Transfer pricing and its effect on connected-party cross-border transactions in Africa 

By: Ralph Wichtmann, MD at Sovereign Trust SA, and Imra Lategan, Head of Private Clients at Regan van Rooy 

Expanding your business from South Africa into Africa can be fraught with legal and tax obstacles – not least of which are the transfer pricing provisions which are to be considered as part of the expansion and day-to-day operations of the business. The crux of these provisions is that all connected-party cross-border transactions have to be entered into on arm’s length terms and, most simply, this means that the parties must transact as if they were doing so with unconnected parties.

In this article, the first of a two-part series, we look at transfer pricing in the context of a South African company expanding into Africa to facilitate the provision of services and sales into Africa: 

• A South African company (SACo) provides engineering services and sells imported engineering equipment to clients in South Africa. 
• SACo is approached by a number of clients in Africa and other jurisdictions to provide similar services and goods. 
• The offshore clients are hesitant to pay a South African company, and would prefer a jurisdiction that trades in USD and does not have exchange control requirements. 
• SACo would prefer to avoid bringing funds into the SA exchange control net. 
• The ultimate beneficial owners (UBOs) of SACo are keen to establish offshore asset bases for estate planning purposes. 
• The UBOs set up a company in Mauritius (MCo) in order to provide the services and goods to the African clients. 
• MCo also acts as the holding company for African subsidiaries, which are created to ease the local business requirements in the African clients’ jurisdictions. 

In this example, some of the most important factors that come into play include: 

Structure 

The UBOs should consider setting up an offshore trust to hold the MCo shares which offshore trust can, in turn, incorporate companies in African countries as needed. Chief among the benefits of an offshore trust structure are keeping the offshore proceeds outside of the SA exchange control net; protection against creditors; protection against the exit tax that would otherwise be applicable if the beneficiaries emigrate from SA; and continuity of ownership in the case of the death of a shareholder. 

Funding 

The UBOs must comply with SA exchange control allowances when funding MCo and/or the offshore trust. The funds being transferred to MCo or the offshore trust can only be classified as a loan or a donation and, depending on the funding mechanism, different tax consequences and anti-avoidance provisions may be triggered. 

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Substance 

Mauritius has specific substance requirements, especially for global business licence companies, which are companies that earn the most of their income from outside of Mauritius. To be compliant, MCo must have enough employees to provide the services for which it is charging. And, to ensure that MCo retains its Mauritian tax residency status, effective management of MCo must reside with the Mauritian employees. 

Permanent establishment 

Creating a permanent establishment means that the income and gain made by MCo, as a result of any of its employees or agents in another jurisdiction, or as a result of contracts being entered into on behalf of MCo in other jurisdictions, will result in a taxable presence in these other jurisdictions. Essentially, the tax authorities in these jurisdictions could tax this income and gains. It is thus imperative that the operations of the company take place in its jurisdiction of formation or incorporation, to ensure that it does not create a taxable presence in another jurisdiction.  

Tax 

Depending on where MCo’s African subsidiaries are located, corporate tax could be levied on their income. When dividends are distributed to MCo, dividends withholding taxes should be taken into consideration. In addition, if MCo’s subsidiaries are funded by way of debt, withholding taxes could apply to the interest. And, to add complexity, the interest rate must comply with the arm’s length transfer pricing principles. 

Further, on receipt of the dividends and interest by MCo, Mauritian corporate tax is levied on the income, subject to tax breaks like the partial exemption on certain streams of income (provided that the interest is part of MCo’s core income generating activity), and possible foreign tax credits. 

If MCo imports from outside of Mauritius and exports into Africa, there are also some fiscal benefits pertaining to this trade. However, permanent establishments could have an effect here, and customs requirements must be considered. 

The flow of dividends from MCo to its Mauritian shareholding trust is beneficial from a tax perspective, but the distribution from the trust to its SA beneficiaries is subject to complex tax rules that depend on how the trust was initially funded, as well as the source of the distribution. 

Controlled foreign company 

If the SA shareholders decide not to use a foreign trust to hold their MCo shares, the controlled foreign company (CFC) rules could potentially attribute all income and gains made by MCo to its SA shareholders in relation to their percentage shares held, and the shareholders would be taxed on their income and gains as SA taxpayers – although there are a few ways to mitigate these risks. Mauritius also has CFC rules that could apply to the subsidiaries that MCo owns in Africa, depending on the percentage shareholding. 

Exchange control 

The SA shareholders have individual exchange control allowances that they may use to exit funds from SA. However, all funds that exit SA must be authorised in terms of exchange control provisions, and non-compliance is a criminal offence. 

These exchange control allowances could be used to fund MCo or the foreign trust. SACo may also avail itself of the foreign direct investment rules, but this would mean that MCo would be effectively owned by SACo, and CFC attribution rules could be applied. 

If MCo owns SACo, authorisation must be obtained  for the resulting loop structure – in which SA residents have an interest in an offshore structure that owns assets in SA. If the loop is correctly placed on record, strict reporting obligations will apply. The shareholders should also be aware of the capital gains tax that will become payable on the sale of SACo to MCo. Capital gains tax might become payable as well as securities transfer tax on the sale and transfer of the share of SACo to MCo. In addition, the market value of the SACo must flow into SA. 

Further, if SACo owns any intellectual property (IP), exchange control will not easily allow this IP to be moved offshore. Tax will come into play if the subsidiaries want to use this IP, and transfer pricing provisions will apply. 

In conclusion, the above risk areas could be mitigated by finalising a transfer pricing policy before planning and implementing any offshore expansion. It is always advisable to consult with a transfer pricing specialist before making any offshore expansion decisions as transfer pricing is an infinitely complex area of tax.