In the case of ABC (Pty) Ltd and the Commissioner for the South African Revenue Service, the Tax Court was confronted with the interpretation of section 31(2) of the Income Tax Act 58 of 1962 (the “ITA”), concerning transfer pricing and the scope of the Commissioner and SARS powers in this regard. Although the court was tasked with determining whether a separation of issues was called for in terms of Rule 33(4) of the Uniform Rules of Court, the court opined on certain aspects of the South African transfer pricing rules.
The lesson to be learned from this judgment is that due to the uncertainty in relation to the application of section 31(2) of the ITA, a taxpayer is best suited to conduct proper benchmarking of its transactions which may qualify as affected transactions and to ensure that the terms and conditions of those transactions meet the ‘arm’s length standard’.
Legal background and Facts of the case:
The Taxpayer was involved in manufacturing, importing, and selling chemical products. In the manufacturing process, certain precious metals (“PGM/s”) are required, which the Taxpayer purchases from a connected Swiss Entity (the “Swiss Entity”). Once the manufacturing process is complete, the finished products are sold to customers in South Africa.
In 2014, SARS carried out an audit in respect of the Taxpayer’s 2011 year of assessment. Subsequently, SARS raised an additional assessment to effect an adjustment it had made to the Taxpayer’s taxable income. In its letter of audit findings dated 22 October 2015, SARS stated that the transactions involving the purchase of the precious metals between the Taxpayer and the Swiss Entity did not meet the arm’s length standard as required by section 31(2) of the ITA. On the strength of the recommendations set out in OECD Transfer Pricing Guidelines (“TPGs”) and SARS’ Practice Note 7 (“PN 7”), which flow directly from the TPGs, SARS adjusted the Taxpayer’s taxable income upwards.
The Taxpayer applied to the Tax Court for separation of issues. The Taxpayer contended that section 31(2) only permitted the Commissioner to adjust the consideration in respect of the transactions between it and the Swiss Entity to reflect an arm’s length price in the event that it had been factually established that the transactions did not take place at arm’s length, and did not permit an adjustment of the consideration between the Taxpayer and third parties. Therefore SARS’ adjustment of the Taxpayer’s profits was not a legitimate exercise of transfer pricing power authorized by section 31(2) of the ITA, and consequently, the additional assessment was legally impermissible.
The Commissioner argued that based on the Taxpayer’s reliance on a specific method in testing the arm’s length nature of the relevant transactions, the Taxpayer accepted that in the course of testing the arm’s length nature of the transactions with the Swiss Entity, the Commissioner was required to test the Taxpayer’s profitability. The Commissioner further argued that the Taxpayer’s reference to the authoritative statement of the arm’s length principle meant the Taxpayer accepted that profits which would have accrued to it, but for the transaction which was not at arm’s length, may be included in its profits and be taxed accordingly.
Furthermore, it must be noted that in testing the arm’s length nature and effecting the adjustment, the Commissioner placed reliance on the TPGs and PN 7. The Taxpayer argued that section 31 makes no reference to the TPGs nor PN 7, and further stated that South Africa is not a member of the OECD, nor do the TPGs have any legal status and therefore, the powers afforded to the Commissioner by section 31(2) must be established only by reference to the statute itself.
Court’s decision and commentary on S31(2)
The court, although not dealing with the merits, had regard to three foreign cases and came to the conclusion that ‘regardless of what method has been used to determine the arm’s length consideration, ultimately, adjustments are made to the profits of the taxpayer to ensure that tax is levied on the correct amount of taxable income’.
The court agreed with the Commissioner that the point to be separated had no cogency. The court supported this conclusion by indicating that the Taxpayer had not made any practical suggestions on how the adjustment ought to have been made in order to determine its taxable income.
The court thereafter considered the taxpayer’s argument that the powers afforded to the Commissioner must be determined with reference to the ITA itself and that no reference should be had to PN 7 or the TPGs. The court agreed with SARS that in relying on PN 7 and the TPGs in its own argument, the Taxpayer effectively indicated that the authority of the two sources is relied on and recognized by both parties. The court accordingly rejected the Taxpayer’s reliance on the Constitutional Court’s judgement in Marshall and Others v Commissioner, South African Revenue Service, where the Constitutional Court held that the use of a unilateral practice of one part of the executive arm of government in the determination of the reasonable meaning to be given to a statutory provision should best be avoided. The court supported this conclusion by indicating that PN7 and the TPGs were materials known to the person responsible for section 31 and may therefore legitimately be used to interpret the section and as the taxpayer relied on these documents in its pleadings it could not divorce itself therefrom.
Reference was also made to the Davis Tax Commission’s Base Erosion and Profit Shifting sub-committee Report (“BEPS Report”), which notes that South Africa is the only African member of the G20, and although not a member of the OECD, South Africa is a member of OECD BEPS Committee. The report further notes that due to this combination of being a major power on the continent and forming part of the OECD in some way it is within South Africa’s interest to “set the ‘tone’ in Africa around key OECD recommendations on BEPS”.
The court opined that, in order to overcome challenges brought about by base erosion and profit shifting it is necessary for countries to adhere to and observe the TPGs, and that international case law reflects that many countries apply the TPGs in their tax law judgments.
Finally, the court held that “there is no gainsaying that TPGs are a world standard in Transfer Pricing matters”, and that the Taxpayer’s attack on SARS’ reliance on the TPGs and PN 7 did not advance or prove its case that an order of separation of issues should be made and to do so would be a waste of resources.
The court concluded by making the following statement:
- The establishment of the arm’s length nature of a transaction is the first step in transfer pricing matters and it involves a factual inquiry which culminates in a decision being made as to which of the methods endorsed by PN 7 is to be employed. Applicant is also wrong in its submission that the question of respondent’s powers – in terms of section 31(2) – can be determined without reference to the merits or to the question of whether the PGM transactions were or were not at arm’s length. As respondent puts it, the question of adjustment does not even arise prior to determining the arm’s length nature of a transaction.
The court’s reasoning seems to suggest that it is open to the Commissioner to reassess the overall profits of the taxpayer, irrespective of the nature of the separate transactions which generated such profits. Although the court was not tasked with pronouncing on the application of section 31(2) itself, the reasoning of the court leaves much to be desired.
The court at no point substantially deals with the actual words used in section 31(2) and whether the Commissioner has the power to reassess a taxpayer in relation to a transaction that does not qualify as an affected transaction and which is not subject to section 31(2). Reference is rather made to foreign judgements and ancillary documents like PN7 and the TPGs. The court’s reliance on these documents is questionable. The Taxpayer’s reliance on PN7 in relation to a valid method of determining the arm’s length nature of a transaction, cannot be deemed to be a binding acceptance by a Taxpayer of all the provisions of that document and can further not dictate how a court should interpret a provision of a statute.
The court quotes Natal Joint Municipal Pension Fund v Endumeni Municipality as support for its conclusions, but seems to overlook an important warning by Wallis J in this judgement, that when interpreting legislation:
judges must be alert to, and guard against, the temptation to substitute what they regard as reasonable, sensible or businesslike for the words actually used. To do so in regard to a statute or statutory instrument is to cross the divide between interpretation and legislation…The ‘inevitable point of departure is the language of the provision itself’.
It is hopeful that when this matter is heard by the Tax Court to determine the merits of the appeal, the court will provide more clarity on the nature of the Commissioner’s powers in terms of section 31(2) of the ITA.