Transfer Pricing: Insights On Landmark Judgment - Transfer Pricing

The tax court, sitting in Johannesburg, was called upon to adjudicate a transfer pricing dispute between ABD Limited (“ABD”), a telecommunications company, and the South African Revenue Service (“SARS”) in respect of ABD's 2009-2012 tax years. Judgment was handed down in February 2024.

Background

ABD licenced its trademark to its subsidiaries (“Opcos”) in various countries for which royalties were paid by each of them to ABD.

In 2011, ABD procured the services of a consultancy to advise it on the royalty it should charge its Opcos. The consultancy, after conducting research, recommended a flat 1% royalty rate (of turnover apparently), being the average of rates between 0.7% and 1.3%. The consultancy recommended the average rate be used as such rate enabled the parties to have confidence about payment levels and employing an average smoothed out the effect of fluctuations in the performance of the Opcos.

Following a transfer pricing audit in 2014, SARS argued that the 1% rate did not reflect an arm's length price.

Acting in terms of section 31 (the applicable transfer pricing provision) SARS sought to determine ABD's tax liability, in respect of its 2009-2012 tax years, by substituting the royalty rate charged by ABD for one SARS contended was the arm's length rate.

Initially SARS relied on the expertise of a Mr David who recommended a royalty rate of 3%.

During the course of the appeal (in 2020), however, it sought to rely on the expertise of Dr Slate, its new expert. Based on his recommendations (that a variable royalty rate should have been charged for each Opco and for each year) SARS sought to further adjust its previously determined ‘arm's length' royalty rate. Dr Slate's recommended rates varied widely (between 0.8% and 9.2%) and would have resulted in a greater tax liability for ABD.

ABD submitted that it had no incentive to charge its Opcos a lower royalty to avoid paying tax in South Africa. This was demonstrable because most of the Opcos operated in jurisdictions that had a statutory rate of tax that was equal to or higher than South Africa's. Understating royalty expenses would also have unduly benefited minority shareholders in the various Opcos at ABD's expense.

Transfer Pricing Guidelines

Both ABD and SARS relied on the OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations (Guidelines) to determine the arm's length royalty rate (despite lengthy heads of argument, no transfer pricing case was actually relied upon by either party).

The court noted that, as per the Guidelines, the thrust of a transfer pricing analysis, in a case involving intangibles (defined in the Guidelines as being something which is not a physical asset or a financial asset but which is capable of being owned or controlled for use in commercial activities and whose use or transfer would be compensated had it occurred in a transaction between independent parties in comparable circumstances), should be the determination of the terms that would be agreed upon between independent parties for a comparable transaction.

The court also explained the arm's length principle, per the Guidelines, as being applicable where:

“conditions are made or imposed between the two enterprises in their commercial or financial relations which differ from those which would be made between independent enterprises, ….”

and that:

“any profits which would, but for those conditions, have accrued to one of the enterprises, but, by reason of those conditions, have not so accrued, may be included in the profits of that enterprise and taxed accordingly.”

The court therefore had to assess the appropriate methodology, from the Guidelines, to determine arm's length royalty rates and, on that basis, determine whether the royalty rate between ABD and each of its Opco's accorded with the arm's length principle.

The court noted that the two methodologies of relevance in this case were the Transactional Profit Split Method (“TPSM”) and the Comparable Uncontrolled Price Method (“CUP”).

A transactional profit method, noted the court, is defined in the Guidelines, as:

“A transfer pricing method that examines the profits that arise from particular controlled transactions of one or more of the associated enterprises participating in those transactions.”

TPSM, noted the court, is defined in the Guidelines, as:

“A transactional profit split method that identifies the relevant profits to be split for the associated enterprises from a controlled transaction … and then splits those profits between the associated enterprises on an economically valid basis that approximates the division of profits that would have been agreed at arm's length.”

CUP, noted the court, is defined in the Guidelines, as:

“A transfer pricing method that compares the price for property or services transferred in a controlled transaction to the price charged for property or services transferred in a comparable uncontrolled transaction in comparable circumstances.”

The court also had regard to the Guidelines' concept of a brand (for transfer pricing purposes). The Guidelines state that in some contexts a brand refers to a trademark and trade name and in others it refers to a trademark or trade name imbued with social and commercial significance and could represent a combination of intangibles including trademarks, trade names, customer relationships, reputational characteristics, and goodwill.

ABD's submissions to the court

ABD called three expert witnesses to testify.

TPSM

Two of its experts (Mr Brine and Ms Sana) relied on the TPSM.

CUPM

ABD's other expert, Dr John, relied on the CUPM (Dr John's expert evidence was bolstered by Ms Sana with regard to questions around comparability).

Dr John's testimony was to the following effect:

ABD sold its Cypriot subsidiary to a non-related party on 15 July 2018 (the sale did not include a brand licence agreement);
on 3 September 2018 a brand licence agreement was concluded between ABD and its former subsidiary (“Cyprus transaction”) at a time when the latter was independently owned - therefore the parties were transacting at arm's length;
the brand licence agreement constituted an internal CUP because ABD, as a party to the licence agreements with the Opcos, was party to the licence agreement with its former subsidiary (unlike an external CUP between completely independent parties where there is no link to the particular transactions analysed);
the CUP method is superior to other methodologies to determine an arm's length price as it seeks to replicate market forces in a transaction between independent entities;
an internal CUP is superior to an external CUP (which is confirmed by the Guidelines because the internal CUP has a more direct and closer relationship to the transactions under review compared to external CUPs and because the financial analysis maybe easier and more reliable as an internal CUP relies on identical accounting standards and practices, and information is more complete and reliable);
based on theory and empirical evidence – including evidence based on Dr John's own research – differences in the Cyprus transaction (compared to the controlled transactions between ABD and Opco) did not impact its comparability - his inability to measure such differences did not alter his opinion thereon;
the Cyprus transaction was appropriate as an internal CUP because most differences between the transactions under review and the Cyprus transaction were not relevant or material. In particular, Dr John confirmed that economic circumstances such as the size of the market, extent of competition, availability of substitute goods and services, and government regulation were relevant for purposes of determining asset value but not the rate of income thereon.

ABD's other expert, Ms Sana, testified that while the Cyprus transaction granted exclusivity (unlike agreements with some of the Opcos) and was of a 3 year duration (unlike agreements with the Opcos, which ran for 10 years or for an indefinite period), such differences did not impact the royalty rate. In her experience exclusivity, while granting a degree of market power and influence, did not have a material impact on price and the shorter duration agreement should have commanded a higher royalty rate because of the risk carried by ABD.

SARS' contentions

TPSM

SARS challenged the evidence of Mr Brine, in relation to determining an arm's length price in terms of the TPSM, on the basis that such evidence constituted hearsay evidence (as he did not prepare the report relied upon by ABD and did not undertake the survey).

CUPM

With regard to the CUPM, SARS questioned whether the Cyprus transaction was a reliable comparable on the basis that the Guidelines required (in respect of all the methodologies described therein to determine arm's length pricing) economically relevant characteristics or comparability factors to be identified in the commercial or financial relations between the associated enterprises in order to accurately delineate the actual transaction.

Such characteristics or factors (broadly categorised) are as follows:

contractual terms of the transaction;
functions performed by each of the parties to the transaction, taking into account assets used and risks assumed (including how these functions relate to the wider generation of value by the MNE group to which the parties belong), the circumstances surrounding the transaction, and industry practices;
the characteristics of property transferred or services provided;
the economic circumstances of the parties and of the market in which the parties operate; and
the business strategies pursued by the parties.

The Guidelines state, in respect of the CUPM, that where there are differences in comparables, the CUPM is still recommended provided that these differences can be measured and accounted for.

SARS challenged Dr John's evidence on the basis that his CUPM method, relying on the Cyprus transaction, was not comparable because:

he had not considered all the comparability factors (which Dr John addressed by stating that he eschewed a mechanical approach to such factors);
he had not measured differences (which Dr John addressed by stating that while he was unable to measure the differences, such differences were not material);
comparability was affected by the unique and valuable contributions made by the Opcos to the intellectual property (which ABD countered by demonstrating that none of the contributions made by the Opcos were exceptional in the sense that contributions were made by some of its Opcos but not by others).

SARS also contended that ABD's former Cypriot subsidiary was not independent of ABD because it was previously an Opco.

SARS' TPSM submissions

SARS relied on Dr Slate's determination of an arm's length royalty using the TPSM.

In doing so Dr Slate sought to calculate the incremental price consumers were willing to pay for the ABD brand. To determine this incremental price, he employed the “willingness to pay” technique to assess how much more a buyer was willing to pay for the ABD branded product compared to an unbranded product.

Dr Slate ascertained the “willingness to pay” by conducting a survey in some of the markets in which Opco operated.

The survey compared the ABD brand to a hypothetical brand (which was unknown to the survey respondents).

Dr Slate designed the survey questions, trained researchers on how to complete the survey, and then measured the results quantitatively (based on quantitative responses).

Dr Slate's survey results demonstrated that ABD customers, in 6 of the 14 markets, were willing to pay a price premium of between 35% and 79% in the business-to-consumer market and between 24% to 52% in the business-to-business market.

Thereafter Dr Slate computed the following amounts:

Opcos' branded revenue derived from selling ABD branded products and services;
Opcos' price premiums earned from selling the ABD brand (using the willingness to pay survey results);
a weighted price premium for all Opcos for the relevant periods;
revenue attributable to the ABD brand; and
costs attributable to the brand (the contribution each party made to the revenue attributable to the brand - which was used to work out the split between ABD and the respective Opco).

Dr Slate then multiplied the revenue attributable to the brand by a split factor to arrive at a royalty rate expressed as a percentage.

Tax court decision

The court concluded that the Cyprus CUP served as a comparable internal CUP. As the royalty in that agreement was 1%, the 1% royalty rate charged to other Opcos constituted a reasonable arm's length rate. Accordingly, there was no factual basis for the section 31 adjustments SARS effected or further adjustments SARS sought.

The court's reasons were as follows:

SARS' TPSM

it agreed with ABD's submission that Dr Slate took into account rights (goodwill) ABD did not licence to the Opcos. This negatively impacted Dr Slate's survey (as the survey questions were based on ABD transferring trademarks and goodwill to the Opcos when only trademarks were licenced);
Dr Slate's survey questions were biased because the questions were not open ended i.e., survey respondents had to select one of five prepared answers (failure to answer from one of the five prepared answers would exclude a particular respondent's survey responses from the survey);
Dr Slate's survey was skewed (a survey respondent may have had a different answer to one of the five prepared answers or may have provided an incorrect response - by falsely agreeing with one of the suggested answers);
Dr Slate's survey was conducted in 2020 yet survey respondents were asked what they would have done in the 2009-2012 period (40% of the survey respondents would have been teenagers and unlikely to have had a phone - never mind being able to pay for the services used);
answers provided by the survey respondents in 2020 in response to questions about their willingness to pay during the 2009-2012 period was inherently unreliable;
Dr Slate relied on an unorthodox technique (willingness to pay) which was outside mainstream approaches (the willingness to pay technique was used by the UK Competition Commission for market definition purposes, not transfer pricing disputes to be resolved in court);
the willingness to pay survey, constructed on a shaky foundation, was not a reliable metric to determine what an arm's length royalty rate would have been;
there was no evidence of the acceptance of the willingness to pay technique as a reliable foundation for the application of the TPSM;

ABD's CUPM

the Cyprus transaction, as an internal CUP, was the most persuasive and the preferred method in the Guidelines;
the Cyprus transaction most closely resembles what would be achieved in a market-based arm's length negotiation; and
criticism about its comparability (as a result of exclusivity, duration of the Cyprus transaction and territory) were not conclusive. The criticism amounted to saying these factors may have led to a different outcome (resulting in the criticism constituting mere speculation which did not constitute refutation).

ABD succeeded by demonstrating its royalty rates were on arm's length terms in terms of only one of the methods relied upon in court. The court therefore did not need to assess ABD's submissions in respect of an arm's length price under ABD's TPSM (nor respond to SARS' criticism of such method or resolve the hearsay challenge).

The tax court awarded part of the costs of the appeal to ABD because, in the court's view, SARS' flip flop, in switching reliance from Mr. David to Dr Slate (based on analysis that had not met the test of rigour) was unreasonable.

Significance

The significance of this decision includes the following:

in South Africa it is one of the earliest court decisions dealing with transfer pricing;
the tax court was guided and/or informed by the Guidelines in arriving at its decision;
parties to transfer pricing disputes must pay particular attention to the nature of the property or services exchanged;
the importance of expert witnesses adopting mainstream and reliable techniques/ methodologies in determining an arm's length price; and
an expert witnesses' reasoning must be sound and rational.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

South Africa: Transfer Pricing: Insights On Landmark Judgment