Transfer pricing and the global trading of financial instruments

Visser, Sarita (2000-03)

Thesis (MAcc)--Stellenbosch University, 2001.

Thesis

ENGLISH ABSTRACT: Sections 31(1)and (2)were introduced to the Income Tax Act 58 of 1962 ("the Act") in 1995. These sections grant the fiscus the power to adjust transfer prices to reflect an "arm's length price". A transfer price is the price placed on a transaction between parts of a single organisation or between members of a group of companies. The term is a way of indicating that it is a price arranged within the same group, and not arrived at in the open market (i.e.not an arm's length price). Transfer pricing is widely considered to be one of the most important tax issues facing multinational companies. The same goes for governments and revenue authorities, which have become more stringent in their efforts to maximise their income. The issue of Practice Note No.7 on August 6, 1999 by the Commissioner of the South African Revenue Service ("SARS")and the disclosure requirements in company income tax returns (IT 14) of transactions between connected persons are indications that SARSmay enforce the provisions of Section 31(1) and (2) more stringently in the near future. Technological changes, the communications revolution, and the spread of financial deregulation have had a dramatic effect in globalising financial markets. Financial firms have developed innovative financial instruments such as derivatives, to meet the global demand to finance trade and investment and to reconcile the often different demands of borrowers and investors. Financial institutions (mainly banks) have organised their activities to be able to meet the demands of investors for global financial products, twenty-four hours a day. As the global trading of financial instruments is usually conducted over several tax jurisdictions and global trading organisations are often highly integrated it poses significant transfer pricing implications. The aim of this study is to: • consider and discuss transfer pricing in South Africa, • to analyse and discuss the global trading of financial instruments, • to apply transfer pricing methodologies to the global trading of financial instruments and to specifically consider the use of traditional transaction methods versus profit split methods for the determination of arm's length prices in the context of the global trading of financial instruments. To this end the study provides a detailed analysis of South Africa's transfer pricing legislation and acceptable methods for the determination of transfer prices as set out in Practice Note NO.7. The factual background, structure of the business, business strategies and organisation of trading activities of a typical global trading organisation are discussed. Furthermore, a detailed functional analysis of the typical global trading organisation is performed. The functional analysis identified the following critical functions that are usually performed by a global trading organisation: sales and marketing; trading and risk management; support/back office;and capitalj risk assumption. The application of the various methods set out in Practice Note NO.7 to reward the functions identified under the functional analysis of the global trading organisation is discussed. In particular the use of traditional transaction methods versus profit split methods, to reward the functions of the global trading organisation, is discussed. The study concludes that the arm's length principle should be applied when determining transfer prices for global trading transactions. The study also concludes that it is impossible to state that traditional transaction based methods or in the alternative profit split methods should always be applied to the global trading of financial instruments as each case would need to be evaluated on its own facts. The study further states that the choice between traditional transaction methods and profit split methods will be influenced to a large extent by the availability of reliable comparable uncontrolled transaction data and/ or the degree of integration of the functions performed. If there is a lack of reliable comparable uncontrolled transaction data and/ or functions are highly integrated, there will be a strong argument for the use of profit split methods. The reliability of the method would however always need to be considered. The study also provides guidance in respect the choice of the most appropriate methods (traditional transaction methods or profit split methods) for determining an arm's length price for the each of the functions of the global trading organisation.

AFRIKAANSE OPSOMMING: OORDRAGPRYSE EN UNIVERSELE HANDEL IN FINANSIËLE INSTRUMENTE Artikel 31(1) en (2) is in 1995 in die Inkomstebelastingwet, Wet 58 van 1962 ("die Wet") ingevoeg. Die artikel verleen aan die fiskus die mag om oordragpryse aan te pas ten einde In arm lengte prys te reflekteer. In Oordragprys is die prys wat gevra word tussen entiteite binne In organisasie of tussen lede van dieselfde groep van maatskappye vir transaksies. Die term dui aan dat die prys binne groepsverband vasgestel is en nie in die ope mark beding is nie (met ander woorde dit is nie In arm lengte prys nie). Oordragprysvasstelling word algemeen beskou as een van die belangrikste belastinguitdagings vir multi-nasionale maatskappye. Dieselfde geld vir regerings en inkomste kantore wat hul inkomste wil maksimeer. Die uitgifte van Praktyk Nota No. 7 op 6 Augustus 1999 deur die Kommissaris vir die Suid Afrikaanse Inkomste Diens ("SAID")en die vereiste in maatskappye se inkomstebelastingopgawes (IT 14) om transaksies tussen verbonde persone te openbaar, is aanduidings dat die bepalings van Artikel 31(1)en (2)in die toekoms strenger deur die SAIDtoegepas gaan word. Tegnologiese veranderinge, die kommunikasie revolusie en finansiële deregulering het grootliks aanleiding gegee tot universele handel in finansiële instrumente. Finansiële instellings het nuwe finansiële instruments soos afgeleide instrumente ontwikkel om te voldoen aan die universele vraag na finansiering en belegging en om die dikwels verskillende behoeftes van beleggers en leners te versoen. Finansiële instellings (hoofsaaklik banke) organiseer hul aktiwiteite om vier en twintig uur van die dag aan die vraag van beleggers na universele finansiële produkte te voldoen. Universele handel in finansiële produkte vind oor verskeie belasting jurisdiksies plaas en die aktiwiteite van universele handels organisasies is dikwels hoogs geïntegreerd. As gevolg van hierdie twee faktore hou universele handel in finansiële instrumente wesenlike oordragprys implikasies in. Die doel van hierdie studie is om: • oordragprysvasstelling in Suid Afrika te bespreek en te oorweeg, • universele handel in finansiële instrumente te analiseer en te bespreek, • oordragprysvasstellingmetodes en tegnieke toe te pas op universele handeldrywing in finansiële instrumente en • spesifiek die gebruik van tradisionele transaksie metodes versus wins verdelings metodes vir die vasstelling van arm lengte pryse in die konteks van die universele handeldrywing in finansiële instrumente te oorweeg. Ten einde bogenoemde doel te bereik analiseer die studie oordragprys wetgewing in Suid Afrika en aanvaarbare metodes in terme van Praktyk Nota NO.7 vir die vasstelling van oordragpryse. Die studie bespreek ook die feitelike agtergrond, struktuur van die besigheid, besigheids strategie en die organisasie van handels aktiwiteite van 'n tipiese universele handels organisasie. Verder is In analise van die funksies van die universele handels organisasie gedoen. Die funksie analise het die volgende kritieke funksies van In universele handels organisasie geïdentifiseer: verkope en bemarking; handel en risiko bestuur; ondersteuning/"back office"; en kapitaal/ risiko aanvaarding. Die toepassing van die metodes in Praktyk Nota NO.7 om die funksies, wat deur die funksie analise identifiseer is, te vergoed word oorweeg. In besonder word die gebruik van tradisionele transaksie metodes versus winsverdelings metodes, om die funksies van die universele handelsorganisasie te vergoed, bespreek. Die studie het bevind dat die armslengtebeginsel toegepas moet word op universele handel in finansiële instrumente. Die studie bevind dat dit onmoontlik is om te bepaal dat tradisionele transaksiemetodes of in die alternatief wins verdelings metodes altyd toegepas moet word op universele handel in finansiële instrumente, omrede elke geval op sy eie feitestel evalueer moet word. Die studie bevind dat die keuse tussen tradisionele transaksiemetodes en winsverdelingsmetodes tot In groot mate beïnvloed sal word deur die beskikbaarheid van betroubare vergelykbare onbeheerde transaksie data en/ of die graad van integrasie van funksies. Indien daar In gebrek aan betroubare vergelykbare onbeheerde transaksiedata is en/ of funksies is hoogs geïntegreerd, sal daar In sterk argument wees vir die gebruik van winsverdelingsmetodes. Die betroubaarheid van die metode sal altyd oorweeg moet word. Die studie verskaf riglyne met betrekking tot die keuse van die mees toepaslike (tradisionele transaksiemetode versus winsverdelingsmetode) vir die vasstelling van arm lengte pryse vir elkeen van die kritieke funksies verrig deur die universele handelsorganisasie.

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