Alex Constantinou and Andrew Sylvester

In a globalised world, transfer pricing between different branches of multinationals is necessary to ensure that revenues are reflected where value is created, and thus that tax can be paid where appropriate. It is described as “the process by which entities set the prices at which they transfer goods or services between each other.” [i] However, transfer pricing can be abused, and transfer mispricing can result in billions in lost tax revenue. In South Africa, the prevalence of this abuse is significant as “South Africa is estimated to lose tens of billions of rand annually from the abuse of transfer pricing by multinational groups.” [ii] This may be owing to under-enforcement; however, transfer mispricing is a general concern to governments around the world.[iii]

Transfer mispricing is the practice of shifting profits offshore to tax havens, thus reducing the company’s tax burden. The best way to illustrate this is by way of example. Suppose company A (the parent) is a multinational corporation based in Japan, but with a subsidiary operating in South Africa. Also assume that the corporate tax rate of South Africa is 20 percent and Japan is 10 percent. In other words, the tax rate is lower offshore and higher in South Africa.

To shift profits away from South Africa to Japan, all the company has to do is to charge a premium for inputs provided by the parent to its subsidiary. This will have the effect of increasing profits offshore while decreasing them locally. For example, if the management fee charged by the parent to the subsidiary would have been $4 million, and it is artificially increased by 500%, then $20 million is charged to the subsidiary’s account, meaning an additional $16 million is carried by the subsidiary as a cost. That is now $16 million that would otherwise have been taxable profit at a rate of 20 percent in South Africa, but is now only taxed at a rate of 10 percent in Japan.

Transfer pricing law has a number of parallels with competition law. The first similarity is that both seek to protect welfare at large: competition law protects consumers from abusive monopolies and cartels, while transfer pricing law protects the state from tax evasion through transfer mispricing. The second similarity is in the underlying approach to assessing an appropriate transfer price and the normal level of profitability in competition analysis. An appropriate transfer price is one which would have resulted from an ‘arm’s length’ negotiation. This arm’s length price is one which would cover the firm’s costs as well as give the firm a reasonable return on capital. In the same way, competition authorities use profitability analysis to understand if a firm’s selling price is excessive or if it only covers costs with a reasonable return on capital.[iv]

The Competition Commission in South Africa has already dealt with excessive prices cases despite their inherent complexity and high costs to litigate. This is because the costs of not litigating are far higher for the wider economy.

The costs associated with enforcement of accurate transfer pricing by SARS are expected to be substantial, however, all that is required to justify enhanced enforcement of the law is for the increased enforcement costs to be less than the lost tax from transfer mispricing. A modified Laffer curve (Figure 1) illustrates the relationship between tax revenue collection and tax evasion; and brings to the fore the value of enforcement. The “Laffer Curve itself simply illustrates the tradeoff between tax rates and the total tax revenues actually collected by the government.”[v] In other words, above a certain tax rate, economic activity is argued to decline. We note however, that the Laffer curve itself is sometimes a debatable economic concept, especially when it comes to assumptions about whether the aggregate economy is on the left or the right of the peak. Our intention here is merely to illustrate conceptually the effect of tax evasion on tax revenues.

Assuming that equilibrium point A produces the theoretical maximum tax revenue T₁*, a corporate tax rate of 28% is optimal if tax revenue maximisation is the policy goal. However, in reality, tax evasion exists and reduces the profile of tax revenues achievable at different tax rates with a maximisation at point B. If T₂* is the tax revenues required by the state, then in the absence of transfer mispricing the corporate tax rate could be lowered to 20% without a loss in tax revenues. Furthermore, if the increased cost of enforcement is less than the tax savings from the reduced tax evasion, then a tax rate above 20% and below 25% could be chosen which covers the enforcement cost, renders the same tax revenue to the state, and reduces the corporate tax rate to companies. The only losers in this situation would be the firms previously evading tax who are now deterred from doing so.

Given that we know transfer pricing abuse results in tens of billions of Rands lost to the South African economy, the cost of enforcement is likely to be less than the loss to the economy.  SARS cannot afford not to strongly improve enforcement.  To put this into perspective, “as a proportion of the size of the economy, South Africa’s illicit financial flows came to 7.6%, nearly twice the average for developing countries.”[vi]