This Article is a follow on from the earlier article (Part 1) setting out some of the key considerations which need to be considered in the context of management services, in particular, the requirement for non-residents to register for income tax in South Africa as well as the withholding tax on service fees which comes into effect on 1 January 2016.
As mentioned in Part 1, there has been an increase in focus on cross-border payments in the context of the current focus on base erosion and profit shifting. In this context, management services, in general, have recently become a main focus area of the South African Revenue Service ("SARS") due to the substantial amounts of money flowing from South Africa on an annual basis as payments for management and related fees. Part 2 of this article deals with the transfer pricing, exchange control and value-added tax considerations in relation to cross border service arrangements.
South African transfer pricing rules
Management fees are one of the key focus areas of the Organisation for Economic Cooperation and Development's ("OECD") Base Erosion and Profit Shifting ("BEPS") project, in particular under Action 10 (other high risk transactions), in terms of which the OECD is directed to "[d]evelop rules to prevent BEPS by engaging in transactions which would not, or would only very rarely, occur between third parties. This will involve adopting transfer pricing rules or special measures to provide protection against common types of base eroding payments, such as management fees and head office expenses."
Although South Africa is not a member country of the OECD, it was awarded OECD observer status in 2004. South Africa is also a member of the OECD BEPS Committee and continues to closely follow the guidance contained in the OECD's Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations ("OECD Guidelines") in respect of transfer pricing matters in the absence of specific South African guidance.
Cross border service arrangements between group entities which are connected persons will be subject to the South African transfer pricing rules. On this basis, such arrangements should be entered into on terms and conditions that would have existed had the parties to that transaction been independent persons dealing at arm's length.
The South African transfer pricing rules in essence place an obligation on each party to the services arrangement, which derives a tax benefit, to calculate its taxable income or tax payable as if that services arrangement had been entered into on terms and conditions that would have existed on arm's length basis.
The transfer pricing rules further provide for a secondary adjustment on the basis that any "adjustment amount" (i.e. the difference between the tax payable calculated in accordance with the arm's length principle and otherwise) is deemed to be a dividend consisting of a distribution of an asset in specie declared and paid by the South African taxpayer to the non-resident connected person in the case of resident companies or a deemed donation in the case of resident natural persons or trusts.
According to the OECD Guidelines, which, as noted above, are accepted by SARS as guidance in the absence of specific South African guidance, intra-group services are provided where an activity is performed by a group member for another group member, and such activity provides the recipient with economic and/or commercial value. Intra-group services can encompass a wide array of services including management, administrative, financial, technical and commercial services.
In this regard, paragraph 7.5 of the OECD Guidelines provides that there are two main issues in the analysis of intra-group services for transfer pricing purposes, namely:
- whether an intra-group service that should be charged for, has been provided; and
- what the charge should be in accordance with the arm's length principle.
Definition of intra-group services
As noted above, the OECD Guidelines point out that intra-group services have been provided if an activity is performed by a group member for another group member and such activity provides the recipient with economic or commercial value. This can be determined by considering whether an independent enterprise in comparable circumstances would have been willing to pay for the activity if performed for it by an independent enterprise or would have performed the activity in-house for itself.
If the activity is not one for which the independent enterprise would have been willing to pay or perform for itself, the activity ordinarily should not be considered as an intra-group service under the arm's length principle. In addition, no intra-group service would also be found in the case of activities undertaken by one group member that merely duplicates a service that another group member is already performing for itself or that is being performed for such other group member by a third party.
Definition of shareholder activities
The OECD Guidelines recognise that an intra-group activity may be performed relating to group members, even though those group members do not need the activity (and would not be willing to pay for it if they were independent enterprises).
The OECD Guidelines further state that such an activity would be one that a group member (usually parent of regional holding company) performs solely because of its ownership interest in one or more other group members, i.e. in its capacity as shareholder and that this activity would not justify a charge to the recipient companies and may be referred to as a "shareholder activity".
Determining an arm's length charge for intra-group services provided
Once it has been determined which of the activities performed qualify as intra-group services, it is necessary to consider what an arm's length charge for the intra-group services provided, would be. An arm's length charge should be the charge which would have been made and accepted between independent enterprises in comparable circumstances.
In trying to determine the arm's length price in relation to intra-group services, the matter should be considered both from the perspective of the service provider and from the perspective of the recipient of the service. In this respect, relevant considerations include the value of the service to the recipient, and how much a comparable independent enterprise would be prepared to pay for that service in comparable circumstances, as well as the costs to the service provider.
In most instances, the cost plus method is regarded as the most appropriate transfer pricing method in determining an arm's length charge for intra-group services, and the mark up to be applied is determined through benchmarking the margins achieved by comparable third party service providers. Such benchmarking is generally conducted on databases such as Bureau van Dijk's ORBIS or AMADEUS, or Thomson Reuters' ONESOURCE, either on a gross margin basis applying the cost plus method, or on a net margin basis applying the transactional net margin basis ("TNMM").
Low value-adding intra-group services
The OECD also recently issued draft guidance on low value-adding intra-group services providing, inter alia, that in respect of services qualifying as low value-adding intra-group services as defined by the OECD, no further benchmarking of the intra-group charge would be required and an uniform mark up of between 2% and 5% would be acceptable. According to the OECD, services that are likely to be seen as low value-adding intra-group services, are services which:
- are of a supportive nature;
- are not part of the core business of the multi-national enterprise group;
- do not require the use of unique and valuable intangibles and do not lead to the creation of unique and valuable intangibles; and
- do not involve the assumption or control of substantial or significant risk and do not give rise to the creation of significant risk.
The benefit of this proposed approach is that no expensive benchmarking would be required. However, these services are narrowly defined, and many typical head office services may not fall within these categories. It would therefore still be important to evaluate the head office services provided in detail in order to determine whether same could potentially qualify as so-called low value-adding intra-group services.
It is also unclear whether SARS will follow this guidance, as SARS seems to have indicated that it is not in favour of safe harbours, as can be seen in the Draft Interpretation Note on Thin Capitalisation.
Value-added tax ("VAT")
South Africa applies a reverse VAT mechanism in respect of the supply of imported services. The VAT liability is on the recipient of the imported services. "Imported services" is defined as a supply of services that is made by a supplier who is resident or carries on business outside of South Africa to a recipient who is a resident of South Africa, to the extent that such services are utilized or consumed in South Africa otherwise than for the purpose of making taxable supplies.
Subject to certain exceptions provided for in the VAT Act, it is therefore only services that are imported wholly or partly for private, exempt or other non-taxable purposes that are subject to the reverse VAT charge.
Exchange control rules applicable to cross border service arrangements
Essentially, payments by South African exchange control residents of service fees to non-resident related parties require prior approval from the Financial Surveillance Department of the South African Reserve Bank ("SARB").
This means that a formal application requesting approval for such service fees needs to be prepared and submitted to the SARB for approval. Based on our experience, the SARB generally approves such applications provided, inter alia, the fees are considered to be market-related.
In the context of service fees paid by South African exchange control residents to non-resident unrelated parties, Authorised Dealers (i.e. most commercial banks) may approve applications by resident entities requesting to make payments in respect of consultancy, management and service agreements entered into with non-residents provided that, inter alia, certain requirements are met. These include:
- Authorised Dealers must view, where applicable, the agreement entered into between the parties;
- The non-resident service provider must be an unrelated party i.e. none of the parties have a direct or indirect interest of shareholding in each other;
- The fees to be paid, are based on fixed or actual costs incurred plus, where applicable, a profit margin of up to 10%. It is noted that where fees are calculated on a percentage of turnover or minimum payments need to be effected, an application to the SARB is required in respect thereof;
- The application must be accompanied by documentary evidence confirming the purpose and amount payable.
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.