Instead of increasing existing taxes or levying new taxes, a way to tackle the looming budget deficit may be to properly implement transfer pricing rules and to ensure appropriate enforcement by the South African Revenue Service (SARS) of such rules.
Budget for financial year 2019
In his medium term budget policy statement on 25 October 2017, Minister of Finance, Malusi Gigaba, advised that South Africa is facing a current Budget deficit in excess of R50 billion.
It is not expected that forecasts will improve for financial year 2019. In addition, in an unexpected move, free tertiary education was recently promised by then President of South Africa, Jacob Zuma, to thousands of students. Bail outs for Public Owned Enterprises are also still required.
Thus, while government needs to carefully manage and reduce, especially wasteful and irregular, expenditure, it will still need to increase tax collections significantly in order to meet its 2018/2019 spending targets. However, there would appear to be little room for the Finance Minister to manoeuvre.
The stagnant economic situation, together with tax competition from other developing as well as developed countries, do not allow for significant corporate tax increases. Collections are already at a low. The ever increasing taxation of high net worth individuals has reportedly led to reduced tax compliance as well as many individuals leaving the country. There has also been some talk of a tax revolt being on the cards as the meagre 13 million registered taxpayers feel that their tax contribution is not well spent. The significant amount of reported (by the Auditor General) wasteful and irregular expenditure by government which, in 2014/2015, was a similar number to the current budget deficit, has been cited in support of this proposal.
Thus, it seems that, other than the potential increase of the Value-added Tax rate, which has been suggested by some commentators as ‘the only option’ remaining, but which may not be a very popular move so soon before the next elections, there does not seem to be room for a further increase in taxes. However, as indicated, additional tax revenue is urgently needed.
An alternative to increasing taxes may be the more focused and streamlined enforcement of existing transfer pricing rules.
Transfer pricing relates to the transfer of goods or services between members of a multinational group which are tax residents in different countries.
The underlying principle, the arm’s length principle, is that members within the multinational group must carry out their intra-group transactions on the same basis (terms, conditions and pricing) as they would be if they were carried on between independent entities in the normal course of their business.
Following the Organisation for Economic Cooperation and Development’s Base Erosion and Profit Shifting (BEPS) Initiative, sophisticated transfer pricing rules, including mandatory transfer pricing documentation requirements, have been introduced and/or significantly updated across the globe and in South Africa. The purpose of these rules is to put a stop to profit shifting through pricing manipulation which may result in the flow of profits to group companies in low or no tax jurisdictions.
For example, the provision of management type of services to a South African group company may result in that company incurring high costs, which would, if deducted for tax purposes, reduce the tax payable of the South African company, but at the same time increase the income of the services provider.
The fees charged for the services by a connected offshore company may, based on the level of mark-up on costs and/or the allocation key applied, not be in line with what independent parties would agree to pay for the same services in the normal course of their business.
If deemed excessive by SARS, part or all of the service charge may be disallowed and this would result in increased income taxable in South Africa, plus a so-called secondary adjustment (20% deemed dividends tax in respect of the declaration of an asset in specie), as well as potential penalties and interest payable to SARS. The monetary impact can be significant: If, for example, a taxpayer’s deduction of service charges payable to its offshore connected person services provider is reduced from R20 million to R10 million, i.e. R10 million is disallowed, the additional amount payable by that taxpayer could end up being as much as R10 million if transfer pricing adjustment (at 28% tax), secondary adjustment as well as maximum penalties and interest all apply.
It should be noted that the obligation to transact on an arm’s length basis, and the burden of proving that it has complied with the transfer pricing rules, lie with the South African taxpayer. In addition, it should be noted that a secondary transfer pricing adjustment would also apply where the taxpayer, itself, makes a transfer pricing adjustment in the tax return, prior to any SARS query.
Until recently, the preparation of transfer pricing documentation, which is used to demonstrate compliance with local transfer pricing rules, was not mandatory. However, this has changed for most taxpayers for financial years commencing on or after 1 October 2016.
The strict enforcement of transfer pricing rules, while designed to ensure fair and equitable revenue collections in all countries, dependent on the location of economic activity of a multinational enterprise, is expected to result in significantly increased revenue collections in South Africa. Ideally this would be achieved through good compliance by the taxpayers. Clearly, well organized enforcement by SARS would encourage such compliance.
The focus needed to be placed on transfer pricing has been pointed out in every Budget Speech for the last 5 or so years, and it was stated as one of the priority areas of the SARS Compliance Programme for 2012-2017. Even prior to South Africa’s introduction of the more stringent BEPS compliant transfer pricing legislation and rules mentioned above, it was reported by SARS that transfer pricing audits had resulted in additional tax revenue in excess of R8 billion. Clearly, in today’s world of global exchange of transfer pricing related information, it can be expected that the potential collections will significantly increase.
SARS enforcement capacity
While it was reported last year that SARS had lost approximately 500 of its approximately 14,500 staff members, it has also been reported that it has recruited several highly skilled and experienced people in all areas, including transfer pricing professionals.
Recently, probing transfer pricing queries, in conjunction with customs or Value-Added Tax related queries or stand alone, have been issued to a number of multi-national taxpayers, clearly indicating the ability of the SARS transfer pricing unit.
Even more detailed and regular transfer pricing reviews can be expected going forward.
Further, SARS has spent significant funds on acquiring and implementing technological tools to assist it with transfer pricing risk assessment. Thus, the globally agreed and implemented BEPS related exchange of information arrangements will make it easy for SARS to identify companies it may benefit it to test in respect of their transfer pricing compliance.
In line with global and African trends, taxpayers engaged in cross-border connected person transactions can anticipate transfer pricing related queries and audits.
The focus on transfer pricing enforcement is expected to generate additional tax revenue, which is due to SARS and help the government to reduce its budget deficit. Comment thereon may be forthcoming in the 2018 Budget Speech.
The message to taxpayers is thus that they should timeously put the right mechanisms in place to ensure comprehensive transfer pricing compliance in order to avoid long and involved transfer pricing audits, disputes and penalties.