The enabling legislation to bring the transfer pricing and thin capitalisation rules into the South African Income Tax Act was passed in 1995. In 1999 the South African Revenue Service (SARS) issued a comprehensive practice note setting out guidance on acceptable transfer pricing methods and the documentation that would be required. In large measure, this was based on the OECD Transfer Pricing Guidelines.

The transfer pricing legislation did not include any punitive consequences for failure to apply arm's length pricing. The legislation effectively provides for the taxable income to be adjusted by the extent to which the prices are not arm's length, and for that adjustment to be deemed to be a dividend. To the extent that there is an adjustment to taxable income, there will automatically be interest payable on the underpayment of tax, unless the taxpayer can on reasonable grounds contend that its version was correct. There were no specific provisions made for penalties. The Income Tax Act itself does, however, provide for penalties where tax is underpaid, but effectively only where there is an intent to evade tax, which will often be inferred where there was fraud or misrepresentation for non-disclosure of material facts. Moreover, where there has been non-disclosure, the SARS may reopen the assessment at any time, indefinitely into the future, whereas if there has been proper disclosure the SARS is prohibited from reopening the assessment after three years have expired from the date of such assessment.

The practice note originally acknowledged that there was no explicit statutory requirement to prepare and maintain transfer pricing documentation. However, it pointed out that it is in the taxpayer's best interest to document how transfer prices have been determined, since this is the best way to demonstrate that transfer prices are consistent with the arm's length principle. It went on to point out that a taxpayer who did not prepare the documentation is at risk on two counts. First, it is more likely that the SARS will examine the transfer pricing in detail and, secondly, if there is an adjustment, the lack of adequate documentation will make it difficult for the taxpayer to rebut the adjustment, either as regards the SARS or in the Tax Court.

Other reasons were given as well. The practice note did, however, also acknowledge that preparing documentation is time-consuming and expensive, and that it was not expected of taxpayers to go to such lengths that the compliance costs were disproportionate to the nature, scope and complexity of the international agreements entered into by taxpayers with connected persons.

Despite this, the tax returns began to call for transfer pricing policies and documentation to be included with the return. The tax return even went so far as to include a question as to whether the company's auditors had reviewed the transfer pricing documentation.

This, coupled with the extent to which the SARS began to undertake transfer pricing audits, not unexpectedly led to advisors urging their clients to have this documentation prepared. The problem is that, as indicated by the SARS itself, this is a comprehensive and expensive exercise, and neither the legislation nor the practice note makes any distinction between large and highly complex groups, and small businesses which happen to transact cross border with connected persons.

Accordingly, on 29 September 2005 the SARS issued an addendum to its practice note. The SARS confirmed that its policy remains that there is no statutory requirement to compile a formal transfer pricing policy document. The requirement to submit such a document with the tax return must therefore be read as a requirement to submit a policy document where the taxpayer has in fact already compiled one. In the event that it has not been compiled, it is sufficient formally to confirm that there is no such document.

Moreover, where a taxpayer has provided full details of the international transactions that it has entered into with connected parties, the absence of formal transfer pricing documentation will not be regarded as non-disclosure. The addendum warns, however, that taxpayers choosing not to prepare documentation must realise that they are at risk and that it may be more difficult to discharge the burd