Transfer pricing in Kenya: beyond Unilever

By Dr. J. Harold McClure, New York City

The United Nations Committee of Experts on International Cooperation in Tax Matters will consider updates to the United Nations Practical Manual on Transfer Pricing for Developing Countries at its 21st session, which commenced October 20. Included is a new country practice chapter for Kenya.

The Kenyan revenue agency (KRA) has limited experience with the enforcement of transfer pricing. The only litigation noted in this country practice chapter is its loss in Unilever Kenya Limited v. The Commissioner of Income Tax. The new country practice chapter outlines procedures that the Kenyan revenue agency could utilize to have successes in challenging transfer pricing that is not arm’s length. We shall argue that these procedures could also allow multinationals to present better defenses of transfer pricing policies that are consistent with the arm’s length standard. Our discussion of Unilever’s African transfer pricing makes assumptions favorable to the view that its intercompany pricing was reasonable.

The Kenya country practice chapter to United Nations Practical Manual on Transfer Pricing for Developing Countries notes:

The audit conducted on Unilever (Kenya) Limited in 1998, revealed that Unilever (Kenya) charged lower prices to Unilever (Uganda) than those charged both to customers in Kenya and to unrelated parties in the export market both in Uganda and elsewhere.

The Kenya revenue agency apparently used a comparable uncontrolled price (CUP) approach to suggest that the price Unilever Kenya Limited received from Unilever Uganda Limited was below the arm’s length standard.

Nonetheless, the taxpayer prevailed using an application of the transactional net margin method (TNMM) to justify the 10 percent markup Unilever Kenya received on the sale of goods to Unilever Uganda. (See Jevans Nyabiage – www.africog.org/ij/2012/court_case_changed_KRAs_view_on_transfer_pricing – as well as the High Court decision)

It seems, though, that if the Kenya revenue agency had more information about Unilever’s operations, specifically access its international intercompany agreements and an understanding of ownership of its valuable intangible assets, the Kenya tax authority would have a better understanding of the taxpayer’s position if the marketing intangibles were owned by Unilever Uganda Limited or alternatively presented a more compelling challenge to the intercompany pricing if the marketing intangibles were owned by Unilever Kenya Limited.

Unilever intercompany prices

Unilever Kenya and Unilever Uganda signed an intercompany contract dated August 28, 1995, where Unilever Kenya would manufacture certain products on behalf of Unilever Uganda.  Unilever Kenya would receive as compensation its production costs plus a markup that would afford Unilever Kenya with a return on its assets equal to approximately 10 percent.

The Kenya revenue agency noted that these intercompany prices were substantially below the prices that Unilever Kenya charged to its domestic buyers and importers not related to Unilever Kenya.

In particular, the Kenya revenue agency noted that Unilever Uganda paid approximately 25 percent less than amounts paid by a third party distributor in Tanzania.

The Kenya revenue agency attempted to utilize the CUP approach even though the intercompany transactions and the third party transactions covered several different goods.

Kenya’s High Court also noted that Unilever Kenya bore certain marketing expenses in its sale of goods to third parties that it did not bear in its related party sales.

For these reasons, the High Court found the Kenya revenue agency’s application of the CUP approach to be flawed.

The High Court briefly noted the resale price method as it turned to the taxpayer’s application of the “cost plus return method,” which the High Court noted was an estimate based on the manufacturer’s production cost plus “an appropriate return on capital employed.”

The High Court also noted that Unilever traditionally afforded its manufacturing affiliate a 10 percent return on assets.

Transfer pricing practitioners often produce TNMM reports using the manufacturing affiliate as the tested party and the return on its assets as the profit level indicator. These reports typically select third party manufacturers as comparable companies, with the results tending to confirm that a 10 percent return on assets is reasonable.

At first blush, Unilever’s transfer pricing policy appears to be reasonable. The High Court ruled that the taxpayer’s approach based on TNMM represented a more reliable evaluation of arm’s length pricing than the Kenya revenue agency’s attempt to use the CUP approach.

Procter & Gamble comparison

Unilever and Procter & Gamble have very similar businesses and are both highly profitable.

Over the three-year period ended June 30, 2020, Procter & Gamble’s operating profits exceeded 20 percent of sales as its cost of goods sold was approximately 51 percent of sales and its operating expenses were approximately 29 percent of sales.

Unilever’s operating profit margin has been similar. Unilever and Procter & Gamble incur significant marketing expenses and enjoy high operating margins because of valuable intangible assets, including product and marketing intangibles. 

These facts show why one could argue that Unilever Uganda receives lower product prices than the Tanzanian independent distributor.

We shall present an illustration of the issues in this litigation that assumes Unilever Uganda represents an African principle that utilizes the intangible assets owned by the UK parent and employs Unilever Kenya as a contract manufacturer.

Unilever Uganda also relies upon various third party and related party distributors to sell goods. The following table presents a hypothetical set of financials based on the following assumptions:

• Sales of products in the region were $100 million;
• Cost of production incurred by Unilever Kenya were 50 percent of sales; and
• Total cost of distribution and marketing were 30 percent of sales with part of these costs borne by Unilever Uganda and part by the distribution affiliates.

Let’s also assume:

• Unilever Kenya’s operating asset to sales ratio represented 100 percent of its production costs;
• The transfer pricing policy established a 10 percent markup over production costs;
• Unilever Uganda affords the distribution affiliates a 25 percent gross margin as their operating expenses represented 20 percent of sales; and
• Unilever Uganda pays intercompany royalties equal to 5 percent of sales to the UK parent.

A hypothetical model of African transfer pricing

Millions	Consolidated	Distributors	Unilever Uganda Limited	Unilever Kenya Limited	Unilever-UK
Sales	$100	$100	$75	$55
COGS	$50	$75	$55	$50
Gross Profits	$50	$25	$20	$5
Operating Expenses	$30	$20	$10	$0
OPB4Royalties	$20	$5	$10	$5
Royalties	$0	$0	$5	$0	$5
Operating Profits	$20	$5	$5	$5	$5

This example is consistent with the facts noted in this litigation as the distributors are paying prices higher than those received by Unilever Kenya.

The distributors receive only a 25 percent gross margin, whereas the distributors and Unilever Uganda collectively are receiving a 45 percent gross margin before the consideration of the intercompany royalty.

But we should note that this gross margin is reduced to only 40 percent when the intercompany royalty is factored into the analysis.

While the related party distributor has a 40 percent gross margin, the third-party distributor has a gross margin of only 25 percent.

The facts in this litigation also argue against a naïve application of the resale price method as the High Court noted that difference in the operating expenses borne by Unilever Uganda versus the third-party distributor in Tanzania.

One of the concerns of the United Nations is that multinationals are shifting income from developing nations to tax haven affiliates by the use of abusive transfer pricing. The OECD has a similar concern that multinationals are engaged in base erosion, that is shifting income from a developed nation with high tax rates to tax have affiliates.

Unilever’s operating affiliates pay intercompany royalties to the UK parent, which is not a tax have entity. For this reason Unilever insists it is not involved in base erosion. One could still question whether its intercompany pricing policies are arm’s length or not.

The income tax rates for Kenya, Uganda, and Tanzania are all 30 percent, so any income shifting among these nations does not lower the worldwide taxes paid by Unilever.

The lack of base erosion, however, does not eliminate the concern over transfer pricing as the tax authorities for Kenya, Uganda, and the UK all have a vested interest in how consolidated income is allocated.

Our illustration of Unilever’s African transfer pricing assumes that the routine return for distribution is 5 percent of sales, and the routine return for manufacturing is 5 percent of sales.

Residual profits are, therefore, 10 percent of sales, which are evenly allocated between the owner of the marketing intangibles and the owner of product intangibles.

Marketing intangible owner

Whether this split of residual profits is reasonable is one of the two key transfer pricing issues.

The other key transfer pricing issue is whether Unilever Uganda is the rightful owner of the marketing intangibles.

The Kenya country chapter to the United Nations Practical Manual on Transfer Pricing for Developing Countries states:

Kenya has embraced internationally recognized guidelines namely United Nations (UN) and OECD Transfer pricing guidelines and the OECD Base Erosion and Profit Shifting (BEPS) project outcomes. Kenya has embraced the BEPS outcomes and has gone ahead to implement some of the recommendations contained in the BEPS reports. Kenya is in the process of reviewing the Income Tax Act and KRA has proposed several amendments to be included in the revised Act to address BEPS issues.

Kenya’s revenue agency expects a multinational to submit country-by-country reporting that is part of the OECD’s Base Erosion and Profit Shifting Action 13 documentation requirements.

The Kenya revenue agency should also ask for the multinational’s master file, which includes the multinational’s key international intercompany agreements and its discussion of what the valuable intangible assets are and which entities own each intangible asset.

The evaluation of Unilever’s African transfer pricing by the Kenya revenue agency would have been better informed with this additional information.