When a company exports its goods for resale to a related company in a country where a lower tax rate is levied, for onward transmission to the end-user in perhaps yet another country, this is called ‘transfer pricing’. The purpose of the manoeuvre is the avoidance of tax. The company in the country with the high tax rate typically exports the goods or services at as low a price as possible to the company in the low tax jurisdiction.
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Consequently, the bulk of the price of the goods will be taxed in the low tax country. The high tax country will obviously lose revenue if such measures are allowed to succeed, and tax authorities in high tax countries have rules in place to combat transfer pricing. However, the high tax country’s tax authorities have no jurisdiction over the company in the lower tax country.
Because they can’t levy any penalty or interest against the low tax company in the other country, the tax authorities in the high tax country will invariably ignore the actual price obtained by the company in the high tax country. Instead, they’ll ‘deem income’ or affix a higher price to the exported articles received by the original company. In turn, this means a higher rate of tax is to be paid in the high tax country. Many countries around the world have laws to combat transfer pricing, which has developed into an internationally recognised and specialised field within the tax profession.
Cardinal rule
In South Africa, Section 31 of the Income Tax Act deals with transfer pricing. The section is very broad and includes all manner of international transactions that involve the transfer of income or profits to a lower tax country. Although transfer pricing isn’t illegal, the abuse or serious mismatch of prices is a form of tax avoidance. Globally, the rules employed in both the identification and the suppression of transfer pricing are similar.
The cardinal rule looked at in international financial or sales transactions between related companies is the ‘arm’s length principle’: if two related companies do business in two separate jurisdictions in circumstances that might give rise to abusive price manipulation or transfer pricing, and even in the case where there’s a tax saving, if the goods or services are supplied cross-border at a price that’s within the price parameters of similar goods or services bought and sold internationally, then the adverse deeming provisions would not apply.
Agreements
The rules are constantly evolving. As companies become more adept at securing tax advantages within the rules, so the tax authorities review the legislation to stop ‘tax leakage’. The latest development is to not only look at pricing (the arm’s length principle) – the agreements between suppliers and buyers of goods and services are now also examined, with any non-arm’s length provisions causing the selling company to suffer deemed income against it.
Peter O’Halloran is head of tax at BDO, Gaborone. Contact him on 00267 390 2779 or at [email protected]. Please state ‘Tax’ in the subject line of your email.
