S.Africa: A South African tax official explains the approach of the South African Revenue Service’s to the transfer pricing treatment of intangibles

SARS Official Sees ‘Backwards’ Analyses

Of Intangibles Transactions by Multinationals
Development: A South African tax official explains the approach of the South African Revenue Service’s to the transfer pricing treatment of intangibles.
Significance: The official says that many multinational groups first focus on selecting their comparables, and then analyze the role of intangibles in the related-party transaction, when they should instead conduct the analysis first.
A South African tax official said multinational groups often have their transfer pricing analysis backwards because they first focus on selecting their comparables and then analyze the role of intangibles in the related-party transaction.
Nishana Gosai, manager, Transfer Pricing (Large Business Centre), South African Revenue Service (SARS) said groups instead should first analyze the transaction then select their comparables.
“From my own experience in South Africa, when it comes to intellectual property, a lot of people think that the starting point is a set of comparables, and whether 6 percent of turnover is the correct amount,” Gosai said.
For SARS, she said, “it is not about that. The comparables, and whether 6 percent is right, or 10 percent is right, comes second to the analysis.”
The tax authority “first wants to understand what it is you are paying the royalty for,” the official said. “What is the IP you are actually getting? What is the value you are getting, and how is it being used to enhance your business?”
Gosai made her remarks April 22 at a meeting of the UN Economic and Social Council (ECOSOC) in New York.
South Africa is one of four developing countries that has set out its own “individual country viewpoint” on transfer pricing practice in Chapter 10 of the 2013 UN transfer pricing manual.
Losses
Gosai said that often when SARS officials start to discuss with taxpayers their transfer pricing treatment of intangibles, “those conversations are not as free-flowing, or smooth, as one would expect.”
During one transfer pricing audit, she said, SARS discovered that a South African entity that had paid a royalty for years to its foreign related party was paying the royalty “for a product that was actually a loss maker. We couldn’t understand why you would pay IP for a product that is a loss maker.”
Gosai said that when the taxpayer representative asked his client, “Why did you hang on to this product?” the taxpayer responded that it was for sentimental reasons.
This, she said, “is a real-life story.”
When a taxpayer is paying a percentage of turnover “for something that is not value generating for sentimental reasons, well and good to you, but as a tax administration, I don’t think we should be giving a deduction for it,” Gosai said.
‘Playing Catchup.’
Gosai said transfer pricing for developing countries is challenging not because those countries do not have the necessary skill sets, but because “we don’t have the quantity of the skill set, and we don’t have the experience that developed countries have. So we are always playing catchup.”
The South African tax official said that in the area of IP, “we are playing catchup on a faster basis, and our learning curve is quite steep.” When a country already faces challenges in routine transactions for goods and services, “your challenge is even more amplified” when it comes to IP.
Fragmentation
Gosai said SARS is seeing cases where IP is fragmented. In one such case, the multinational group charged separate royalties for:

• the visuals on the product box;
• the product itself and some of the innovations around the product components;
• the packaging of the product because “the packaging has unique features that can keep the product fresh”; and
• the product brand name.
Gosai said SARS asked the company about the recipe for the product “because we sort of knew the product was historically a South African developed product.” The company’s response was that the recipe is “really not our value at all” because it is different in different countries.
SARS then asked the company why the brand name was transferred to a related entity offshore and was told that entity was “the first to register it.” Any group entity can register a brand name anywhere, and the company that registers the brand name first is the legal owner, the company told the tax authority.
‘Gobsmacked.’
The case, Gosai said, illustrates the kind of complexity that tax authorities face when dealing with IP issues.
“We were gobsmacked,” she said. Surely a multinational group would know were one of its brand names has originated, she said, so why would a group entity race to register a brand name without informing the rest of the group? According to Gosai, SARS did not get satisfactory answers to these questions.
Advisers
The advisers in the case also struggled to value the different components of IP, the SARS official said. In their correspondence to the company, the advisers said it was unclear where the IP was owned, how it was developed and which entity developed and promoted the IP.
Gosai said the IP “seems to be sitting all over the world, and in different entities, and not necessarily in a centralized IP hub.”
If the advisers were struggling to value the IP and the company does not have the necessary information, Gosai asked, “how can we as tax authorities even make a determination?”
In this case, she said, “6 percent versus 8 percent is of little consequence because we don’t even know if we are analyzing the correct transaction or the correct IP.”
Crown Jewels
Gosai said one issue SARS is struggling with is why a company ever would sell IP that gives it a competitive advantage. OECD transfer pricing guidelines, she noted, acknowledge that some transactions will take place only within the context of a multinational group.
“When it comes to IP, we struggle with that because at arm’s length, nobody would ever have sold the IP to any third party, especially if it helps a company maintain its competitive position.”
Although migrating IP offshore within a multinational group does not result in the income stream from the IP being lost to the multinational group, it does result in loss of revenue to the tax administration.
Capacity Building
Developing countries need to develop their capability and capacity quickly in order to deal with complex transfer pricing IP issues, Gosai said.
“The need is now,” she said. “The need is critical and it is urgent.”
South Africa is building in-house transfer pricing capability and is coordinating with external experts who will help the tax authority understand IP transactions “not only in a South African context, but in a global context.”
Gosai said the asymmetry of information between tax administrations and taxpayers leads to protracted and unnecessary disputes. If SARS got the right information, “that would go a long way to understanding IP better, and to resolving disputes and maybe creating less adversarial audits for a taxpayers and a tax administration.”
However, SARS does not get the information it asks for, she asserted; rather, it gets the information the taxpayer wants to provide.
In some cases, she said, “we have asked taxpayers to give us their valuation study and contract of sale; three years later and we have not had sight of that.”
Legacy Issues
Gosai said South Africa still is dealing with IP legacy issues resulting from apartheid.
During apartheid, SARS allowed many companies to migrate their IP offshore to participate in international trade while avoiding international sanctions.
“These agreements were done on a specific basis, for a specific time, and there were specific checks and balances” to ensure “that the money comes back to South Africa.”
However, Gosai said that after apartheid, many companies “stopped realizing that the money needed to come back. So the IP has stayed offshore, but the royalties don’t come back to South Africa.”
Gosai said South Africa still is dealing with this issue “20 years post-democracy. Paperwork, people, memories have all lapsed.”
Base Erosion
Gosai said taxpayers’ transfer pricing treatment of IP results in base eroding payment for South Africa.
“We have spoken to our reserve bank who have managed to give us statistics around royalty payments over a period of time, and it amounts to billions of rands that have left the country over a five- to 10-year period.”
To contact the reporter on this story: Kevin A. Bell in Washington at kbell@bna.com
To contact the editor responsible for this story: Molly Moses at mmoses@bna.com