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18 Aug 2020
BY Jens Brodbeck

Taking stock – transfer pricing developments in the first six months of 2020

The Coronavirus (COVID-19) crisis and its devastating effects on societies and economies across the globe has made 2020 a year of extra-ordinary circumstances. This which makes it difficult to keep track of ongoing developments which, under normal circumstances, would be under the spotlight. Below is a short summary of some of the important international and local South African developments in the area of transfer pricing. In a second article to follow, we will summarise the latest transfer pricing related developments on the African continent.


Digitalisation of the economy

The transfer pricing related topic that received the most media attention in 2019 was the search for a consensus-based long-term solution to the tax challenges arising from the digitalisation of the economy. This was not only the result of the complexity of the topic, but also because it appeared to have become the pawn of widely differing economic interests. This threatened the global consensus on the arm’s length principle as the basis for transfer pricing, and resulted in three competing proposals to address the tax challenges of digitalisation.

At the end of January, however, the Inclusive Framework on Base Erosion and Profit-Shifting (“BEPS”), which groups 137 countries and jurisdictions on an equal footing for multilateral negotiation of international tax rules, decided to move ahead with a two-pillar negotiation to address the tax challenges of digitalisation with the objective of working toward an agreement by the end of 2020. 

It was agreed that negotiation should be pursued on the new rules on where tax should be paid ("nexus" rules) and on what portion of profits they should be taxed ("profit allocation" rules), on the basis of a "Unified Approach" on Pillar One, to ensure that MNEs conducting sustained and significant business in places where they may not have a physical presence can be taxed in such jurisdictions. The Unified Approach agreed by the Inclusive Framework draws heavily on the Unified Approach released by the OECD Secretariat in October 2019, as a response to the three competing proposals mentioned above.

The Programme of Work, agreed in May 2019, has been revised under Pillar One, which outlines the remaining technical work and political challenges to deliver a consensus-based solution by the end of 2020, as mandated by the G20. While it was the intention of the Inclusive Framework members to meet in July in Berlin, this time frame has become obsolete as a result of the pandemic. Until a new time plan has been made public, it is also very difficult to assess how far the various parties have been able to achieve some sort of political agreement on the detailed architecture of this proposal. In particular, it will be interesting to see how the Inclusive Framework will deal with the proposal to implement Pillar One on a "safe harbour" basis, as proposed in a 3 December 2019 letter from US Treasury Secretary Steven Mnuchin to OECD Secretary-General Angel Gurría, which has raised concerns by many Inclusive Framework members.

The Inclusive Framework also welcomed the significant progress made on the technical design of Pillar Two, which aims to address remaining BEPS issues and ensure that international businesses pay a minimum level of tax. They noted the further work that needs to be done on Pillar Two.

Transfer pricing guidance on financial transactions

A topic that received less attention in the media, but which for most MNEs is as important, at least in the short to mid-term, is the treatment of financial transactions from a transfer pricing perspective. This was one of the focus areas of the OECD/G20’s BEPS Project and, in October 2015, as part of the final BEPS package, the OECD/G20 published the reports on Action 4 (Limiting Base Erosion Involving Interest Deductions And Other Financial Payments) and Actions 8-10 (Aligning Transfer Pricing Outcomes with Value Creation).

The content of these reports, however, did not find its way into the revision of the OECD Transfer Pricing Guidelines based on the final BEPS package in October 2015 and, instead, the reports mandated follow-up work on the transfer pricing aspects of financial transactions.

On the 11 of February, the OECD finally released its much anticipated report “Transfer Pricing Guidance on Financial Transactions: Inclusive Framework on BEPS: Actions 4, 8-10”.

The report is significant, as sections A to E of this report are included in the OECD Transfer Pricing Guidelines as Chapter X, while section F is added to Section D.1.2.1 in Chapter I of the Guidelines, immediately following paragraph 1.106. As a result, it is the first time the OECD Transfer Pricing Guidelines include detailed guidance on the transfer pricing aspects of financial transactions, which was outstanding for a long time and had led to considerable uncertainty not only in South Africa. There is, accordingly, a high expectation that the guidance contained in the report will contribute to consistency in the interpretation of the arm’s length principle and help avoid transfer pricing disputes and double taxation.

The guidance in this report describes the transfer pricing aspects of financial transactions. It also includes a number of examples to illustrate the principles discussed in the report. Of particular interest is:

  • Section B, which provides guidance on the application of the general principles contained in Section D.1 of Chapter I of the OECD Transfer Pricing Guidelines to financial transactions, in particular, how the accurate delineation analysis under Chapter I applies to the capital structure of an MNE within an MNE group. It also clarifies that the guidance included in that section does not prevent countries from implementing approaches to address capital structure and interest deductibility under their domestic legislation (an approach which seems to be followed in South Africa – see below).
  • Sections C, D and E address specific issues related to the pricing of financial transactions (eg, treasury functions, intra-group loans, cash pooling, hedging, guarantees and captive insurance). This analysis elaborates on both the accurate delineation and the pricing of the controlled financial transactions.
  • Finally, Section F provides guidance on how to determine a risk-free rate of return and a risk-adjusted rate of return.


Interest limitation rules

Following the OECD Report on the Transfer Pricing Guidance on Financial Transactions, National Treasury in South Africa, on 26 February, published the Discussion Paper on Reviewing the Tax Treatment of Excessive Debt Financing, Interest Deductions and Other Financial Payments. The Discussion Paper sets out government’s proposal to replace the existing interest limitation rules (specifically those in section 23M of the Income Tax Act, 1962) with a more uniform approach to all interest payments flowing out of the country, based on the recommendations by the OECD. In particular, government proposes to restrict net interest expense deductions to 30% of earnings before interest, taxes, depreciation, and amortization (EBITDA).

This proposal was one of the measures announced in the 2020 Budget to broaden the corporate income tax base (together with the proposal to limit the use of assessed losses carried forward to 80% of taxable income). Both measures were to be effective for years of assessment commencing on or after 1 January 2021 and, as a result of the COVID-19 pandemic, were postponed to at least 1 January 2022.

In line with this postponement, the deadline for submission of comments on the content of the Discussion Paper was also extended twice. Comments are now due by 30 September 2020.

Updated interpretation notes based on latest OECD guidance

While National Treasury was quick with its proposal to restrict net interest expense deductions, The South African Revenue Service has not been as responsive. In particular, while its Strategic Plan for 2020/2021 – 2024/2015, specifically states that the provision of clarity of legal obligations, to ensure consistency of legal obligations as well as certainty and predictability, through inter alia advance pricing agreements, interpretations note, and explanatory guidelines as one of its key actions, it has still not finalised its draft interpretation note on thin capitalisation (which dates back to 2013), nor has it issued an interpretation note dealing with transfer pricing in general, taking into account all the latest developments and resulting updates to the OECD Guidelines as a result of the BEPS Project.

Instead of providing the clarity of legal obligations, which it regards as a strategic objective, it continues to make changes and updates to the transfer pricing legislation. This creates more uncertainty, such as the ill-advised proposed inclusion of the “associated enterprise” definition into the transfer pricing legislation, which was well intended but would have resulted in expanding the application of the transfer pricing rules based on a concept that is extremely complex and open to interpretation.


Jens Brodbeck

Executive | Tax

+27 83 442 7401