Tax authorities more demanding on transfer pricing compliance within the financial services arena

Although most organisations’ treasury teams have an in-depth understanding of financial transactions, they may not be fully up-to-date with transfer pricing (TP) compliance and this may expose them to risk.

“Times have changed with regard to TP and tax authorities are now demanding much more documentary evidence of arm’s length pricing of related party transactions,” says Jeannè Havinga, associate director Tax Services, PwC South Africa.

“A typical example is a guarantee provided by a holding company to a subsidiary. Traditionally, the subsidiary would ask a local bank for an indicative rate that the bank would charge them for a similar guarantee amount – in other words, similar to the guarantee fee amount and for the same duration that their holding company was providing,” continues Havinga.

This bank quote (usually informally e-mailed to the subsidiary) would then be used by the subsidiary as a comparable uncontrolled price (CUP) to prove to a tax authority that the fee they were being charged by their holding company was arm’s length.

“Today, this quote typically wouldn’t be enough. The view of many tax authorities is that these types of CUP’s are not reliable unless the subsidiary has documentary evidence that the bank providing the quote had undertaken a detailed financial screening of the subsidiary and the quote provided to the subsidiary has actually been approved by the bank’s management approval committee,” says Havinga.

In South Africa, foreign South African Reserve Bank (SARB) regulations require that foreign loans be approved by the SARB. Typically, taxpayers would argue that if the SARB approved the loan, then it automatically followed that the interest on the loan was acceptable, but this is not sufficient for transfer pricing.

“The Reserve Bank does not have transfer pricing expertise and is not required to have transfer pricing expertise. The fact that the SARB approved the loan does not mean that the interest on the loan complies with the arms length principle – although some of the supporting arguments justifying the nature and purpose of the foreign loan may be used to support the arm’s length nature of the interest on the loan,” Havinga.

Common pitfalls for companies trying to validate that the pricing of their loans are arm’s length include no stand-alone credit rating for the borrower or using one blended interest rate for all transactions.

“Companies also often include flexibility, such as call or pre-payment options, without considering the impact of such options on the interest rate being applied,” she says. “Companies also tend to use one-page e-mails as loan documents which do not refer to any approval by the relevant management committees and which do not recognise or address foreign exchange risk or operational substance of the applicant.”

Havinga says that red flags for South African Revenue Services (SARS) include a lack of consideration for withholding taxes and interest-free loans, particularly if the company is loss-making.

“Providing group companies with interest-free loans without any reference or substantiation as to the purpose of such loans can put companies at risk from a TP perspective,” she says “especially in later years when the company is assessed and the persons initially involved in the decision to extend the loan are no longer available to discuss the details of the loan with the tax authority.”

SARS is also on the lookout for longstanding, non-fluctuating current account balances and guarantees provided with no remuneration to the guarantor. “The Revenue Services would typically review the company’s annual financial statements and request a schedule to show the accrual and balance in order to support any statement by a taxpayer that interest has been paid during the specific period under review.”

Yet another red flag is long-term funding within cash pools. For TP purposes, companies would be expected to maintain full documentation covering market conditions and their reactions to such market conditions, for example how they dealt with excess cash at close of business.  

“SARS will typically conduct what almost amounts to an opportunity cost analysis,” says Havinga.  “This opportunity cost analysis would simply ask the taxpayer what other options the taxpayer had at the time - had they not conducted business with a related party.”

The building blocks of an arm’s length loan include creditworthiness, terms and conditions, volume and interest rate.

“To determine an arm’s length range of interest rates it is necessary to understand the creditworthiness of the borrowing entity on a stand-alone basis,” says Havinga. “In accordance with OECD guidelines, it is also necessary to ensure that the terms and conditions associated with the transaction are compliant with the arm’s length principle.”  

As far as volume is concerned, in addition to the interest rate, consideration should also be given to whether the borrowing entity could have raised equivalent debt from a third party and also if the borrowing entity would have entered into such a transaction.

Establishing a robust range of arms length interest rates is also critical, taking into consideration the creditworthiness of the borrower, terms and conditions, and the volume of the loan.  The interest rate should typically be tested against third party sources such as Dealscan and Bloomberg to ensure an arm’s length rate is applied to the financial transaction at hand.