Economic substance? ‘Show, don’t tell!’
By Agnes Koni
Do you have boots on the ground?” is a military idiom which refers to having active troops who are physically present and fighting in a war zone. Multinational enterprises (MNEs) are not armies, but the “troops on the ground” question is one that revenue authorities might raise when querying “economic substance”. In particular, do they have real business operations and significant people who are decision makers and actively engaged in the business as well as in controlling the associated significant risks, as opposed to having a “shell” with registered addresses but no employees or operations. The Organisation for Economic Co-operation and Development Transfer Pricing Guidelines (OECD TP Guidelines) view economic substance as the economically significant activities, people functions and responsibilities, assets and risks of the parties in order to determine where and how value is created.
As the importance of transfer pricing (TP) is increasingly appreciated, the focus for many MNEs has traditionally been complying with the TP documentation requirements based on the arm’s length principle especially when their related party transactions exceed a certain statutory threshold. For instance, in Tanzania there is a legislative requirement for MNEs with inter-company transactions exceeding Sh10 billion to submit a contemporaneous TP documentation with the income tax return. The TP documentation provides taxpayers with a front line of defense should the tax authorities come knocking on their doors.
But this process is evolving as tax authorities around the world become more aggressive on TP issues and tightly scrutinise whether transactions have economic substance and whether the local company derives real value. Payments made to low tax jurisdictions can raise a red flag and prompt more detailed query on this front. This poses a challenge for taxpayers to think beyond the traditional TP documentation and to consider how to manage their TP risks more proactively and with greater certainty.
Having returned home to Tanzania, after a period of secondment working in Kenya, I have found that the trend of TP audits in Tanzania mirrors what I found in Kenya. In particular, the need to demonstrate the economic substance of related party transactions is paramount when dealing with such controversies. Both the Kenya Revenue Authority (KRA) and Tanzania Revenue Authority (TRA) have increasingly adopted a “show, don’t tell” approach to TP audits, requiring more contextual information and far more details which may not be contained in a standard local compliance TP documentation. Failure to provide this level of detail may result in challenge as to whether the transactions in question have sufficient substance.
Furthermore, there are certain related party transactions that both the KRA and the TRA have been paying special attention to, requiring taxpayers to demonstrate and show that such transactions have economic substance. Transactions of particular focus tend to include payments for services, royalty payments and interest payments.
For example, where there is a payment for services rendered by a foreign related party, then the following elements have to be taken into consideration to analyse the economic substance of the transaction: i) demonstrate the economic benefit of the transaction for the local taxpayer (either by demonstrating how the services received have increased in revenue, profitability, cost reductions, time savings , increased competitiveness or market share etc. ), ii) demonstrate the capabilities of the service provider, iii) analyse and prove the non-duplicity with other services received by the local taxpayer or with activities performed by the local entity, and iii) demonstrate with sufficient evidence that the services were actually rendered.
The objective of this renewed scrutiny is to assess whether the actual transactions possess the commercial rationality of arrangements between unrelated parties under comparable economic circumstances in order to ensure that taxpayers are not shifting profits to no- or low-tax jurisdictions that lack sufficient substance to create value. In fact even if the transaction is not with a low tax jurisdiction, the revenue authority may still seek to enquire as to the arms’ length nature of the price; the point being, even if they agree that there is no tax avoidance motive they may still feel that they are not getting their “fair share” of the “tax cake” as compared to the other jurisdiction.
Increasingly, the question to ponder is how can MNEs ensure their TP documentation and the terms in their intercompany agreements or transactions aligns with the actual facts and conducts on the ground? This is often the more significant outcome to overcome, since the revenue authority may set aside the context of the documentation and contractual terms of the controlled transaction and look further into the actual conduct of the parties to assess value created in relation to the economically significant activities, assets and risks assumed by the parties.
As we are witnessing increased targeted TP audit and TP adjustments, MNEs should not only rely just on traditional TP documentation but should also be able to demonstrate that TP arrangements within the group reflect the substance of where and how value is created. MNEs should also regularly review their intercompany agreements so as to identify any misalignment in the documentation and maintain consistency with the facts on the ground before tax authorities knock on their doors.
Shifting from meeting basic TP documentation requirements to demonstrating economic substance for related party transactions certainly will increasingly become even more important in the following years, due to the digital transformation that the global economy is going through including East Africa. Therefore, it is imperative for taxpayers to be able to justify the substance and commercial rationality of their intercompany transactions in order to avoid unwarranted TP adjustments.
Agnes Koni is an Senior Associate specialised in Transfer Pricing at PwC Tanzania. She has recently returned from na 18-month secondment with PwC Kenya.
