CURBING TRANSFER PRICING MANIPULATION IN SOUTH AFRICA: LESSONS FROM SELECTED JURISDICTIONS by ABEL MABAWUZENI MBOWENI STUDENT NUMBER: 12289711 submitted to the Faculty of Law in accordance with the requirements for the degree of DOCTOR OF LAWS (LLD) at the UNIVERSITY OF PRETORIA SUPERVISOR: Dr BT KUJINGA DECLARATION I declare that “CURBING TRANSFER PRICING MANIPULATION IN SOUTH AFRICA: LESSONS FROM SELECTED JURISDICTIONS” is my own work and that all the sources that I have used or quoted have been indicated and acknowledged by means of complete references. ________________________ _____________________ SIGNATURE DATE (Mr) i ACKNOWLEDGEMENTS The fear of God is the beginning of all wisdom. Let me give glory and exaltations Him the creator of all things. I would not have succeeded with this work had it not been for the love and unwavering support of the following people: My wife Ausie, for your patience and support throughout this long, arduous and winding road. Your prayers were a pillar of strength when I felt weak and thought of throwing the towel. Thank you very much. My children, Singi and Mimi- thanks for understanding when I sometimes did not have time to be with you. Your patience and innocent smiles kept me going. I owe you my success; this one is for you my angels. My parents thank you for your love and guidance I would not be the man that I am today had it not been for you. Inkomu Vacanyi. All my siblings thank you for your support. My twin brother Lawrence, we are in this together. My brother in law, Khumbula Masinge, your computer skills are beyond measure. Thank you very much for your patience and unquestionable support. You have been the mainstay of my success. This thesis would not have seen the light of day had not been for you. Khanimambo. Sibongile Dhlamini, your incisive and intelligent comments, your ability to see my blindspots is what made this thesis a masterpiece that it is. I am indebted to you. Bayete! The SARS library staff, Antoinette de Beer and Lisa Letoaba, thanks for your patience, and support. You are heavenly sent. Last but not least, Dr BT Kujinga, your patience, understanding, guidance, constructive criticism and expert knowledge in the field of tax, I will forever be grateful to you. Thank you very much, Doc. SOLI DEO GLORIA ii SUMMARY Transfer pricing manipulation is a worldwide problem which results in a massive loss of revenue which is meant to finance government socio-economic programmes. South Africa is not immune to this problem. South Africa is losing billions of Rands in tax revenue due to this scourge. This research is an attempt to find ways and means which can be employed to combat or control the problem. In order to find the envisaged solutions, this research investigates the causes of the problem by analysing the weaknesses and the strong points of the arm’s length principle which is the basis of transfer pricing practice in South Africa and elsewhere. The research also investigates and analyses the corporate reasons for Multinational Enterprises (MNEs) to engage in transfer pricing with a view to demonstrating that transfer pricing is a neutral tax avoidance concept if it is applied for genuine business considerations. The investigation also entails analysing the legal framework of transfer pricing in South Africa which is embodied in section 31 of the Income Tax Act 58 of 1962. The research analyses the efficacy of section 31 in dealing with the sophisticated transfer pricing manipulation schemes. In addition, an extensive reference to the Organisation for Economic Co-operation and Development (OECD) Transfer Pricing Guidelines is made as South Africa relies heavily on the guidelines. A comparative analysis of selected topics is also conducted with the United States (US) and India with a view to drawing lessons from those jurisdictions. Based on the outcome of the analysis and the lessons drawn from the comparative analysis, findings are presented followed by legislative proposals or recommendations which will help to eradicate the problem. It is hoped that implementation of the recommendations taking into account the socio-economic conditions of South Africa will help to deal with the problem. iii KEYWORDS Advance Pricing Arrangements Arm’s Length Principle Arm’s Length Range Associated Enterprise Connected Persons Comparability Analysis Comparable Uncontrolled Price Method Contribution Analysis Cost Plus Method Formulary Apportionment Method Impermissible Tax Avoidance Independent Enterprises International Transactions Multinational Enterprises Mutual Agreement Procedure Profit Split Method Resale Price Method Tax Avoidance Tax Planning Thin Capitalisation Transfer Pricing Manipulation Transfer Pricing Methods iv CONTENTS DECLARATION .................................................................................................................................................. i ACKNOWLEDGEMENTS ................................................................................................................................... ii SUMMARY ...................................................................................................................................................... iii KEYWORDS ..................................................................................................................................................... iv CHAPTER 1 ...................................................................................................................................................... 1 INTRODUCTORY CHAPTER .............................................................................................................................. 1 1.1 Background: The Transfer Pricing Concept ..................................................................................... 1 1.1.1 Example of a Transfer Pricing Transaction .................................................................................. 2 1.2 Historical Overview of Transfer Pricing Regulation ......................................................................... 3 1.3 Transfer Pricing Manipulation ......................................................................................................... 5 1.4 Thin Capitalisation ........................................................................................................................... 6 1.5 Problem Statement ......................................................................................................................... 7 1.6 Research Questions ......................................................................................................................... 8 1.7 Methodology ................................................................................................................................... 9 1.8 Scope of the Study ........................................................................................................................... 9 1.9 Outline of the Chapters ................................................................................................................. 10 CHAPTER 2 .................................................................................................................................................... 13 THE ARM’S LENGTH PRINCIPLE AND TAX PLANNING CONCEPTS ................................................................. 13 2.1 Introduction ................................................................................................................................... 13 2.2 The Arm’s Length Principle ............................................................................................................ 13 2.2.1 The Arm’s Length Principle as Basis for Transfer Pricing .......................................................... 13 2.2.2 Historical Overview of the Arm’s Length Principle .................................................................... 14 2.3 The Features of the Arm’s Length Principle .................................................................................. 15 2.3.1 Comparability ............................................................................................................................ 15 2.3.2 Functional Analysis .................................................................................................................... 17 2.3.3 Transactional Feature ................................................................................................................ 18 2.3.4 Open Market Feature ................................................................................................................ 19 2.4 The Advantages of the Arm’s Length Principle ............................................................................. 19 2.5 Problems Associated with the Application of the Arm’s Length Principle .................................... 20 2.5.1 Difficult to Apply in Some Cases Involving Intangibles .............................................................. 20 2.5.2 Failure to Differentiate Profits made by Related and Unrelated Parties .................................. 21 2.5.3 Treating Related Companies as Though they were Unrelated ................................................. 22 v 2.5.4 The Administrative Burden of Using the Arm’s Length Principle .............................................. 24 2.6 Tax Avoidance ................................................................................................................................ 25 2.6.1 Permissible Tax Avoidance .......................................................................................................