South Africa prevails with a TNMM analysis in transfer pricing dispute, but should it have?

By Dr. J. Harold McClure, New York City

A South African court, on December 3, 2020, allowed the South African Revenue Service (SARS) to prevail with a transactional net margin method (TNMM) analysis even though the taxpayer argued that its intercompany pricing was consistent with market pricing.

The case, ABC (Pty) Ltd. v. Commissioner (case number IT 14305), involved a South African affiliate that manufactured catalytic converters and sold them to third-party vehicle manufacturers. This affiliate purchased platinum group metals (PGMs) from a Swiss affiliate which were mixed with other chemicals to create a coating for substrates as part of the manufacturing process.

The taxpayer asserted that the intercompany prices were consistent with market pricing. As such, the taxpayer argued that the appropriate approach for the evaluation of the intercompany pricing was the comparable uncontrolled price approach.

The only financial information provided in the court decision is that the South African affiliate’s operating profits represented a 1 percent markup over total costs during 2011.

This cost base included the intercompany payments for the PGMs and other raw materials and the affiliate’s labor costs. SARS used an application of the TNMM to assert an increase in operating profits equal to approximately 114.16 million South African rands, which translated into over $15.7 million using the 2011 exchange rate between the South African rand and the US dollar.

The court noted that SARS had selected allegedly comparable manufacturers and that the adjustment was based on the median markup over total costs. The court did not identify these alleged comparable companies or what this median markup was. In fact, the court decision provided no information on the South African affiliate’s financial information, such as the composition of its total cost base or the assets utilized by the manufacturing affiliate.

The markup over total costs (m) for a manufacturer should be seen as a weighted average of the return to value-added expenses and the return to pass-through costs:

• m = x^.v + (1 − x)z, where
• x = the ratio of value-added expenses relative to total costs;
• v = the ratio of operating profits attributable to fixed assets relative to labor costs; and
• z = the ratio of operating profits attributable to inventories relative to pass-through costs.

The following table illustrates this model in terms of the South African catalytic converter manufacturing affiliate by making the following assumptions:

• material or pass-through costs = $300 million per year; and
• labor costs = $100 million per year

It posits three transfer pricing policies, including a cost plus 1 percent markup under the taxpayer’s transfer pricing policies.

 If SARS proposed an increase in the markup to cost plus 5 percent, operating profits increase from $4 million per year to $20 million per year. The table considers an intermediate position where profits are $8 million per year or cost plus 2 percent.

The table posits that inventories = $20 million per year or 6.67 percent of material costs. The table also posits that fixed assets = $80 million or 80 percent of fixed assets.

 If the cost of capital = 8 percent, the profits attributable to inventories = $1.6 million (z = 0.00533) and the profits attributable to fixed assets = $6.4 million (v = 0.064).

Under these assumptions, a TNMM analysis would support a 2 percent markup over total costs as arm’s length where the return to operating assets (ROA) = 8 percent.

Illustration of a TNMM Analysis

Millions	Taxpayer	Intermediate	SARS
Sales	$404	$408	$420
Material costs	$300	$300	$300
Labor costs	$100	$100	$100
Profits	$4	$8	$20
Inventory	$20	$20	$20
Fixed assets	$80	$80	$80
Markup	1%	2%	5%
ROA	4%	8%	20%

The taxpayer’s transfer pricing policy resulted in a 4 percent ROA, which was less than even the interest rate on 10-year South African government bonds.

SARS proposed a considerable increase in the profits for the manufacturing affiliate, which the table illustrates as cost plus 5 percent, which implies ROA = 20 percent. Such a large transfer pricing adjustment is not consistent with our illustration of TNMM.

The taxpayer did not challenge the SARS application of TNMM. The taxpayer’s sole argument was that TNMM was not an appropriate method for determining arm’s length pricing. While the pricing of platinum could be based on an application of the comparable uncontrolled price approach, the court decision provided very little information on either the market for this commodity or the catalyst converter market.

South Africa’s catalyst converter market

The Southern African Institute of Metals and Metallurgy issued a 2012 report entitled “The Catalytic Converter Industry in South Africa.” The report noted how the South African government had promoted this sector’s development since the early 1990s through the Motor Industry Development program. The catalytic converter sector has been dominated by multinationals that tend to source production facilities in close proximity to vehicle manufacturers to minimize logistic costs.

South Africa possesses certain advantages in terms of close access to platinum as well as a skilled labor force. While its production costs were seen as competitive, logistic costs limited South African affiliates’ ability to compete on a global scale despite these advantages.

The report also noted that production in 2012 was at only 70 percent capacity, and capacity utilization was forecasted to decline from 2012 to 2016. While the report noted that the world’s desire to limit carbon emissions might eventually lead to increased demand for South African produced catalytic converters, the market during the period under review in the court decision likely kept market prices low.

Implications for transfer pricing

The above table’s illustrative financial model suggests that a 1 percent markup over total costs led to a low return to operating assets for the South African affiliate in this litigation. An application of TNMM assumed that the manufacturing affiliate received profits less than the cost of capital for this sector.

Market conditions, however, are often such that a firm may fail to receive its cost of capital even under arm’s length pricing.

Platinum is a commodity where market prices exhibit considerable variability. During 2011 the average price for platinum exceeded $1700 per ounce. Given that the intercompany transaction involved the purchase of platinum from its Swiss affiliate, an application of the comparable uncontrolled price approach may have provided a more appropriate analysis if the taxpayer prepared a credible application of a market pricing instead of a profits-based approach.

The TNMM may still play a role as a sanity check if applied for an extended period. The logic is that a manufacturing affiliate under arm’s length pricing would not receive an actual return persistently below its cost of capital.

SARS, however, only examined the financial information for this manufacturing affiliate for 2011, which was a period where market conditions may have led to low profits under arm’s length pricing.