Home Articles ANALYSIS: Arm’s length pricing between connected persons

ANALYSIS: Arm’s length pricing between connected persons

Tax law generally applies to actual terms on which a transaction has been concluded as opposed to what the transaction would have been had it been entered into at arm’s length. Some exceptions exist where tax arbitrage can take place if the actual terms of a transaction are susceptible to manipulation. The most comprehensive of these exceptions is probably section 31 of the Income Tax Act, 1962 (Act 58 of 1962), which deals with cross-border transfer pricing.


The risk posed by the manipulation of prices is clear in a cross-border context where tax rates differ between countries. Taxable profits can be shifted to the low-tax country by manipulating the price of the transaction to achieve an inflated deduction in the high-tax country or to understate income in the high-tax country. This risk would generally exist where the greater group that a taxpayer belongs in is indifferent as to the location where the group’s profits arise.

In the cross-border context, section 31 of the Act requires the party that achieves a tax benefit in South Africa from non-arm’s length terms and conditions in transactions with certain connected persons to determine its taxable income as if the transaction had taken place at arm’s length terms and conditions. Compliance with section 31 requires significant effort by taxpayers, including the compilation and constant updating of transfer pricing policies and documentation.


In 2010 the broadening of transfer pricing rules to domestic transactions was hinted at in the budget speech; this did not materialise. In 2013, limitations on the deductibility of interest on excessive debt paid to certain connected persons (effectively a thin capitalisation adjustment) were proposed without explicitly limiting it to cross-border transactions. The debate around domestic transfer pricing rules, as a policy issue, may therefore be far from over.

In the context of domestic transactions between connected persons, the scope and incentive for manipulation of prices may be considerably less than in cross-border transactions. The tax rates applicable to different taxpayers do not differ as significantly as it may do between taxpayers situated in different countries. Exempt entities could pose a risk, but this risk is largely mitigated by the regulated nature of these entities1 and by the fact that in many cases the exemptions are subject to the entity not being part of a scheme to avoid tax, which the shifting of profits to such an entity would be.2 Finally, taxpayers in different positions may motivate manipulation of the prices of transactions; a prime example would be a transaction where the recipient of income is in an assessed loss position, while the payer may be entitled to a deduction. An inflated deduction could defer the parties’ overall tax liability. The need and policy considerations for domestic transfer pricing rules to address the above concerns are however topics beyond the scope of this article.

The question considered in this article is whether the current lack of comprehensive domestic transfer pricing rules means that the arm’s length principle is not an issue to be concerned about in domestic transactions. The article aims to highlight some instances under the current provisions of the Act where taxpayers have to be aware of the arm’s length pricing in domestic transactions between connected or related persons.


The Act contains various references to terms such as market values, arm’s length prices and adequate consideration, which may all come down to arm’s length terms and conditions. A discussion of a few of these provisions in the context of domestic transactions follows.


Paragraph 38 of the Eighth Schedule to the Act states that where a person disposes of an asset to a connected person for consideration that does not reflect an arm’s length price, that person must be deemed to have disposed of the asset for an amount equal to its market value. Although not limited to transactions between connected persons, section 58(1) of the Act deems a property to have been disposed of under a donation where the consideration on the disposal is not adequate in the Commissioner’s opinion. Disposing of assets at amounts other than arm’s length prices may therefore have capital gains tax as well as donations tax implications.

Until recently, section 23J limited the cost of the asset in the hands of the acquirer for purposes of capital allowance. Despite the scrapping of section 23J, many of the sections of the Act providing capital allowance deem the cost of an asset to be the lesser of the actual cost for the taxpayer and the cost which a person would have incurred under a cash transaction concluded at arm’s length. This limitation applies irrespective of whether the parties to the transaction are connected in relation to each other.

The corporate roll-over provisions in Part III of Chapter II may eliminate some of the above concerns. It does however appear as if the legislature has recognised the importance of considering the arm’s length principle, even in such re-organisation transactions. The introduction of section 24BA, which requires the parties to an arrangement to reflect on whether the consideration for shares issued in exchange for assets is similar to what independent persons dealing at arm’s length would have agreed to, is a good example of this.


In terms of section 11(a), read with sections 23(f) and 23(g), a taxpayer would be entitled to a deduction in respect of expenditure incurred to extent that the expenditure is incurred in the production of income and for purposes of the taxpayer’s trade. It was clearly stated in the case of Port Elizabeth Electric Tramway Company Ltd v CIR that expenditure may be said to be in the production of income if the expenses are attached to an operation bona fide performed for the purpose of earning income. Necessity of the expenditure is therefore not a requirement. In a number of cases, amongst others ITC 1518 and ITC 1530, it was however held that expenditure that was excessive in relation to the underlying transaction (in ITC 1518 services rendered and in ITC 1530 risk taken on a loan) may not be treated as being incurred in the production of income. In both cases the transactions were entered into between the taxpayer and a connected or related person. In considering whether expenditure is excessive, arm’s length principles, similar to those applied for transfer pricing purposes may come in useful. The judgment in the Tax Court case No 12262 shows this.

The second issue from a deduction point of view relates to the ‘trade’ requirement in section 23(g). In the case of Solaglass Finance Company (Pty) Ltd v CIR a group treasury company suffered losses on loans to related entities. The majority judgment on the deductibility of the losses was that the activities of the company were conducted for a dual purpose, namely to realise a profit for the company (taxpayer’s own trade) but also for the benefit of the group (not the taxpayer’s own trade). At the time section 23(g) required expenditure to be incurred wholly and exclusively for the purposes of the taxpayer’s own trade. The dual purpose resulted in the deduction not being allowed. Non-arm’s length prices may in these circumstances for purposes of the current section 23(g) indicate that expenditure is incurred for a purpose other than the taxpayer’s own trade, resulting in a partial disallowance. It is submitted that this issue can be overcome by ensuring that arm’s length prices (or margins) are charged. This should result in the benefit to the group being similar to that which would be obtained from any other service provider and the purpose of the expenditure from the taxpayer’s perspective being limited to its own trade.


A dividend is widely defined in section 1 of the Act as “any amount transferred or applied by a company that is a resident for the benefit or on behalf of any person in respect of any share in that company”. In the case of C: SARS v Brummeria Renaissance & Others it was held that the term ‘amount’ would include anything with a money value, irrespective of whether it can be turned into money or not. Benefits made available by a company to its shareholders at consideration that differs from what persons dealing at arm’s length would have agreed, may indicate that benefits with a money value are being transferred to the shareholder by reasons of its share in the company, which in turn would constitute a dividend in specie that could potentially be subject to dividends tax.


An impermissible tax avoidance arrangement may exist in terms of section 80A of the Act if amongst others the arrangement has “created rights or obligations that would not normally be created between persons dealing at arm’s length”. This may include non-arm’s length pricing. If all the other requirements of section 80A, including that the sole or main purpose of the arrangement was to obtain a tax benefit, are met, a transaction may be exposed to a risk of adjustments by the Commissioner in terms of section 80B to re-allocate amounts amongst parties involved.


Section 102(1) of the Tax Administration Act (the TAA) places the burden on the taxpayer to proof “that an amount … is not taxable”, “that an amount … is deductible” or “that a valuation is correct”. It is submitted that unlike cases decided under the section 82 of the Act3 the onus to proof that the correct amount to be used for tax purposes now clearly falls on the taxpayer. It is therefore submitted that in the cases where the Commissioner questions the amount relating to a domestic transaction in instances such as those discussed above, the taxpayer may be required to justify and substantiate the pricing of the transaction. Documentation similar to those used for transfer pricing may be required for this purpose for these types of transactions.


It is submitted that the answer to the question posed earlier in the article is that being oblivious of arm’s length pricing principles in respect of domestic transaction would be to a taxpayer’s own detriment, in particularly transactions between connected or related persons. Despite the lack of comprehensive domestic transfer pricing rules, arm’s length principles remain relevant and should be considered in this context.


1 “Affected transaction” means any transaction, operation, scheme,    Pension funds as an example.

2   Refer to section 30(3)(c) of the Act as an example.

3   Section 102 of the TAA replaced section 82 of the Act.

Author: Pieter van der Zwan is an associate professor and tax programme leader at North-West University