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South Africa: Are you prepared for a transfer pricing audit?

24 June 2024
– 5 Minute Read
| Tax

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Overview

  • A taxpayer may believe that it has safeguarded against a transfer pricing attack because it has obtained an independent transfer pricing analysis. However, the transfer pricing experts used by SARS may quickly identify discrepancies when they conduct a transfer pricing audit.
  • There has never been a more pressing moment to engage with us to undertake an independent audit to confirm that the functional analysis has been performed correctly and reflects the actual functions performed, assets used and risks involved in the context of intra-group cross-border transactions. This will enable us to prepare a transfer pricing defence file to prepare the taxpayer to defend a transfer pricing dispute with SARS.

It has been widely reported that the South African Revenue Service (SARS) is focusing on taxpayer compliance with the aim of collecting additional tax revenue.  Further, SARS is gradually rebuilding its capacity and technical skills with an emphasis on hiring transfer pricing specialists. Auditing cross-border related party arrangements is seen as an easy way to address the shortfall. This creates the expectation that SARS will be more active in the market, with taxpayers experiencing an increase in transfer pricing-related queries and audits often leading to litigation.

In line with global trends, South African tax law has evolved over the past few years, increasing the compliance requirements related to transfer pricing. Most multinational enterprises are required to prepare and submit a transfer pricing master file and a local file. Higher revenue-earning multinational enterprises are also required to attend to country-by-country reporting. These international reporting initiatives will be further enhanced with the implementation of Pillar 1 and Pillar 2, which aim to address tax avoidance and ensure coherence with international tax rules.

The evidence of the change of focus by SARS is illustrated by the recent decision on a transfer pricing dispute by the Gauteng Tax Court (heard on 14 February 2024). SARS attacked the transfer pricing arrangements by the taxpayer, even though the taxpayer had obtained independent confirmation by a transfer pricing specialist on its cross-border pricing arrangements.  SARS presented evidence of its own independent analysis by two transfer pricing experts, which contradicted the pricing recommended by the expert used by the taxpayer. Fortunately, the taxpayer won the case, but SARS is expected to appeal.

To prepare a transfer pricing policy defence, taxpayers need to engage a competent transfer pricing specialist to perform and document a functional and economic analysis. The functional analysis aims to identify the functions, assets and risks involved in the cross-border intra-group activities of the enterprise and to determine key strategic insights into the inner workings of such business. It should provide an understanding of the relative contributions of the parties to the transaction and their roles in overall value creation. The results of the functional analysis are then used to perform the economic analysis, which aims to identify independent comparable supplies of goods or services and to select appropriate methodologies to determine the acceptable range of arm’s length pricing.

Taxpayers should also prepare appropriate intra-group agreements to evidence their intra-group cross-border transactions. Preparation of such intra-group agreements should be viewed as a critical part of the taxpayer’s transfer pricing documentation. These agreements need to accurately reflect the actual functions undertaken, assets used, and which entity takes responsibility for any risks flowing from such agreements. It is advisable to first undertake a functional analysis before the agreements are drafted, since the actual functions and risks involved are often incorrectly reflected in such agreements.

A key aspect of any functional analysis is to determine whether the intra-group cross-border agreements actually reflect the real activities, assets and risks involved in the transactions with other group companies. Discrepancies can have a material impact on the subsequent economic analysis and thus the pricing applied to the transaction.

When the intra-group agreements correctly reflect the information contained in the functional analysis, this mitigates the potential tax exposure and improves the chances of a successful defence in the case of a SARS audit. If the pricing of supplies under such intra-group agreements is determined based on intra-group agreements that do not correctly reflect reality, the independent analysis is not valid and can be contested by SARS.

Multinational enterprises must not only have documentation to support their transfer pricing, but a deeper understanding of their cross-border transactions with related parties at all levels of their organisations involved in such transactions. The MOST critical aspect is to ensure that what is happening in practice (i.e. in the factory, the research and development team, the logistics team, the financial disclosure team, etc.) aligns with what has been documented in the intra-group agreements. By way of example, if an agreement provides that the South African supplier of goods takes the risk of the transport and delivery of the goods to the foreign group company, the goods cannot then be delivered FOB to the local port.  Larger organisations, with many ‘moving parts/ bodies’ are most at risk.  Aligning the activities of employees to what is documented between the parties and recorded in the functional analysis is crucial.  Getting this wrong is likely to lead to a taxpayer’s downfall in court, as witnesses who are called to testify may contradict the facts as reflected in the contractually agreed arrangement.    

Therefore, a taxpayer may be of the view that the enterprise is safeguarded against a transfer pricing attack because it has obtained an independent transfer pricing analysis. However, the transfer pricing experts used by SARS may quickly identify discrepancies when they conduct a transfer pricing audit. 

There has never been a more pressing moment to engage with us to undertake an independent audit to confirm that the functional analysis has been performed correctly and reflects the actual functions performed, assets used and risks involved in the context of intra-group cross-border transactions. We would then prepare a transfer pricing defence file, using the expertise of our tax dispute litigators to ensure that the taxpayer is prepared to defend a transfer pricing dispute with SARS.