If you have intellectual property (“IP”) that is used by a connected person outside of South Africa, and that foreign connected person is not required to make market-related royalty payments to you for the use of the IP, you are most probably contravening the transfer pricing provisions in our Income Tax Act.
A connected person (in respect of a company) is loosely defined as: an entity in which one holds more than 50% shares; or an entity in which one owns at least 20% shares, and no other person holds the majority voting rights of the entity.
SARS has conducted searches through various databases to identify all foreign registered IP (i.e. patents, trademarks and designs) owned by South African taxpayers. Where no or nominal foreign royalty income is declared by those taxpayers in their tax returns, they are flagged for future queries.
Ironically, the CGT valuations prepared by taxpayers may, in this instance, act to taxpayers’ detriment. Generally, these valuations were prepared using the relief from royalty approach, which: determines the profitability of the company; justifies a reasonable profit-split for the notional use of the IP by the owner (presuming that the IP is owned by an unconnected third party); translates the royalty rate to a percentage of turnover; forecasts turnover growth for the useful economic life of the IP; applies the royalty rate to the turnover; and discounts the future notional royalties at an appropriate discount rate to arrive at the value of the IP.
Accordingly, SARS could merely have regard to the CGT valuation and apply the same profit split to the profits of foreign connected persons using the IP to determine a reasonable royalty rate for transfer pricing purposes. However, further adjustments may be required for IP such as trademarks, to account for additional advertising and marketing spend by the foreign connected person.
Mere application of “the 25% Rule” or reliance on Benchmarking reports is insufficient. A much more in-depth analysis is required.
Should SARS effect a transfer pricing adjustment, arm’s length royalty payments will be deemed received by the South African IP owner and taxed at the South Africa income tax rate. No corresponding deduction will typically be available to the foreign connected person. In addition, the adjustment should trigger STC; interest and a possible 200% penalty on the amount adjusted, and the general 3-year prescription period applies.
It is therefore important for South African taxpayers to keep track of their foreign registered IP and to categorise it as: “defensive” (i.e. used as a barrier to entry for potential competitors); “infringing use” (i.e. used to permit entities within foreign territories to perform otherwise infringing acts, such as manufacturing); “distribution” (i.e. used solely to prevent entrance of third party infringing products into the protected territory); and “marketing” (i.e. trademarks).
By its very nature, defensive IP is not used by foreign connected persons and therefore seldom requires the payment of royalties. On the other hand, where infringing use IP is used by foreign connected persons, royalties are payable. Depending on how distribution arrangements are structured, distribution IP may or may not trigger royalty payments, and marketing IP will generally require the payment of royalties, adjusted for marketing and advertising spend of the foreign connected person.
At the very least, any use of IP by a foreign connected person should be reduced to writing. From an administrative perspective, it is also advisable for South African taxpayers to retain information regarding: expenditure in respect of the development, registration and maintenance of foreign IP; negotiations between the parties; comparable royalty rates (although Benchmarking Reports should not exclusively be relied upon to determine royalty rates); profitability, advertising and marketing expenditure of the respective parties; and other IP used by the foreign connected person.