New transfer pricing regulations were published in the Government Gazette on 6th April 2018. The new regulations are an expansion of the already existing transfer pricing laws, in the Income Tax Act, and are meant to improve the enforcement of the arm’s length standard in transactions involving associate business entities in order to combat potential profit-shifting between jurisdictions where Multi-National Enterprises (MNEs) operate, and to minimize double taxation disputes.
The new regulations require all businesses whose turnover is K20 million and above to conduct and document arm’s length analysis exercises for each fiscal year to justify the pricing of the products and services traded in during that fiscal year amongst associated businesses. The K20 million threshold does not apply to MNEs and therefore all MNEs are bound by the regulations regardless of turnover.
The new regulations are consistent with and tied to the guidelines contained in the Organization for Economic Co-operation and Development (OECD) Transfer Pricing Guidelines and the United Nations (UN) Practical Manual on Transfer Pricing for Developing Countries.
The transfer pricing documentation requirement is part of the global collaboration to combat “Base Erosion and Profit Shifting” (BEPS). A practice that has seen substantial amounts of tax revenue eluding governments in both developed and developing countries. Countries that implement this standardized documentation and reporting for Multi-national Enterprise (MNE) are required to legislate the reporting requirement in their domestic laws and sign the Multilateral Competent Authority Agreement for the Automatic Exchange of Country-by-Country Reports on income and taxes paid by corporates. Zambia is yet to sign the agreement.
What is Transfer Pricing, is it a Vice?
Transfer pricing is the determination of prices of products and services between related businesses. Businesses are considered to be related if (1) they are controlled by the same person, or persons, (2) one has shares in the other, (3) one is a subsidiary of the other, (4) they are in a partnership or in a joint venture.
There are several factors that influence the pricing of products and services amongst related parties. These include among others:
Therefore, transfer pricing in itself is not a vice, and neither is it a vice to set prices on transactions with related parties at lower or higher than arm’s length price. It is only “toxic” to society when it’s motive is to avoid or evade taxes. However, regardless of what the motive is, it affects the taxes payable by an entity in a tax jurisdiction, and therefore, in every case of transfer pricing, the arm’s length price must be established for taxation purposes. Where it is found that the transfer price for whatever reason is substantially different from arm’s length prices, and therefore amounts to underpayment of taxes in one jurisdiction, adjustments must be made for purposes of computing taxes.
How is Profit Shifting Between Jurisdictions Done and Why?
Profit shifting is done, for example, by overcharging products or services to a member of a group of companies that is in relatively high tax countries, in order to reduce its taxable profit while increasing the profit of the group member that is resident in a low or no tax country. A group member may appear to be underperforming this way, but the arrangement is favorable for the business owners because they make substantial gains by way of avoiding to pay taxes in the relatively high tax country. The hosting, country from which the tax is avoided or evaded, on the other hand, suffers injustice in that it incurs costs to make the economic environment conducive for the MNE to operate and make profit yet the due tax on the MNE’s income, which is needed for a country’s economic development eludes it. Figures 1 and 2 illustrate profits are shifted from one jurisdiction to another and taxes avoided in a controlled price and environment.
Figure 1 depicts a scenario where TP Group of Companies has a manufacturing plant in Hight Tax Country and a headquarters in No Tax Country. At arm’s length transfer prices, the research and development and manufacturing subsidiary of the TP Group of Companies that is resident in Hight Tax Country realizes 10,000,000 per annum for a given volume of supplies to its headquarters in Low Tax Country which performs the marketing distribution and sales functions. Headquarters on the other hand charges the manufacturing subsidiary 3,000,000 for management and other services. Together with other local costs, amounting to 1,000,000 the subsidiary realizes before tax profits of 6,000,000 and pays 35% tax of 2,100,000 to High Tax Country. TP Group of Companies’ after-tax profit from the manufacturing subsidiary is 3,900,000.
Headquarters in No Tax Country sales the imported products from their manufacturing subsidiary in High Tax Country and realizes 15,000,000. It also receives income of 3,000,000 from management and other services charged at arm’s length prices from its subsidiary. Total revenue for Headquarters is therefore 18,000,000. Headquarters imports the finished products at 10,000,000 and incurs local costs of 1,000,000. Headquarters therefore make a profit of 7,000,000 and pays no tax.
Total group profits under arm’s length conditions for TP Group of Companies are 10,900,000 and the group pays a fair tax of 2,100,000 in Hight Tax Country.
If for any of the reasons given above, TP Group of Companies decides to change the transfer pricing policies on management and others services to its subsidiary in Hight Tax Country and increases them to, say, 8,000,000 per annum. The before tax profits for the subsidiary will fall to 1,000,000 as illustrated in figure 2. The profits for headquarters will increase to 12,000,000, and TP Group of Companies as a whole will realize an after-tax profit increase of 1,750,000, to 12,650,000 from 10,900,000 as illustrated in figure 2. At the same time, the tax that will be paid in High Tax Country will fall by the same amount (1,750,000) to 350,000.
In most cases it is the tax avoidance motive that influences MNEs to charge their associated entities lower or higher than arm’s length prices, and for this reason, tax laws of most jurisdictions require that for tax computation purposes, arm’s length prices must be established for purposes of computing taxable income.
How do the New Regulations Affect Taxpayers and Administration?
The new regulations which have been legislated through Statutory Instrument number 24 of 2018, signed by the Minister of Finance Ms. Margarete D. Mwanakatwe on 28th Mach 2018 and published in the Government Gazette on 6th April 2018 are the following.
The businesses that are bound by the Transfer Pricing regulations need to undergo a process of determining and documenting arm’s length prices for all transactions that involve associated parties. Typically, the outcome of the arm’s length price determination processes it a set of records called:
- The Master File
- The Local File; and
- The Country by Country (CbC) Report
The Master File generally contains descriptions of the global business, (1) including products, services, and business strategies, (2) the major entities in the group and what functions they perform; (3) the general categories of controlled transactions that take place within the MNE group, (4) the group’s significant intangible assets and which entities are involved in their creation, management, or enhancement and (5) the group’s financing structure as it relates to transfer pricing. This file is standardized and is filed with tax authorities. It is this file that tax authorities that have adopted the OECD/UN guidelines are required to share with competent authorities of other tax jurisdictions for purposes of checking consistence with declarations of related parties in other countries.
The Local file is prepared for each country in which the MNE does business, and each one will contain (1) a description of the local entity’s business, (2) a description of its transactions with related companies within the MNE group, (3) financial information specific to the local entity, and (4) an economic analysis that provides support for the transfer pricing policies applied to the local entity’s-controlled transactions. The Local file is often varied d to suit to take care of local practicalities of a countries business and legal environment.
A CbC report contains information on the group’s global activities and financial attributes by tax jurisdiction, presented in a consistent format.
The documentation is mandatory and failure to maintain and /or submit the reports attracts penalties and/or imprisonment under the Income Tax Act.
The process of determining arm’s length prices requires analysis of financial records of a lot of taxpayers in similar circumstances and bench marking. It is a laborious process requiring specialized skills and use of computer programs. Affected taxpayers will have to resource their tax departments with Transfer Pricing Skills if they do not already have or seek services of tax consultants.
The Zambia Revenue Authority, being part of the party to the policy of implementing the new regulations has already formed a specialized, transfer pricing audit unit to for undertaking transfer pricing audits.
While this additional requirement introduces both administrative and compliance costs in tax administration, the benefits that are expected from the improved compliance outweigh the losses that may results from implementing it.