Demystifying the conundrum of transfer pricing adjustments

The arm's length principle is the international standard for determining transfer prices between related entities (for example the price at which goods are sold or service rendered). It states that the transfer prices should be set as if the entities were unrelated and engaged in transactions under normal market conditions. By adhering to this principle, multinational enterprises (MNEs) should avoid shifting profits between jurisdictions to exploit differences in tax rates or regulations.

Transfer pricing adjustments arise as a result of intra-group transactions and pricing not being aligned with the arm’s length principle.

Transfer pricing adjustments are to be considered by taxpayers and adjustments made before finalisation of the tax affairs for a said financial year. In the event where transfer pricing adjustments are not carefully evaluated by taxpayers they can be made by revenue authorities during an audit or investigation to reflect the arm’s length principle.

Article 9(1) of the Organisation of Economic Co-operation and Development (OECD) Model Tax Convention (MTC), permits adjustment to the profits of one enterprise where the terms of transactions between associated enterprises differ from terms that would be agreed between unrelated enterprises in similar circumstances. These adjustments can affect the determination of taxable income and can lead to additional taxes or penalties.

Transfer pricing adjustments can be categorised into two types i.e., primary adjustments and secondary adjustments.

Primary adjustments

The Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations’ (OECD Guidelines) defines a primary adjustment as “an adjustment that a tax administration in a first jurisdiction makes to a company’s taxable profits as a result of applying the arm’s length principle to transactions involving an associated enterprise in a second tax jurisdiction”.

For example, assume that a South African (“SA”) company buys goods from its foreign related party at a price higher than the arm’s length price. It is determined that the company in SA buys the goods from its foreign related party at ZAR 150 million however, the arm’s length price for the goods bought by SA amounts to ZAR 100 million. The primary adjustment would involve decreasing the transfer price of ZAR 150 million to match the arm's length price which will require the SA company to make a primary adjustment of ZAR 50 million resulting in an increase in taxable income of ZAR 50 million and tax thereon of 28% (27% financial years commencing on or after 1 April 2022).

Secondary adjustments

A Secondary adjustment arise from primary adjustment which is a resultant effect of the primary adjustment.

A secondary adjustment is defined by the OECD Guidelines as an “adjustment that arises from imposing tax on a secondary transaction in transfer pricing cases”. A secondary transaction is defined as “a constructive transaction that some jurisdictions will assert under their domestic legislation after having proposed a primary adjustment in order to make the actual allocation of profits consistent with the primary adjustment. Secondary transactions may take the form of constructive dividends, constructive equity contributions, or constructive loans.”

Countries impose secondary adjustments as primary adjustments change the allocation of taxable profits of an MNE group for tax purposes but it does not alter the fact that the excess profits represented by the adjustment are not consistent with the result that would have arisen if the controlled transactions had been undertaken on an arm’s length basis. To align the actual allocation of profits and to not only consider taxable income but actual income, secondary adjustments are often imposed by countries.  

Internationally countries policies in terms of secondary adjustments differ, some countries might impose them (e.g. SA) and others might not (e.g. United Kingdom). The exact form that a secondary transaction takes and the consequent secondary adjustment will depend on the facts of the case and on the tax laws of the jurisdiction that asserts the secondary adjustment. 

For example, X, a foreign company resident in Country A, holds 100% of the shares in Z, a company resident in SA. X lends Z R100 million on 30 June 2021. Interest is payable at 10% per year. X has a 31 December financial year-end.

Z determines that an arm’s length amount of debt is R100 million however, an arm’s length interest rate is 6% per year.

Z must effect a primary adjustment in calculating its taxable income by not claiming a tax deduction for interest of R560 000 (R2 000 000¹ × 28%). This will increase Z’s taxable income by R560 000 for the year ended 31 December 2021.

The differential of R2 000 000 will constitute a deemed dividend in specie by Z to X for the purposes of dividends tax. X will be liable for dividends tax at the rate of 20%².

Impact on withholding tax on interest when having transfer pricing adjustments

In terms of the Interpretation Note 127 (issued by SARS on 17 January 2023), in the event where there are transfer pricing adjustments in respect of funding transactions, the IT Act has no legislative mechanism to enable a taxpayer to recoup the interest withholding tax already suffered where the amount is also subject to a secondary adjustment in terms of section 31.

Taxpayers should ensure that their funding transactions are at arm’s length and that the right procedures were applied in determining an arm's length price (i.e., performing a benchmark analysis to determine the arm’s length interest and gearing position of the entity). If not, taxpayers are going to be subject to transfer pricing adjustments and would suffer these in addition to the interest withholding tax on interest.

Below is an extract of the Interpretation Note 127 issued by SARS which seems to corroborate with our view of the impact on withholding tax on interest:

¹This amount is a result of the difference between the 10% interest rate and the 6% interest rate ((R100mil x 10% x (6/12) – R100mil x 6% x (6/12))

²For the reasons set out in sections 64FA(1) and 64FA(2), a resident company will not qualify for an exemption from dividends tax under section 64FA(1) or a reduced rate of dividends tax under section 64FA(2) on a deemed dividend in specie which arises under section 31(3)(i). Accordingly, the deemed dividend will be subject to dividends tax at a rate of 20%.

“Section 31(2), if applicable, requires that taxable income or tax payable of the person in whose hands the tax benefit results or will result must be calculated as if the terms and conditions of the affected transaction had been arm’s length. It does not deem the underlying transaction to have been conducted at an adjusted amount for purposes of the Act as a whole and therefore does not alter the amount of interest paid or due and payable to the lender. Accordingly any “adjustment” to taxable income or tax payable under section 31(2) will not impact on the calculation of withholding tax on interest under Part IVB of the Act. In addition, section 31(3) is a secondary adjustment which also does not re-characterise or alter the amount of interest paid or due and payable to the lender.”

Difference between pricing adjustments and Transfer Pricing adjustments

Pricing adjustments are mostly confused with transfer pricing adjustments. As mentioned above, transfer pricing adjustments aim to align the profits and tax liabilities of related entities with the arm's length principle to avoid profit shifting. Whereas a pricing adjustment, for example in the context of intra-group transactions, can refer to any adjustment made to the price of a product, raw material procured etc.. Pricing adjustments can be made for various reasons, such as market changes, negotiation outcomes, or changes in costs.

For example, ABC a foreign company resident in Country X, holds 100% of the shares in XYZ, a company resident in SA. ABC is a manufacturer of equipment and spare parts and XYZ procures equipment and spare parts from ABC for resale in the local market as a fully-fledged distributor. ABC and XYZ all form part of the same the Group. The Group has a transfer pricing policy, based on the arm’s length principle, supported by relevant benchmarking studies, that evaluates distribution entities, such as XYZ, selling equipment and spare parts in the local market to be based on an operating margin (OM) of 10%.

During the current financial year, XYZ achieved an OM of 15%, the OM was viewed by the Group as high and deviated from the targeted OM of 10% set by the Group in their transfer pricing policy. The Group is in the process of finalising year-end accounts and are evaluating pricing adjustments to ensure the financial results of all entities are aligned before finalisation and sign-off.

The above results in a need for a change to the original price setting during the financial year to adjust the intra-group price of the purchased equipment and spare parts from ABC. To reach the targeted OM of 10% for the distribution of equipment and spare parts, a pricing adjustment is being proposed by the Group to XYZ to align the OM of X with the Group’s transfer pricing policy of 10%. There may be other tax impacts arising from transfer pricing and pricing adjustments, such as Value Added Tax or Customs and Excise which are not dealt with in this article.

A pricing adjustment would be considered to align an existing transaction that is supported from an arm’s length perspective to the transfer pricing policy of the Group. The adjustments being effected are purely from an accounting perspective which are supported from an arm’s length perspective for transfer pricing purposes. Transfer pricing adjustments on the other hand are made to transactions that are not arm’s length in nature.

Authors: 

Ishmael Masangu, Consultant - Transfer Pricing

Reviewer

Charl Hall, Senior manager - Transfer Pricing

14 September 2023