Making sense of transfer pricing - what you need to know
Transfer pricing is a concept describing the way related companies i.e. within the same group set prices when they trade with one another across borders. Imagine a South African company that provides services to its subsidiary in Canada. The price it charges for those services is a "transfer price."
Transfer pricing and taxes
Incorrect pricing of goods and services may result in ‘shifting profits’ and reducing overall taxes paid. For example, an Entity A that operates in a high-tax jurisdiction may buy goods at an inflated price from Entity B, a related party in a low-tax jurisdiction. Lowering taxes for Entity A will effectively result in reduced overall taxes between the related parties.
Tax authorities such as SARS put measures in place to ensure that prices charged between related entities across boarder remain fair—not too low or too high—so the right amount of tax is paid in each country. This fairness is based on the arm's length principle, which means the price should be the same as what two unrelated companies would agree upon.
The Rules You Need to Know
The Arm's Length Principle
This is the heart of transfer pricing. It’s like saying, “What would this transaction look like if these companies weren’t related?” Use this principle to evaluate every inter-company transaction.
Example:
A South African firm exports machinery to its Australian subsidiary. The selling price should be comparable to what it would charge an independent customer in Australia.South African Regulations:
Section 31 of the Income Tax Act 58 of 1962 (ITA) allows SARS to adjust prices if transactions aren’t at arm’s length.
SARS Interpretation Note 127 explains how transfer pricing rules apply, especially to loans and financing.
Common Methods to Set Prices
The following methods can be used to identify the correct pricing for the transactions:
Comparable Uncontrolled Price (CUP) compares the price charged to a related party with the price charged to an unrelated party for the same thing.
Cost Plus Method adds a reasonable profit margin to the cost of the product or service.
Resale Price Method starts with the final selling price and work backward to determine a reasonable cost for the related party.
Why Should You Care About Transfer Pricing?
If your clients operate internationally, their transactions must comply with transfer pricing rules. Here’s what can happen if they don’t:
SARS might step in and increase their taxable income.
They could face penalties and interest for underpaid taxes.
The company’s reputation could suffer.
What Happens if SARS Gets Involved?
The case of ABD Limited v SARS shows what can go wrong—and how to protect your clients.
ABD Limited, a South African telecoms company, charged its foreign subsidiaries a 1% royalty for intellectual property. SARS argued this rate was too low and issued additional tax assessments.
Key considerations from the case:
The Tax Court emphasised that transactions should be priced as they would be between independent parties in line with the arm’s length principle.
The taxpayer's ability to defend its pricing policies hinged on comprehensive documentation, transfer pricing studies and reliance on independent expert advice. ABD Limited had a robust transfer pricing study showing the rate was reasonable.
Understanding that SARS may challenge transfer pricing arrangements, especially if they perceive a risk of profit shifting. In the ABD case SARS’s alternative method misinterpreted the nature of the intellectual property, leading the court to side with the company.
How to Apply This Practically
Understand Your Client’s Transactions
Identify any cross-border dealings with related parties.
Categorise them—goods, services, royalties, loans, etc.
Benchmark Pricing
Research market rates for similar transactions.
Use databases or industry reports to find comparable prices.
Look at what other companies charge for similar software in the same market.
Document Everything
Keep agreements, market studies, and pricing justifications.
Update this annually to reflect market changes
Watch for Red Flags
Transactions with subsidiaries in low-tax countries
Big profit discrepancies between related parties in different countries.
Consult When in Doubt
If the transaction involves something complex like intellectual property, consider hiring a transfer pricing expert.
Real-World Scenario
A South African company provides marketing services to its subsidiary in Australia, charging R500,000 per year.
Questions You Need to Ask:
Are the transactions between related parties? A subsidiary would normally fall under the definition of connected persons.
Are the prices charged arm’s length?
How much would an independent marketing agency charge in Australia for the same services? If there are comparable transactions within the industry use the CUP method to benchmark against similar services.
Document how the price was determined and why it’s arm’s length.
Ensure the pricing reflects differences in expertise, location, or scope of work.
Transfer pricing might seem technical, but it boils down to ensuring that related companies deal with each other fairly, just like independent businesses would. As an accountant, your role is critical in helping clients navigate these rules. By understanding the regulations, benchmarking properly, and maintaining solid documentation, you can protect them from unnecessary tax adjustments and penalties while ensuring compliance.
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