that this clause did not undermine the 30-year non-redemption requirement. However, SARS disagreed, stating that the clause introduced a potential obligation to repay within 30 years, thus breaching the requirements of Section 31(7). The court upheld SARS’s position. This case highlights how contractual clauses can disqualify a taxpayer from TP exceptions, even when the overall structure appears compliant.

🤔How does It Work?

Tax compliance is relatively straightforward. It involves adhering to a country’s laws and tax rules, including the arm’s length principle. The OECD Guidelines outline five methods that companies can use to determine an arm's length price. These include the Comparable Uncontrolled Price (CUP) Method, the Resale Price Method, the Cost-Plus Method, the Transactional Net Margin Method, and the Transactional Profit Split Method. These methods are mostly self-explanatory by name, but if you're interested in a deeper dive into how each one works, let me know in the comments, I’d be happy to explore them in a follow-up post. 

The Court in ABD Limited v The Commissioner for the South African Revenue Service recognised the importance of using established Transfer Pricing Methods to dertemine the arm's length price. In this case, ABD Limited charged a 1% royalty fee for the use of their Intellectual Property by their subsidiaries. They also charged the same fee to an unrelated third party however SARS challanged this rate, claiming that it was too low. They argued that the profit-split method should be used and later changed its argument to the use of the Willingness-to-pay (WTP) Method. The court rejected SARS’s approach, ruling in favour of the CUP Method, which was supported by the third-party comparable. This case reinforced the importance of using established, recognised TP methods that align with the OECD Guidelines, especially when reliable internal comparables exist.

🌍Why It Matters in the South African Context?

TP manipulation allows MNEs to shift profits from high-tax jurisdictions to low-tax jurisdictions. In doing so, they exploit mismatches between international tax systems to reduce their overall tax burden. As a result, some countries lose out on critical tax revenue. This speaks to more than just profits but now seeps into governments funds and allocations. For developing coutries this lost revenue could be used to fund health, education and even eradicate poverty. Therefore, it is important that these countries focus on TP and find ways to curb this lost tax revenue.

In 2023, South Africa introduced Advance Pricing Arrangements (APAs). These can help multinationals avoid transfer pricing disputes by agreeing in advance with tax authorities on what the arm’s length price should be for certain cross-border transactions. It’s a good step forward because it gives more certainty, helps prevent disputes, and makes compliance easier.

The Base Erosion and Profit Shifting (BEPS) project, introduced by the OECD and G20, aims to stop tax avoidance and profit shifting by big companies. It includes 15 Actions to align where profits are taxed with where real value is created. BEPS also brought in two major pillars:

• Pillar I focuses on taxing big digital companies where their users or customers are based, even if the company isn’t physically there. This applies to multinationals earning more than 20 billion euros.
• Pillar II aims to stop the use of tax havens by setting a 15% global minimum tax, so no matter where profits are moved, the company still pays at least 15% tax somewhere.

⚠️While South Africa has made progress, there are still challenges:

• Section 31 does not regulate domestic TP, allowing for potential abuse between local related parties.
• There’s no dedicated TP legislation or penalty framework, leaving gaps in enforcement and compliance clarity.

🙋🏽‍♀️Personal Reflections?

Personally, I am interested to see how a Transfer Pricing professional handles the complexity of these transactions, whether they work in government or in the private sector. I’m curious about the practical side, how exactly do they apply the rules, assess risk, and structure these cross-border dealings?

TP is an exciting and niche field, it is not just about tax but fairness, equity, and the way our global economy is structured. It’s a highly specialised area of tax that focuses on cross-border transactions, which means constantly engaging with international tax systems and legislation. It’s dynamic, technical, and global, certainly a field that keeps one on their toes.

💭What do you think?

Do you think Transfer Pricing is becoming more important in developing countries? Have you seen how it affects industries like mining, digital services, or retail?

Let’s start a conversation!