South Africa’s first “real” Transfer Pricing case, setting the tone for Transfer Pricing disputes?

ABD Limited is a telecommunications company in South Africa with subsidiaries worldwide. ABD Limited licensed the right of use of intellectual property (IP) to these subsidiaries (hereafter referred to as Opcos). The IP related to the use of the ABD name, logo and other associated visual IP brand elements and systems. ABD Limited charged the Opcos a royalty based on 1% of the profits generated from the use of the IP. The extent of what the right represented as well as whether the royalty charged by ABD Limited to the Opcos is arm’s length, was in dispute. SARS raised additional assessments for the period 2009 to 2012.

The calculation of the royalty is based on two factors. Firstly, the size of the profit earned by the Opco from the use of the IP and then how that profit is divided between the Opco and ABD Limited.

SARS engaged an external expert whose advice led SARS to raise additional assessments. In the appeal to these assessment , SARS relied on the expertise of another external expert. The second external expert suggested that ABD Limited should have applied a variable royalty rate based on the country and year it was earned, resulting in an even higher royalty rate to apply than determined by the first external expert. ABD Limited argued that SARS was inconsistent with their approach taken and therefore their arguments and analysis could not be relied on.

ABD Limited similarly relied on the expertise of an independent consultancy company who found that the 1% rate was appropriate by comparing royalty rates in different territories where the Opcos operate. It was concluded that the 1% applied was an average of the comparable rates. ABD Limited’s advisors supported the royalty charge by considering two transfer pricing methods which are accepted methods as prescribed by the Organisation for Economic Co-operation and Development (OECD) in the Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations (OECD Guidelines) which are to be applied in the determination of the arm’s length price in transactions between related parties.

The methods considered by ABD Limited’s advisors were the Transactional Profit Split Method (TPSM), which examines profits from controlled transactions and splits them between associated enterprises based on an economically valid basis and the Comparable Uncontrolled Price (CUP) method, which compares prices in controlled transactions to those in uncontrolled transactions under similar circumstances.

The Tax Court disregarded the argument on utilising the TPSM and only considered the arguments made in terms of the application of the CUP method.

To support the 1% royalty, an internal CUP was used by ABD Limited. ABD Limited sold a subsidiary in Cyprus to a third party. Once the sale was concluded (i.e. when the Cyprus entity was independently owned) the parties entered into a brand licence agreement. In terms of the brand licence agreement, ABD Limited sought to recover a royalty from the Cyprus entity at 1%. Although there were some contractual differences between the terms of the agreement concluded with the Cyprus entity compared to the terms with the Opcos (as highlighted by SARS during the appeal), ABD Limited considered these differences to be immaterial.

The Tax Court was in favour of the taxpayer as they were of the view that the analysis presented by ABD Limited applying the CUP was the most persuasive.

SARS argued another approach where they set out a methodology to determine what incremental price consumers are willing to pay for a brand. They developed surveys in which ABD customers were asked about their preferences for the ABD brand versus a hypothetical company. The survey was based on responses from various markets in Africa and was conducted in 2020, however the customers had to indicate what they might have done in the period 2009 to 2012. SARS’ approach sought to determine the weighted price premium and made the assumption that goodwill was included in the Opco licence agreements. For various reasons, the Tax Court was of the opinion that the secondary argument presented by SARS was not plausible and that they used unorthodox methodology and not commonly used to deal with transfer pricing issues.

From a practical perspective, the approach and analyses undertaken by both SARS and ABD Limited could raise interesting debates. It was surprising to see that neither SARS nor ABD Limited considered the use of an external CUP by performing an economic analysis (benchmark) by comparing royalty rates between independent third parties providing similar licensing agreements. 

It is also noted that SARS chose to rely on the expertise of external experts instead of utilising internal resources with transfer pricing knowledge.

Although transfer pricing is not an exact science, proper understanding and appropriately applying transfer pricing methods helps strengthen a case. In the case of ABD Limited, it was evident that the taxpayer was able to support and argue its case better which led to the win for the taxpayer. From the case it could be viewed that the courts are unlikely to consider arguments in transfer pricing matters that lack thorough analysis or methodologies not supported by the OECD.

The outcome of the case is an exciting time for the South African transfer pricing landscape, giving insight into a debate of technical transfer pricing elements and being able to see how these matters could be considered by the courts. It is believed that there are more cases to follow and that the key take-away from this case should be that transfer pricing analysis and documentation is of the utmost importance to mitigate transfer pricing risks and potential transfer pricing adjustments.

Should you require any assistance or have any questions pertaining to transfer pricing please speak to our team of specialist.

Authors:

Kaneez Khair, Manager Tax Consulting
Maemu Mulaudzi, Consultant Tax

10 April 2024