CPA Dennis Wakaba
Transfer pricing has recently become a hot issue in the country, with the Kenya Revenue Authority concentrating on audits in the area. So, what is transfer pricing?
Transfer pricing is a method of pricing the activities between related entities whereby the transacting entities must price their trading at arm’s length. There are various methods that the taxpayers can use to calculate the arm’s length price as provided in the OECD guideline.
However, arriving at the proper transfer price is not a black-and-white issue that simple formulas can give 100% conclusive and satisfying solutions, but they can aim to. There are a lot of dynamics to it, which necessitated the attempted introduction of Advance Pricing Agreements via an amendment to the annulled Finance Bill 2024, and we hope to see the return of the proposed amendment in the near future.
The Advance Pricing Agreements seek to provide certainty to the taxpayer, upon disclosure of all material facts, on the promise that upon agreement, their transfer pricing method will not be subjected to an audit and possible secondary adjustments by the revenue authority. Does this mean that the Advance Pricing Agreements cannot be audited alone? The response is no because the revenue authority may want to satisfy itself by stating that the taxpayer disclosed all the material facts related to the particular transaction(s) for which the taxpayer approached the revenue authority for an Advance Price Agreement.
So, how do advance pricing agreements work? A taxpayer approaches a revenue authority of a country and seeks to reach an agreement on an arrangement that gets to determine the appropriate selection of variables, being assumptions of future events, method, comparable entities and transactions and their ensuing adjustments, so that the taxpayer can get to determine the appropriate transfer price for the selected transactions over an agreed fixed period. The negotiations will typically involve the taxpayer, the country’s revenue administrator and one or more associated enterprises.
The associated enterprise will approach the revenue authority with all the relevant details, such as details of assumptions, historical market data, the criteria for the selection of comparable transactions, countries involved, and any expected future changes where they can be reasonably predicted. The revenue authority will then keep engaging the Taxpayer to provide more documents where it feels more clarity and information is required, even though the Taxpayer has an obligation to provide all necessary documents to help justify their method of choice.
Typically, an advance pricing agreement will also provide a provision for revision or cancellation of the deal in future years where there has been a considerable change in the facts and assumptions that informed the agreement, such as a significant change in economic circumstances resulting in currency fluctuation and a shift in business operations. In some cases, advance pricing agreements, like in Ireland, provide that the agreement reached can be applied retrogressively in the prior years. Still, such an agreement would require the agreement of the revenue authority, the Taxpayer and, in some instances, the double taxation treaty partner. In such a case, the tax authority would commit not to make any secondary adjustment to the already occurred transactions upon applying the agreed-upon transfer pricing method.
To ensure compliance with the advance pricing agreements, the revenue authority apply a proactive approach to this, where they require taxpayer to do an annual filling showing the extent to which the taxpayer has complied, and also re-assuring the revenue authority that the significant assumptions have not significantly changed. Additionally, the revenue authority may as well, commit to audit the tax payer, but must not audit to establish whether the agreed method is the correct method, but to establish as to whether the taxpayer is complying with the method consistently, whether material disclosures were done and as well to confirm that there have not been significant changes in the assumptions earlier presented.
There can be three different types of advance pricing agreements that a country can legislate in its tax laws. They are; unilateral advance pricing agreements, bilateral advance pricing agreements and multilateral advance pricing agreements.
A unilateral advance price agreement involves only the revenue authority and the tax payer in the country involved. A bilateral advance price agreement involves the tax payer, the revenue authority of that tax payer, the associated enterprise in that other country, and as well as the revenue authority of the associated enterprise. A multilateral advance price agreement involves the tax payer, two or more associated enterprises in two or more foreign countries, and two or more revenue authorities of the foreign countries where the two or more associated enterprises are located.
There are a number of countries that have legislated advance price agreement in their tax laws with the first country to adopt being Japan in 1986, followed by other early adopters like Germany and India and here in Africa we have our neighbours Uganda and particularly Tanzania who adopted this in 2016 via amendments in their Income Tax Act Sec 33(1) and have embedded the methods of arrangement in their transfer pricing regulations, and as well other African countries like Nigeria and recent adopter like South Africa.
There are many reasons why we expect that this should be introduced in our tax laws as soon as the next amendment is done in the Income Tax Act.
Provided all the important assumptions have been met, advance price agreement provides for a great amount of certainty to the tax payers on the treatment of the specified transactions. The tax payer can then be in a better position to predict its tax liability. This consequently goes along to attracting foreign investors who an element of certainty is incredibly important to their investment decision.
Additionally, the taxpayer can allocate resources in other vital areas that would have been used to continuously examine its own transfer pricing policy documentation and compliance and work towards mitigating the litigations of transfer pricing issues. The revenue authority will know more about the taxpayer from the point of application to approval of the advance price agreement. Thus, frequent resource-consuming audits will not be necessary.
Further, advance price agreements can significantly improve the relationship between the taxpayer and the country’s revenue authority. Engaging in the discussion of complex issues related to transfer pricing can foster good cooperation, which can further lead to a balanced review of the information and data submitted to the revenue authority, unlike in normal audits, where there is a lot of suspicion between the two parties. This ripple effect further leads to more cooperation with the treaty partners.
In closing, as more inventions are made and the globe moves towards unprecedented dynamics in business operations and arrangements, advance price agreements will become the go-to option for many businesses that have cross-border transactions. We look forward with anticipation to this amazing provision being re-introduced into our tax laws in a comprehensive manner.
CPA Dennis Wakaba Msc Finance UoN is a freelancing consultant and Board Member
