Transfer Pricing - The Inevitable Outcome of Globalisation and Trade Development

The concept of Transfer Pricing (TP) is an elusive one. For instance, what does TP mean? How is an entity likely to be at risk from a potential TP exposure? Does having a TP exposure mean that I am avoiding tax? If related party transactions are inevitable, what should I do to comply with TP legislation? In a nutshell, “what the hell is it all about?” 

Globalisation and specialisation are some of the reasons for an increasing number of intercompany transactions. With resources, talents and specialisations spread out across the globe and with businesses seeking to efficiently access and utilise them, both cross and intra-border intercompany transactions are inevitable. Some studies indicate that more than 60% of world trade takes place within multinational enterprises (MNEs), and most of these are driven by factors other than tax avoidance. However, this also underpins the importance of transfer pricing. Transactions between third parties are priced at “selling prices” but when the same happens between related parties, they are done at a “transfer price” which may or may not be the same as the “selling price” that would apply between third parties. MNEs will eventually want to generate profits overall but this may not necessarily be the focus for each entity in the chain.

Transfer price is the price which is paid for goods or services between related parties. For management accounting, MNEs have a discretion to some extent on defining how to price and distribute the profits and expenses to the subsidiaries located in various countries. However, for tax purposes, transfer prices should be at arm’s length (i.e. conditions and pricing should be as third parties’) to avoid shifting of profits from high tax jurisdictions to low tax jurisdictions. The arm’s length principle is adopted throughout the world to this effect, as well as in Tanzania as reflected in the Tax Administration (TP) Regulations 2018. 

By way of example, you could have an automotive manufacturing company whose production plant is situated in country A where there is technical know-how and cheap labour but sources inputs (body components, sensors and windshield & auto glass) from related parties residing in countries B, C and D. The company then distributes automobiles through its related party in country E. Transactions between these five entities are driven by cost efficiencies so as to arrive at one transaction with the final customer (i.e. third party); however, if the pricing is not right, then one or more tax authorities will feel short changed and seek to make adjustments (even if there was no tax avoidance motive).  

Recently, inter-company transactions have been facing increased scrutiny by the revenue authorities concerned at potential erosion of the tax base (taxable income) as a consequence of inter-company transactions. However, MNEs are equally concerned - as whilst the concerns of governments are well understood, the MNEs themselves risk possible double taxation where transfer pricing adjustments result in inconsistent treatment of the same transactions in two different countries.   

By way of illustration, suppose that a group operating across East Africa has its Kenya hub charge Tanzania and Uganda $100 each for certain centralised services, so USD 200 in total; in net terms across the three countries, the result is nil (USD 200 income in Kenya offset by expenses of USD 100 in Tanzania and USD 100 in Uganda); then suppose that the Kenya Revenue Authority disputes the USD 200 as under-priced and adjusts the income to USD 220, and at the same time both the Tanzania Revenue Authority and Uganda Revenue Authority dispute the costs arguing that these are overstated - for arguments sake by 25% (so for Tanzania - USD 25 and Uganda - USD 25); the net result would then be double taxation of USD 70 (being the USD 20 adjustment in Kenya, and cumulative USD 50 adjustment for Tanzania and Uganda) - this double taxation would be the result of more income being assessed in Kenya (USD 220) than expense recognised for deduction in Tanzania - USD 75 and Uganda - USD 75 (USD 150 in total). With corporate income tax rates the same (30%), it is unlikely that there could be a tax avoidance motive; but that is not the point - the issue is how can you clearly demonstrate to the local Revenue Authority that it has not been short changed.

Although transactions between local related entities can also give rise to a TP risk, in practice the greatest risk tends to relate to cross-border intercompany transactions. To mitigate this risk it is important to understand transfer pricing as a concept, and reflect this in arm’s length prices and contracts aligned with TP policy; but on its own this is not sufficient as there is a need to ensure that the conduct reflects the contractual terms so as to satisfy the relevant tax authority that there is substance to the policy and related agreements.

The importance of TP documentation is that it is the first opportunity for a business to explain its transactions and pricing to the tax authority in light of its specific circumstances and business realities (as compared perhaps to other businesses in the same sector) and thereby support its argument that its transactions are at arm’s length. In any case, in Tanzania there is a legislative requirement for any entity with intercompany transactions exceeding TZS 10 billion to submit TP documentation with the tax return. And, even if  this threshold is not exceeded, the documentation nevertheless should be in place as TRA have the power to request it, and where they do it must be submitted within 30 days. Otherwise, a TZS 52.5 million penalty for non-submission of TP documentation can apply.  In addition, the lack of such documentation raises the risk that the tax authority will question if sufficient thought has been given to pricing and so ask the question “what the hell is this all about?”, and with that hand them the initiative to tell the affected business’s story as they see it. 

By Omari Nina is a Senior Associate, Tax Services at PwC Tanzania.