How transfer pricing works-
Head Office, parent company, Divisions, branches or subsidiaries of a firm trading amongst themselves will invariably set the prices at which goods and services will be exchanged. The prices need not be the same as the prevailing market prices since they are all members of the same group again transactions of that nature could exclusively be for such group. For instance, a patent could be meant only for companies within the group so no open market price would exist.
The liberty of negotiating prices amongst members of the group creates a huge lacuna for tax evasion which is the most intricate to unearth. For illustration sake let’s consider a US Multinational Necta-US. with a wholly owned subsidiary Ken-Necta based in Kenya. Ken-Necta produces honey in its farms at a cost of $2 per Kilo exclusively meant for export to Necta-US. at $6 a Kilo. Necta-US sells the product in the US local market at $12.
Tax rates are as follows:
United States
Kenya
Income tax rate
21%
30%
Import Duty
10%
Withholding tax
10%
*import duty is deductible for income tax purposes. (Ignore other costs involved in the export)
*Subsidiary repatriates all profits as dividend
The Prices $2 the farming cost and $12 selling price are fixed but $6 is an intra group price so it can be manipulated. Assume the group marks it at $3 this would be the scenario. Assume all other factors constant.
Arm’s Length Price
Negotiated Price
Necta-US
Ken-Necta
Necta-US
Ken-Necta
Sales
12
6
12
3
Purchases/production cost
6
2
3
2
import duty
0.6
0.3
Taxable income
5.4
4
8.7
1
Tax @ applicable rates
1.134
1.2
1.827
0.3
Profits after tax=dividend
4.266
2.8
6.873
0.7
WHT on Dividend
0.28
0.07
Total Tax
1.734
1.48
2.127
0.37
Global Tax
3.214
2.497
Through the above trickery Kenya would be losing a tax of $ 1.11 (1.48 – 0.37) per unit.
TRANSFER PRICING RULES IN KENYA
Section 18(3) of the income tax act CAP 470 creates the legal basis for dealing with transfer pricing in Kenya. According to the subsection
“Where a non-resident person carries on business with a related resident person and the course of such business is such that it produces to the resident person or through its permanent establishment either no profits or less than the ordinary profits which might be expected to accrue from that business if there had been no such relationship, then the gains or profits of such resident person or through its permanent establishment from such business shall be deemed to be of such an amount as might have been expected to accrue if the course of that business had been conducted by independent persons dealing at arm’s length”.
KRA relied on this legislation until they had a day out in court with Unilever. In the aforesaid case Unilever Kenya Ltd and Unilever Uganda Ltd had entered into a contract dated August 28, 1995 whereby the Kenyan unit was to manufacture on behalf of the Unilever Uganda and supply to it such products, as it required in accordance with the orders issued. These goods had been marked up by only 5% between the two companies leading to loss to the Kenyan Company. KRA was of the opinion that the above transactions were meant to avoid tax in line with Section 23 of the act and further that OECD Guidelines could not be applied in Kenya (in violation of transfer pricing rules). Long protracted court battle led to a land mark ruling that “due to the absence of Kenyan transfer pricing legislation, a multinational could not be faulted for using its own recognized transfer pricing principles”. This ruling shaped the transfer pricing rules 2006 which were enacted a couple of months later.
The transfer pricing rules 2006 applicable in Kenya are adopted from the organization for economic development and corporation (OECD) which are applicable in many countries. The rules were created
(a) to provide guidelines to be applied by related enterprises, in determining the arm’s length prices of goods and service in transactions involving them, and
(b) to provide administrative regulations, including the types of records and documentation to be submitted to the Commissioner by a person involved in transfer pricing arrangements
Scope of the rules
(a) Transactions between associated enterprises within a multinational company, where one enterprise is located in, and is subject to tax in, Kenya, and the other is located outside Kenya;
(b) transactions between a permanent establishment and its head office or other related branches, in which case the permanent establishment shall be treated as a distinct and separate enterprise from its head office and related branches.
Transactions subject to TP rules
(a) The sale or purchase of goods;
(b) The sale, purchase or lease of tangible assets;
(c) The transfer, purchase or use of intangible assets;
(d) The provision of services;
(e) The lending or borrowing of money; and
(f) Any other transactions which may affect the profit or loss of the enterprise involved.
THE ARMS LENGTH PRINCIPLE
When independent enterprises transact with each other, the conditions of their commercial and financial relations (e.g. the price of goods transferred or services provided and the conditions of the transfer or provision) ordinarily are determined by market forces. When associated enterprises transact with each other, their commercial and financial relations may not be directly affected by external market forces in the same way, although associated enterprises often seek to replicate the dynamics of market forces in their transactions with each other.
Tax administrations should not automatically assume that associated enterprises have sought to manipulate their profits. There may be a genuine difficulty in accurately determining a market price in the absence of market forces or when adopting a particular commercial strategy. It is important to bear in mind that the need to make adjustments to approximate arm’s length conditions arises irrespective of any contractual obligation undertaken by the parties to pay a particular price or of any intention of the parties to minimize tax.
When transfer pricing does not reflect market forces and the arm’s length principle, the tax liabilities of the associated enterprises and the tax revenues of the host countries could be distorted. Therefore, OECD member countries have agreed that for tax purposes the profits of associated enterprises may be adjusted as necessary to correct any such distortions and thereby ensure that the arm’s length principle is satisfied. OECD member countries consider that an appropriate adjustment is achieved by establishing the conditions of the commercial and financial relations that they would expect to find between independent enterprises in comparable transactions under comparable circumstances.
Statement of the arm’s length principle –
[Where] conditions are made or imposed between the two [associated] enterprises in their commercial or financial relations which differ from those which would be made between independent enterprises, then any profits which would, but for those conditions, have accrued to one of the enterprises, but, by reason of those conditions, have not so accrued, may be included in the profits of that enterprise and taxed accordingly.
COMPARABILITY FACTORS
Comparability analysis” is at the heart of the application of the arm’s length principle. Application of the arm’s length principle is based on a comparison of the conditions in a controlled transaction with the conditions that would have been made had the parties been independent and undertaking a comparable transaction under comparable circumstances.
The economically relevant characteristics or comparability factors that need to be identified in the commercial or financial relations between associated enterprises are broadly categorized as follows
The contractual terms of the transaction – The controlled transactions may have been formalized in written contracts which may reflect the intention of the parties at the time the contract was concluded in relation to aspects of the transaction covered by the contract, including in typical cases the division of responsibilities, obligations and rights, assumption of identified risks, and pricing arrangements. Where a transaction has been formalized by the associated enterprises through written contractual agreements, those agreements provide the starting point for delineating the transaction between them and how the responsibilities, risks, and anticipated outcomes arising from their interaction were intended to be divided at the time of entering into the contract.
Functional analysis – The functions performed by each of the parties to the transaction, taking into account assets used and risks assumed, including how those functions relate to the wider generation of value by the MNE group to which the parties belong, the circumstances surrounding the transaction, and industry practices. The analysis focuses on what the parties actually do and the capabilities they provide. Such activities and capabilities will include decision-making, including decisions about business strategy and risks
The characteristics of propertytransferred or services provided- Differences in the specific characteristics of property or services often account, at least in part, for differences in their value in the open market. Therefore, comparisons of these features may be useful in delineating the transaction and in determining the comparability of controlled and uncontrolled transactions. Characteristics that may be important to consider include the following: in the case of transfers of tangible property, the physical features of the property, its quality and reliability, and the availability and volume of supply; in the case of the provision of services, the nature and extent of the services; and in the case of intangible property, the form of transaction (e.g. licensing or sale), the type of property (e.g. patent, trademark, or know-how), the duration and degree of protection, and the anticipated benefits from the use of the property
The economic circumstances of the parties and of the market in which the parties operate – Economic circumstances that may be relevant to determining market comparability include the geographic location; the size of the markets; the extent of competition in the markets and the relative competitive positions of the buyers and sellers; the availability (risk thereof) of substitute goods and services; the levels of supply and demand in the market as a whole and in particular regions, if relevant; consumer purchasing power; the nature and extent of government regulation of the market; costs of production, including the costs of land, labour, and capital; transport costs; the level of the market (e.g. retail or wholesale); the date and time of transactions; and so forth.
The business strategies pursued by the parties – Business strategies would take into account many aspects of an enterprise, such as innovation and new product development, degree of diversification, risk aversion, assessment of political changes, input of existing and planned labour laws, duration of arrangements, and other factors bearing upon the daily conduct of business. Business strategies also could include market penetration schemes. A taxpayer seeking to penetrate a market or to increase its market share might temporarily charge a price for its product that is lower than the price charged for otherwise comparable products in the same market.
Selection of transfer pricing method
“Traditional transaction methods” and “transactional profit methods” that can be used to establish whether the conditions imposed in the commercial or financial relations between associated enterprises are consistent with the arm’s length principle.
Traditional transaction methods are
the comparable uncontrolled price method or CUP method,
the resale price method, and
The cost plus method.
Transactional profit methods are
the transactional net margin method and
The transactional profit split method.
In addition to the five methods above, the law provides for such other method as may be prescribed by the Commissioner from time to time, where in his opinion and in view of the nature of the transactions, the arm’s length price cannot be determined using any of the methods contained in these guidelines
The selection of a transfer pricing method always aims at finding the most appropriate method for a particular case. For this purpose, the selection process should take account of the respective strengths and weaknesses of the OECD recognized methods; the appropriateness of the method considered in view of the nature of the controlled transaction, determined in particular through a functional analysis; the availability of reliable information (in particular on uncontrolled comparable) needed to apply the selected method and/or other methods; and the degree of comparability between controlled and uncontrolled transactions, including the reliability of comparability adjustments that may be needed to eliminate material differences between them. No one method is suitable in every possible situation, nor is it necessary to prove that a particular method is not suitable under the circumstances.
Traditional transaction methods
Comparable uncontrolled price method (CUP)
Transfer price in a controlled transaction is compared with the prices in an uncontrolled transaction and accurate adjustments made to eliminate material price differences.
CUP requires a very high degree of comparability in products or services.
Illustration
Associate Tea (K) Ltd produces and sell tea to its parent company, Global Tea Inc. at Sh. 85 per Kilo. Associate Tea sells its surplus in the tea auction at Shs.100 per Kilo. In the same market their competitor sales similar type of tea of the quality and quantity at the same stage of production and under similar conditions at Sh. 85 still to the Tea auction.
Transfer price will be determined as follows
For purposes of taxation a comparable uncontrolled price of Sh. 100 shall be considered.
The following factors will be considered in determining whether uncontrolled transaction is comparable.
Quality of the product
Contractual terms
Geographic market in which the transaction takes place
Date of the transaction
Intangible property associated with the sale
Resale price Method
(v) Profit split Method
The transactional profit split method then splits the combined profits between the associated enterprises on an economically valid basis that approximates the division of profits that would have been anticipated between independent enterprises. This method is most appropriate in case of interconnected transactions, unique and valuable intangibles.
There are two types of PSMs:
Contribution analysis: the total profits from the controlled transaction(s) are split between the associated enterprises based on the relative value of their functions performed, assets employed and risks borne participating in the controlled transaction(s).
Residual analysis: requires the allocation of market returns to routine functions based on a functional analysis and the allocation of the residual profit in proportion to the relative value of non-routine contributions (e.g. intangibles) as measured by, for example, expenditures related to development of intangible assets.
Illustration
Architect (UK) Ltd bids and wins a design and build contract which they deliver jointly with their local associate Engineering (K) Ltd. According to construction standards Architects contribute 10% of the work while engineers contribute the remaining. However, Architects (UK) bargains for at least 20% of the profits to set aside for them because of their brand name, what won them the contract. Profits of Sh. 1 billion are realized at the end of the contract.
The profits shall be split as follows
Profits
Sh.1 Billion
Functional share (80%)
Architects UK 10% of 80%
0.08 Billion
Engineering (K) 90% of 80%
0.72 Billion
Residual share (exclusive 20%)
0.2 Billion
TRANSFER PRICING DOCUMENTATION
The Commissioner may, where necessary, request a person to whom these Rules apply for information, including books of accounts and other documents relating to transactions where the transfer pricing is applied
The documents shall include documents relating to –
(a) The selection of the transfer pricing method and the reasons for the selection;
(b) The application of the method, including the calculations made and price adjustment factors considered;
(c) The global organization structure of the enterprise;
(d) The details of the transaction under consideration;
(e) The assumptions, strategies, and policies applied in selecting the method; and
(f) Such other background information as may be necessary regarding the transaction.
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The books of accounts and other documents shall be prepared in, or be translated into, the English language, at the time the transfer price is arrived at.
TRANSFER PRICING PENALTIES
There are no specific transfer pricing penalties. However, the Commissioner for Domestic Taxes can conduct an audit and make adjustments in the taxable profit and demand taxes, where applicable. Any tax due and unpaid in a transfer pricing arrangement is deemed to be an additional tax for the purposes of sections 38 and 84 of the Tax Procedures Act.
Section 84 (2)(b) of the Tax Procedures Act provides that a penalty of 20% shall immediately become due and payable on the tax shortfall after the due date
Section 38 (1) of the Tax Procedures Act provides that a late-payment interest of 1% per month — or part thereof — shall be charged on the tax amount remaining unpaid for more than one month after the due date, until the full amount is recovered
Section 85 of the Tax Procedures Act prescribes a tax avoidance penalty equal to double the amount of tax that would have been avoided
In a resale price method, the resale price margin (i.e. the gross margin) that the reseller earns from the controlled transaction is compared with the gross margin from comparable uncontrolled transactions.
Illustration
Ujenzi (K) Ltd the sole distributor of High density steel bars (HDS) in Kenya receives steel bars from the producer Steelsmith (UK) at undisclosed price. The bars are then sold in the local market at Sh.10, 000 a unit. Gross profit margin of 40% is realized on other Steel bars of the same structural properties. The transfer price will be determined as follows.
Selling price (arm’s length )
10,000
Resale Margin (40%)
(4,000)
Cost of goods (Transfer price)
6000
Note: the firm may indicate that the bars Were acquired at a very high price and declare a loss (iii) Cost price method
This method is most appropriate when there are no comparable uncontrolled sales and the related buyer does not add substantial value or offer routine services on the goods it purchases. The method begins with costs incurred by a manufacturer on goods eventually sold to an associate. An appropriate mark-up is added to the costs which is determined based on the rate earned by suppliers in comparable uncontrolled transactions. The cost plus method considers direct and indirect costs but excludes operating expenses (overheads). This method is useful where the goods or services sold by the manufacturer do not contribute to any intangible asset or assume unusual risks. Manufacturing is usually a routine function especially where the person does not add substantial value or use intangibles.
Illustration
Malcom (K) Ltd produces and sells Gypsum boards to its associate in South Sudan at undisclosed price. It has been established that its raw materials cost Sh. 3000 for every board produced while labor and fabrication costs Sh. 2000 a unit. Marketing and distribution costs amount to Sh. 500 a unit. Its competitors make a mark-up of 30%. The transfer price will be determined as follows
Cost of materials
3000
Other manufacturing costs
2000
Total Manufacturing costs
5000
Mark-up on costs @30%
1500
Transfer price
6500
Overheads (mkt &Distr)
(500)
Profit
1000
Transactional profit methods iv. The Transaction Net Margin Method
The TNMM looks at the net profit margin relative to an appropriate base (e.g. costs, sales, assets) that a taxpayer makes from a controlled transaction. The method Tests the profitability of the related party against the profitability of “comparable” third parties engaged in similar business activities relative to an appropriate base. Profits are compared using profit level indicators (PLIs) which could be operating profit to sales or operating profit to total costs or operating profits to assets
The arm’s length net profit indicator of the taxpayer from the controlled transaction(s) may be determined by reference to the net profit indicator that the same taxpayer earns in comparable uncontrolled transactions (internal comparable’s), or by reference to the net profit indicator earned in comparable transactions by an independent enterprise (external comparables).
Associate Ltd Manufacturers a drug exclusively exported to parent Ltd. Manufacturing cost amount to Sh. 600 while operating expenses amount to Sh. 300. Such a drug is produced and sold by Competitor Ltd at a net profit margin of 10%. What would be the most appropriate transfer price.
Net profit = 10% (uncontrolled comparable)
Total expenses = Sh.900 (600+300) which = 90%
Sales = 100% which is Sh.1000
Transfer price = Sh.1000
The TNMM is a “one-sided” method. The ‘tested party’ is the least complex of the related parties, i.e. performs less functions, has no intangibles, etc.
This method is applied where
there are several varied transactions
Data for traditional transactional methods is limited (uses operating profits)
(v) Profit split Method
The transactional profit split method then splits the combined profits between the associated enterprises on an economically valid basis that approximates the division of profits that would have been anticipated between independent enterprises. This method is most appropriate in case of interconnected transactions, unique and valuable intangibles.
There are two types of PSMs:
Contribution analysis: the total profits from the controlled transaction(s) are split between the associated enterprises based on the relative value of their functions performed, assets employed and risks borne participating in the controlled transaction(s).
Residual analysis: requires the allocation of market returns to routine functions based on a functional analysis and the allocation of the residual profit in proportion to the relative value of non-routine contributions (e.g. intangibles) as measured by, for example, expenditures related to development of intangible assets.
Illustration
Architect (UK) Ltd bids and wins a design and build contract which they deliver jointly with their local associate Engineering (K) Ltd. According to construction standards Architects contribute 10% of the work while engineers contribute the remaining. However, Architects (UK) bargains for at least 20% of the profits to set aside for them because of their brand name, what won them the contract. Profits of Sh. 1 billion are realized at the end of the contract.
The profits shall be split as follows
Profits
Sh.1 Billion
Functional share (80%)
Architects UK 10% of 80%
0.08 Billion
Engineering (K) 90% of 80%
0.72 Billion
Residual share (exclusive 20%)
0.2 Billion
TRANSFER PRICING DOCUMENTATION
The Commissioner may, where necessary, request a person to whom these Rules apply for information, including books of accounts and other documents relating to transactions where the transfer pricing is applied
The documents shall include documents relating to –
(a) The selection of the transfer pricing method and the reasons for the selection;
(b) The application of the method, including the calculations made and price adjustment factors considered;
(c) The global organization structure of the enterprise;
(d) The details of the transaction under consideration;
(e) The assumptions, strategies, and policies applied in selecting the method; and
(f) Such other background information as may be necessary regarding the transaction.
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The books of accounts and other documents shall be prepared in, or be translated into, the English language, at the time the transfer price is arrived at.
TRANSFER PRICING PENALTIES
There are no specific transfer pricing penalties. However, the Commissioner for Domestic Taxes can conduct an audit and make adjustments in the taxable profit and demand taxes, where applicable. Any tax due and unpaid in a transfer pricing arrangement is deemed to be an additional tax for the purposes of sections 38 and 84 of the Tax Procedures Act.
Section 84 (2)(b) of the Tax Procedures Act provides that a penalty of 20% shall immediately become due and payable on the tax shortfall after the due date
Section 38 (1) of the Tax Procedures Act provides that a late-payment interest of 1% per month — or part thereof — shall be charged on the tax amount remaining unpaid for more than one month after the due date, until the full amount is recovered
Section 85 of the Tax Procedures Act prescribes a tax avoidance penalty equal to double the amount of tax that would have been avoided
