TRANSFER PRICING, BASE EROSION, PROFIT SHIFTING AND THE

EXTRACTIVE INDUSTRY SECTOR

19 November 2014

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CONTENTS

• What is transfer pricing? • Transfer mispricing • Global issue • Global response • BEPS Actions • BEPS Outcomes - 2014 • South African response • International forums • Extractive industry sector • Where to from here? • Importance of balance • Closing remarks

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WHAT IS TRANSFER PRICING?

• The price at which entities within a multinational enterprise (“MNE”) transact with each other for transfer of goods and services is known as a “transfer price”

• Goods and services have a wide meaning; includes tangible and intangible property, granting of financial assistance, granting of guarantees, cessions, etc.

• Setting transfer prices or “transfer pricing” is important because, according to UNCTAD, over 60% of world trade is within or involves MNEs

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TRANSFER MISPRICING (1)

• Due to their relationship, entities in MNEs have the ability to distort transfer prices and ultimately profits reflected in particular jurisdictions, thereby eroding the tax base and depriving countries of their correct share of taxes

• For this reason tax administrations have cause for concern where transfer prices are incorrect or mispriced

• Transfer pricing is thus an essential feature of cross-border activities of MNEs and its outcomes may be perfectly acceptable but “transfer mispricing” is not!

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TRANSFER MISPRICING (2)

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Sale of product

• Market price of product R50

• Transfer price used R30

• Costs R20

Tax Payable

• Income tax payable on market price profit R8.4 (30x28%)

• Income tax payable on transfer price profit R2.8 (10x28%)

• Net income tax loss to South Africa R5.6

Other Fees to Review

• 5 % Marketing fee charged on transfer price R0.5

• 20% Royalty fee charged on transfer price R2

• Total amount deductible from South Africa R2.5

GLOBAL ISSUE

• Global financial crisis put spotlight on declining tax revenues

– Apple (Used technicalities in Irish & American law to pay little or no corporate tax on at least $74bn over the past 4 years)

– Caterpillar (Didn’t change its business but used its corporate structure to attribute 85% of its parts profits to a Swiss subsidiary, reducing its tax contribution by $2.4bn)

– Google (2.4% tax rate on non-US profit compared to US rate of 35%)

– Microsoft (Senate investigation found it reduced its tax bill by 44% -US$2.43bn by using an international network of controlled foreign corporations and the exploitation of various loopholes in the US corporate tax code)

• Increasing burden on ordinary citizens to cover tax shortfall

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GLOBAL RESPONSE

• G20/OECD launched Base Erosion and Profit Shifting (BEPS) Action Plan in July 2013, which aims at addressing mismatches, gaps and weaknesses in international tax and treaty law that permit double non-taxation

• Focus is on transfer pricing, transparency (country-by-country reporting) and other aspects affecting international taxation (treaties, controlled foreign company rules, hybrids, etc.)

• Of 15 action items in the BEPS Action Plan, 4 are directly related (**) to transfer pricing and a further 5 action items may impact (*) on transfer pricing

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BEPS ACTIONS (1)

Action 1 * Address the tax challenges of the digital economy (Sept 2014)

Action 2 * Neutralise the effects of hybrid mismatch arrangements (Sept 2014)

Action 3 * Develop recommendations regarding the design of CFC rules (Sept 2015)

Action 4 * Limit base erosion via interest deductions/ other financial payments (Dec 2015)

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BEPS ACTIONS (2)

Action 5 Counter harmful tax practices Incl. compulsory spontaneous exchange of rulings (Sept 2014 – Dec 2015)

Action 6 Prevent treaty abuse Action 7 * Prevent artificial avoidance of PE status (Sept 2015) Action 8 ** Ensure that profits associated with the transfer and

use of intangibles are appropriately allocated in accordance with value creation (Sept 2014 – Sept 2015)

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BEPS ACTIONS (3)

Action 9 ** Prevent BEPS by transferring risks or allocating excessive capital to group members, align returns with value creation (Sept 2014 – Dec 2014)

Action 10 ** Other high risk transactions, re-characterise transactions, management fees & head office expenses (Sept 2015)

Action 11 Establish methodologies to collect & analyse data on BEPS (Sept 2015)

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BEPS ACTIONS (4)

Action 12 Recommendations for mandatory disclosure rules for aggressive tax planning & design model for exchange of information on tax schemes between tax administrations (Sept 2015)

Action 13 ** Re-examine transfer pricing documentation and incl.

CBCR (Sept 2014) Action 14 Make dispute resolution mechanisms more effective

(Sept 2015) Action 15 Develop a multilateral instrument (Dec 2015)

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BEPS OUTCOMES - 2014

• Outcomes on 7 of the actions were presented to G20 Finance Ministers in September 2014, with remaining outcomes scheduled for 2015

• Outcomes on 2 of the actions directly related to transfer pricing – intangibles and country-by-country reporting

• Finance Ministers endorsed outcomes and mandated OECD and Global Forum on Transparency and Exchange of Information to:

– develop toolkits to support developing countries addressing BEPS

– launch pilot projects to assist developing countries to move towards automatic exchange of information

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SOUTH AFRICAN RESPONSE (1)

BEPS SOUTH AFRICA Digital economy VAT Act s1 definition of “electronic services”: 2013

Regulations : 2014

Hybrid instruments ITA ss8E & 8EA : 2012

CFCs ITA s9D : 1997

Interest limitation ITA ss23K, 23M, 23N : 2011 - 14

Transfer pricing ITA s31 : 1995

Mandatory disclosure ITA s76A : 2003

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SOUTH AFRICAN RESPONSE (2)

• Legislative Response: Introduced transfer pricing legislation in 1995; most recent amendments in principle in 2011 and 2014

• Section 31 of Income Tax Act, 1962, provides that transfer prices must be at arm’s length (i.e. MNE entities need to transact at terms and conditions that would have prevailed had they been independent of each other); SARS may adjust if not (primary adjustment)

• Arm’s length principle is rooted in Article 9 of double tax agreements and guidance at a generic and transactional level on its application is contained in OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations

• Section 31 goes further than many jurisdictions; 2012 – 2014 excess funds flowing offshore treated as interest bearing loans, from 2015 as taxable dividends in specie or donations (secondary adjustment)

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SOUTH AFRICAN RESPONSE (3)

• SARS Response: Transfer pricing unit established at Large Business Centre

• Audits require scarce skills; are resource and fact intensive, requiring understanding of company, industry, global value chain, strategic decision making, business models, etc. and so take at least 18 months

• As a result of limited resources a focus on strategic auditing – high risk, high value transactions

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SOUTH AFRICAN RESPONSE (4)

• Over last 3 years the transfer pricing unit has audited

more than 30 cases and has made transfer pricing of

just over R20 billion, at a conservative measure, with

an income tax impact of over R5 billion

• A similar number of cases are currently in progress

and others are in the process of being risk assessed

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SOUTH AFRICAN RESPONSE (5)

• Part of the solution to transfer mispricing involves keeping abreast of international best practice and active participation in international forums to ensure that South Africa’s issues are taken into account

• At an international level SARS is working with the OECD, United Nations, African Tax Administration Forum, World Bank and IBSA

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INTERNATIONAL FORUMS OECD United Nations World Bank ATAF IBSA

Committee on Fiscal Affairs: Working Parties e.g. WP1 (tax treaties), WP6 (transfer pricing), and WP11 (tax avoidance)

Sub-Committee on Transfer Pricing – update of the guide – UN Practical Manual on Transfer Pricing for Developing Countries

Transfer Pricing in Mining: An African Perspective (compilation of a guide book for African tax administrations conduct transfer pricing audits in the mining sector.

BEPS Technical Working Group

Technical workshops and sharing of best practice

Task Force on Tax and Development

Ad-hoc capacity building

Global Forum on Exchange of Information

BEPS Project

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EXTRACTIVE INDUSTRY SECTOR

• The dynamics of transfer mispricing in the extractive industry sector is no different to any other sector and the industry is not the sole cause for concern

• Due to the size and significance of the extractive industry sector in South Africa, it remains a key focus area for SARS

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WHERE TO FROM HERE? (1)

• SARS takes protection of South African tax base seriously

• Ongoing focus on strengthening SARS capacity and capability

• Ongoing dialogue with MNEs on levels of tax compliance

• Continual review of audit and risk assessment processes – quest for improvement, automation and modernisation

• Continuing participation in OECD, UN, ATAF, the World Bank and IBSA

• Ongoing co-operation with other tax administrations and review of international approaches to the extractive industry

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WHERE TO FROM HERE? (2)

• Collaboration with National Treasury and the Davis Tax Committee – post-BEPS actions and implementation

• Legislative requirement for MNEs to maintain specific transfer pricing documentation to be considered

• Legislative measures to underpin outcomes of BEPS Action Plan (e.g. country-by-country reporting) to be considered

• Legislative framework for Advance Pricing Agreements (APAs) system – advance agreement on transfer pricing between tax authority and taxpayer – to alleviate enforcement burden and encourage compliance to be considered

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IMPORTANCE OF BALANCE

• Whilst there is no denying the significance of transfer mispricing, it is vitally important that South Africa responds in a manner that is balanced and which does not pose a deterrent to foreign direct investment

• Key considerations for investors and MNEs are tax systems that are broadly consistent with international norms and offer certainty

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CLOSING REMARKS (1)

• Still much that needs to be done

• Increasing capability, tighter legislation, greater taxpayer co-operation and more advanced systems are some of the immediate challenges

• Transfer pricing audits do not yield quick and certain results and are complex, resource and time intensive

• There is no easy solution and SARS has to work within the confines of both domestic and international law

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CLOSING REMARKS (2)

“Tax is the price of civilisation, transfer pricing is the price of globalisation”

(adapted from “Transfer pricing, tax havens and global governance”, by Ganapati Bhat)

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Questions?