SAFE HARBOR REGIMES IN TRANSFER PRICING-AN AFRICAN PERSPECTIVE.

• Date: 22 September 2022
• Author: Ezenagu, Alexander

I. INTRODUCTION 421
                A. Overview 421
                B. Reasons for Considering Simplified Methods 422
                II. SAFE HARBORS 429
                A. The OECD Transfer Pricing Guidelines on
                Safe Harbors 430
                B. The OECD's Prescriptions for Safe Harbor Regimes
                and Their Limitations 432
                III. TYPES OF SAFE HARBORS 435
                A. Exemption from Transfer Pricing Rules and/or
                Documentation 435
                1. Exemption from Transfer Pricing Rules 436
                2. Exemption from Transfer Pricing Documentation 437
                B. Exemptions for SMEs in Developing Countries 438
                C Exemptions for Small Transactions 441
                IV. SUBSTANTIVE SAFE HARBORS 442
                A. Sectoral Safe Harbors 443
                V. Design of Safe Harbor Regimes 446
                A. Specification of the Safe Harbor Transfer Pricing
                Methodology 446
                1. Safe Harbor Margins 446
                a. Price Range 446
                b. Interest Rate 448
                B. Opt-in or Opt-out Participation in Safe Harbors 450
                C. Unilateral, Bilateral or Multilateral Safe Harbor
                Regimes 451
                1. Unilateral Safe Harbors 451
                2. Bilateral Safe Harbors 452
                3. Multilateral/Regional Safe Harbors 454
                VI. CONCLUSION 455
                

I. INTRODUCTION

A. Overview

Applying transfer pricing rules in Africa poses great difficulties. The absence of reliable comparables to benchmark prices and terms fixed by related entities in their transactions with one another means that jurisdictions struggle to apply the arm's-length principle in intra-firm dealings (as prescribed by tax treaties and domestic laws). Furthermore, the requirement for an individualized facts and circumstances analysis in transfer pricing promotes subjectivity in transfer pricing audit and administration. This subjectivity creates an environment of uncertainty for taxpayers and potential investors, who find it hard to predict tax outcomes. In addition, this requirement for individualized facts and circumstances analyses is resource-intensive, time-consuming and complex in implementation for everyone involved. This is particularly true for the tax authority, who is in competition with the big accounting firms to arrive at the appropriate tax return for the taxpayer. This is where safe harbor regimes may be useful.

Safe harbor regimes are established to reduce the burden of tax compliance and ease the administration of the tax system while at the same time providing tax certainty. For taxpayers subject to the transfer pricing rules of taxing jurisdictions, safe harbor regimes have the potential to ameliorate the compliance burden involved in establishing the arm's-length price for transactions entered into with related entities. For tax authorities, safe harbor regimes could help to ensure effective management of limited resources needed for tax enforcement. Finally, they may be used to secure and increase corporate income tax of taxing jurisdictions.

Both the Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations (TPGs) issued by the Organisation for Economic Co-operation and Development (OECD) and the United Nations (UN) Practical Manual on Transfer Pricing for Developing Countries ("UN Practical Manual") recommend the application of safe harbor regimes to small and medium-sized enterprises (SMEs) and small transactions, which are deemed to carry low tax risk despite their creation of significant compliance and enforcement burdens. For rich countries, reductions in compliance costs and burdens for taxpayers and tax authorities are the guiding reasons for introducing safe harbor regimes. For African countries, increasing and guaranteeing corporate income tax collection is equally important. The appreciation of this additional policy objective would aid in the effective introduction and design of appropriate safe harbor regime(s) for African countries.

This Article makes a case for the cautious introduction and use of safe harbors by tax authorities in African countries to achieve increased revenue collection, tax efficiency, certainty, simplicity and convenience, and to circumvent the complicated comparability analysis.

B. Reasons for Considering Simplified Methods

The rules for allocating the taxable income of Multinational Enterprises (MNEs) are important considerations for tax authorities and governments; they determine the income and expenses of companies, which affect the taxable profits those companies return to the tax authorities. (1) These tax revenues are important for economic development and crucial to building basic infrastructure. They also contribute to improving the quality of life of the citizenry.

The internationally agreed upon principle for the allocation of income of MNEs is embodied in Article 9 of the model tax treaties, which gives power to national tax authorities to adjust the profits of entities which are part of an MNE group. (2) The criterion for such adjustments generally involves allocating to the tax jurisdiction the income which the entity would have earned if it had been independent. In his paper on transfer pricing, Sol Picciotto points out that almost all African countries have legislation which gives power of adjustment of taxable profits to tax authorities, akin to the provision of Article 9 of model tax treaties. (3) To assist with the application of this provision, the Committee on Fiscal Affairs of the OECD issued TPGs (4) in 1995, which have subsequently been revised. Picciotto's paper further reveals that of the African countries with provisions on adjustment of taxable profits, 17 have transfer pricing regulations based on the OECD's TPGs. (5)

The legal status of these TPGs depends on the domestic laws of taxing jurisdictions. Though generally regarded as soft law, (6) they have been given some form of legal effect in several jurisdictions, even in countries which are not members of the OECD. To other tax jurisdictions, the TPGs are mere persuasive instruments at best. For example, in the recent judgment of the High Court of Malawi, the court held that, "where local legislation provides for the law, it is always imperative to apply that law and use any international instruments in interpreting that local law." (7) It should be noted, however, that tax authorities in most jurisdictions aim as far as possible to remain in line with the TPGs. Hence, the quasi-legal nature of these TPGs poses some limits to countries' ability to choose the approach most suited to their conditions for attributing income to MNEs within their jurisdictions. Given the established flaws in the application of the OECD's TPGs, many countries are in search of alternatives or simplified measures. (8) A discussion of those flaws follows.

A central difficulty of applying the TPGs is the requirement of conducting an individual analysis of each entity within an MNE corporate group, coupled with the search for comparables to benchmark transactions between related entities. The transactional approach requires an analysis of the relationships between entities in a corporate group according to the individual facts and circumstances of each entity (a process known as functional analysis). The purpose of this individual analysis is to ensure that the transfer price set for transactions between related parties conforms to the price two independent parties would have fixed for similar transactions. (9) This comparability analysis aims to find the most reliable comparables (uncontrolled transactions) for the transaction between related entities (controlled transactions).

A controlled transaction is deemed comparable to an uncontrolled transaction where there are no material differences between them that could affect the price being determined; where there are differences, adequate adjustments can be made to eliminate the effects of such differences. In other words, "the economically relevant characteristics of the two transactions and the circumstances surrounding them are sufficiently similar to provide a reliable measure of an arm's length result." (10) In considering whether transactions are comparable, the TPGs lay down the procedures for conducting what is usually termed a functional analysis. (11) Briefly, this entails consideration of:

(1) the contractual terms of the transaction; (2) 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 functional analysis); (3) the characteristics
                of the property transferred, or services provided; (4) the economic
                circumstances of the parties and of the market in which the parties
                operate; and (5) the business strategies pursued by the parties. (12)
                

To effectively carry out this analysis, a tax authority must have sufficient technical knowledge of the economic sector of the taxpayer, its business model, the goods or services transferred and the terms of the transaction. The tax authority must then search for comparable transactions between unrelated entities to arrive at arm's-length prices or terms.

The difficulty with this requirement is that in many cases suitable comparable transactions do not exist. This is mainly due to the integrated nature of MNEs, the uniqueness of goods and services due to their technological superiority, peculiar industry practices, and the business models adopted by MNEs when transacting with related entities. In more precise terms, the individual facts and circumstances analysis fails to recognise the economies of scale, scope, synergy, and the interrelation of diverse activities created by integrated businesses, all of which are integral to the corporate group. It denies the reality that the commercial activities of related entities are not decided on standalone transactional bases. Business transactions between related entities are structured to promote the common enterprise and increase the total profit of the corporate group. (13)

The arm's-length principle does not allocate value to the common enterprise which contributes to...