ABC Ltd is in the business of manufacturing, importing, and selling chemical products. It has a catalyst division that is focused on manufacturing and selling catalytic converters (catalysts) which is used in the abatement of harmful exhaust emissions from motor vehicles. To produce the catalysts, applicant requires, inter alia, some metals known as the Precious Group of Metals (PGMs). It purchases the PGMs from a Swiss entity (“the Swiss Entity”). The PGMs are liquified and mixed with other chemicals to create coating for substrates, all being part of the manufacturing process. Once the manufacturing is complete, the catalysts are sold to customers in South Africa known as the original equipment manufacturers (OEMs). ABC Ltd and the Swiss Entity are connected parties as defined in section 1 of the ITA.
Following an audit carried out in 2014 the revenue service issued an assessment for FY 2011 by an amount of R114 157 077.
According to the revenue service the prices paid for the PGMs had not been at arm’s length. The assessment set aside the CUP method and instead applied the TNMM method using ROTC as the Profit Level Indicator. The assessment was based on a detailed analysis of the total cost base incurred by ABC Ltd in acquiring the PGMs and other raw materials, including the manufacturing and distribution costs of the catalysts. The role played by ABC Ltd in purchasing and manufacturing the catalysts, the assets and the risks involved, which risks applicant had accounted for in its financial statement was also taken into account.
ABC Ltd held that the South African arm’s length provision in section 31(2) of the ITA only permitted tax authorities to adjust the consideration in respect of the transactions between it and the Swiss Entity to reflect an arm’s length price for the purchase and supply of PGMs; in the event the ‘jurisdictional facts’ called for by section 31 were established as a matter of fact. It also stated that even if it had been found that it had not paid an arm’s length price for the PGMs, which it denies, the tax authorities was only entitled to adjust the price/consideration paid for the PGMs as between applicant and the Swiss Entity, not the consideration between applicant and third parties. In this regard, the tax authorities’ adjustment of ABC Ltd’s profits pursuant to its application of the TNMM was not a legitimate exercise of transfer pricing power authorized by section 31(2). As a consequence, ABC Ltd argues, the additional assessment is legally impermissible. The issue which ABC seeks separated therefore, is whether the conduct of tax authorities fell within the powers set out in section 31(2).
Decision of the Tax Court
ABC Ltd’s appeal was dismissed by the Tax Court.
The judge referred to three recent (2020) international transfer pricing court cases (The Coca Cola Company (TCCC) and Subsidiaries v The Commissioner of Internal Revenue US, Canda v AgraCity Ltd and Denmark v ECCO A/S) and stated that these cases illustrated that regardless of what method has been used to determine the arm’s length consideration, ultimately, adjustments are made to profits of the taxpayer to ensure that tax is levied on the correct amount
of taxable income.
“Applicant [ABC Ltd] refers to the process of establishment of the arm’s length nature of a transaction between connected persons as jurisdictional facts. Plain from its own advocation of the CUP method is that it accepts that there are various methods that can be employed in establishing the arm’s length nature of a transaction. The appropriateness of a method to test the arm’s length nature of a transaction however, is determined by the circumstances of a case. See in this regard PN 7 and the TPGs. It cannot merely be artificially assumed as applicant argued during the hearing of this matter. In this regard, and for the purpose of advancing the separation application, applicant submitted that the court may accept (artificially so) that the price it paid for the PGMs to the Swiss Entity was not an arm’s length price, even though this is denied. But this cannot be done and applicant knows this. For example, in furtherance of its preferred CUP method, applicant went further and stated that there would have been no need for adjustment had respondent [COMMISSIONER FOR SOUTH AFRICAN REVENUE SERVICE] adopted the CUP method. From the preceding statement, it must be accepted that applicant is aware that the establishment as a fact whether a consideration is or is not at arm’s length precedes the question of adjustment, regardless of what method is employed. 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 inquiry into the arm’s length nature of a transaction is an overriding principle in transfer pricing matters and cannot be receded to the back. I agree. Respondent at one point likened applicant’s approach with the separation application to determining quantum in a damages claim prior to determining the question of liability. I agree. On the conspectus of evidence before this court, ordering a separation will not achieve any practical benefit. On the contrary, it would result in piecemeal litigation, increase costs, and delay finalisation of the matter. At first, one may be allured by the points raised by applicant. However, on close interrogation there is neither a cogent point worthy of testing nor will the objects set out in Blair Atholl be served with the separation.”