The Kenya Revenue Authority last month released the draft Transfer Pricing (TP) guidelines ahead of a stakeholders’ workshop scheduled for June 20.
The move comes amidst persistent claims by the authority and non-governmental organisations that Kenya is losing significant revenues through transfer pricing.
The draft guidelines specify conditions and procedures that taxpayers will apply when selecting and applying transfer pricing methods.
Just like the TP rules, the draft guidelines borrow from the OECD TP guidelines, and if published will expand the scope of the TP regulations to include compensating adjustments, corresponding adjustment, primary adjustments and expands the persons covered under the definition of related parties.
The draft TP guidelines recognise the need to make compensating adjustments in the tax computations prior to the filing of the return.
Interestingly, the draft guidelines do not allow negative (downward) TP adjustments to the tax computations contrary to the spirit and intention of transfer pricing, which is to ensure that Kenya receives its fair share of tax revenues.
The draft guidelines define corresponding adjustment as those made to the tax liability of an associated enterprise in a second tax jurisdiction following primary adjustments made by the KRA to ensure that the allocation of profits in the two jurisdictions is consistent with the arm’s length principle.
In a related party transaction where a Kenya-based company purchases goods from a related firm, KRA may deem the price that the local company is charged to be too high and adjust the cost of the goods downwards thereby increasing the profit that is taxable in Kenya.
This effectively shifts profits from the jurisdiction of the second company to Kenya. The corresponding adjustments allow the second company to adjust the profit it declares in the second country downwards.
Since the guidelines propose to bar negative adjustments, where a subsidiary of a Kenyan company suffers a transfer adjustment on transactions with the parent Kenyan company, the KRA will not allow a corresponding adjustment in Kenya, a classic case of the KRA “having its cake and eating it”!
The draft TP guidelines propose to expand the definition for related parties to include individuals’ relations.
This is expected to cover associations by marriage, consanguinity or affinity to an individual in the management, control or capital of the other – an indicator of the KRA’s increased focus and scrutiny of family-held enterprises.
The draft TP guidelines also recognise that there is no true hierarchy of TP methods and therefore, certain systems may be more reliable in a particular transaction. The reliability will depend on facts and circumstances of each case.
The determination of the arm’s length price is intrinsically linked to the prices charged between unrelated parties for similar transaction. The determination of this price is only possible through the use of comparable companies.
Accessing commercial databases is one of the reasons that make transfer pricing documentation expensive.
The draft TP guidelines have set out a preference for the comparable companies in the following order: internal comparable, external (third party) local comparable derived from non-database sources, local comparables derived from a third party database and finally, external foreign comparables derived from a database.
Where an external database is used, the KRA will now require the taxpayer to produce the database and demonstrate how the search was carried out.
It is not economical for taxpayers to maintain their own databases and, therefore, they continue to rely on their tax advisors for this service to leverage on economies of scale.
One challenge the taxpayers will however face is access to databases where the KRA carries out a TP audit many years down the line when the database may no longer be accessible, introducing new challenges on user policy and rights associated with access to the commercial database.
Finally, the draft TP guidelines provide that the most acceptable arm’s length price should lie at the median of the interquartile range.
However, where the tested party results lie at the upper side of interquartile range a downward transfer pricing adjustment is not acceptable bringing to focus the principle of equality.
This conflicts with internationally accepted practice where a price falling within the inter-quartile range is accepted as a good indicator of a reasonable price.
KRA’s move to open the draft TP guidelines to stakeholder review and comments is, however, welcome as this will form a basis for the development of a more robust and equitable TP regime.
Ms Ndirangu is a Senior Tax Advisor at KPMG. The views expressed here are her own and do not necessarily reflect the views of KPMG.