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Tax Q&A · Transfer pricing extended

Does ignoring indirect taxes in TP, like VAT or WHT, risk double/triple taxation for cost-plus firms?

FULL QUESTION

When it comes to transfer pricing, sometimes the indirect taxes seem ignored. If a company is not registered for VAT, for example, in Kenya pays withholding taxes on freelancers/external consultants and operates on a cost-plus method doesn’t this result in double or even triple taxation (not in the sense of corporation tax, of course)?

ADDITIONAL WRITTEN ANSWER

In Kenya, transfer pricing primarily addresses the allocation of income and expenses between related entities to ensure transactions occur at arm’s length for corporate income tax purposes. However, indirect taxes like Value Added Tax (VAT) and withholding tax can also significantly impact a company’s tax obligations, especially when operating under a cost-plus method.

VAT Considerations:

If a company is not registered for VAT, it cannot charge VAT on its sales or reclaim VAT on its purchases. This means that any VAT paid on goods and services becomes an additional cost. Under the cost-plus method, this non-recoverable VAT is included in the cost base, leading to a higher markup and, consequently, higher prices charged to related entities. This can result in cascading tax effects, as the final consumer bears the burden of VAT embedded in the cost structure.

Withholding Tax Implications:

Payments to freelancers or external consultants are subject to withholding tax, which the company must deduct and remit to the Kenya Revenue Authority (KRA). If these payments are included in the cost base under the cost-plus method, the markup is applied to costs that have already been taxed via withholding. This can lead to an effective increase in the tax burden, as the markup amplifies the impact of the initial withholding tax.

Potential for Multiple Taxation Layers:

Combining non-recoverable VAT and withholding taxes within a cost-plus framework can create multiple layers of taxation:

  • Initial Taxation: VAT paid on inputs and withholding tax on payments to consultants.
  • Markup Application: The cost-plus method applies a profit margin on top of these taxed amounts, increasing the overall cost base.
  • Final Taxation: The end consumer pays VAT on the final product or service, which now includes the compounded costs of initial taxes and the applied markup.

This sequence can lead to a form of tax-on-tax, escalating the total tax burden throughout the supply chain.

Mitigation Strategies:

  • VAT Registration: Registering for VAT allows a company to charge VAT on its outputs and reclaim VAT on its inputs, reducing the cascading effect of non-recoverable VAT.
  • Transfer Pricing Policies: Carefully structuring transfer pricing policies to exclude tax components from the cost base can prevent the amplification of tax burdens through markups.
  • Tax Planning: Engaging in comprehensive tax planning to understand and mitigate the interplay between direct and indirect taxes can help in minimizing unintended tax consequences.

In summary, while transfer pricing regulations in Kenya focus on direct taxes, indirect taxes like VAT and withholding tax can compound the tax burden, especially under a cost-plus pricing model. Proactive tax management and strategic planning are essential to prevent multiple layers of taxation and to ensure compliance with Kenyan tax laws.

PLEASE SEE WORKING EXAMPLE: Scenario

Company X operates in Kenya but is not registered for VAT. It provides IT consulting services to a related company, Company Y, located in South Africa. The pricing method applied is cost-plus, with a markup of 20%.

Key Transactions and Costs:

  • Freelancers/Consultants: Company X engages local and international freelancers to provide the services, paying a total of KES 1,000,000. These payments are subject to withholding tax at 5%.
  • Operational Costs: Company X incurs operational expenses of KES 200,000, which includes non-recoverable VAT at 16% embedded in the costs (KES 32,000 VAT component).
  • Pricing to Related Entity (Company Y): The cost-plus pricing method adds a 20% markup on the total cost base to determine the charge.

Step-by-Step Analysis

1. Withholding Tax on Freelancers

  • Withholding tax deduction on freelancer payments:

Withholding Tax Paid=KES1,000,000×5%=KES50,000

  • Company X bears this withholding tax unless agreed otherwise with freelancers. This KES 50,000 becomes part of the cost base under the cost-plus method.

2. Operational Costs and Embedded VAT

  • Non-recoverable VAT of KES 32,000 forms part of the operational costs. Since Company X is not VAT-registered, it cannot reclaim this amount, increasing the total cost of service provision.

3. Cost-Plus Pricing Calculation

  • Total cost base before markup:

Cost Base=(Freelancer Costs+Operational Costs)=(KES1,000,000+KES200,000)=KES1,200,000

  • Adding markup of 20%:

Final Price to Company Y=KES1,200,000×(1+20%)=KES1,440,000

4. Indirect Tax Effects on Pricing

  • Withholding Tax Amplification: Since the withholding tax of KES 50,000 is included in the cost base, the markup applies to a cost that has already been taxed. This effectively amplifies the tax burden, as:

Markup on Withholding Tax Component=KES50,000×20%=KES10,000

  • VAT Compounding Effect: The embedded non-recoverable VAT (KES 32,000) is also marked up, contributing:

Markup on Non-Recoverable VAT Component=KES32,000×20%=KES6,400

This adds to the cascading tax burden.

5. Final Tax Burden

  • Total indirect taxes absorbed in the pricing:

Indirect Tax Effects=(Withholding Tax Paid+Markup on Withholding Tax)+(Non-Recoverable VAT+Markup on VAT)

Substituting values:

Indirect Tax Effects=(KES50,000+KES10,000)+(KES32,000+KES6,400)=KES98,400

This amount represents the indirect tax component within the final price of KES 1,440,000, which could have been mitigated with appropriate tax planning.

Potential Issues Highlighted

  • Double Taxation: The withholding tax paid at the freelancer level and embedded VAT result in an indirect tax-on-tax effect due to the markup.
  • Cascading VAT: Non-recoverable VAT amplifies costs for non-registered entities, as they cannot reclaim input VAT.
  • Distortion of Transfer Pricing: Including tax costs in the cost base inflates the transfer price, potentially creating tax mismatches between jurisdictions (e.g., Company Y’s deductibility issues in South Africa).

Mitigation Strategies in This Example

  • Register for VAT: If Company X registers for VAT, it can reclaim the KES 32,000 VAT embedded in operational costs, thereby reducing the cost base.
  • Separate Tax Costs from Cost Base: Excluding withholding tax and VAT components from the cost base for transfer pricing purposes ensures these taxes are not further amplified through markups.
  • Tax Planning and Policy Review: A comprehensive review of both direct and indirect tax impacts can align transfer pricing policies with local tax regulations, reducing unintended tax burdens.

By applying these strategies, Company X can minimize the cascading tax effects while ensuring compliance with Kenyan tax laws.

VIDEO SCRIPT

You are correct when we think about transfer pricing, our minds often go straight to direct taxes—corporate income tax, profit attribution, and ensuring compliance with arm’s length principles.

But there’s an equally important, yet often overlooked, element: indirect taxes.

Value Added Tax (VAT) and withholding taxes, for example, can significantly complicate the transfer pricing equation, especially when they interact with pricing methodologies like the cost-plus method. Ignoring their impact can lead to unintended consequences, including multiple layers of taxation.

Let’s take your scenario in Kenya to illustrate this.

Imagine a company that provides services to its related entities, operating under a cost-plus pricing model.

The company engages freelancers or external consultants to support its operations, but it’s not registered for VAT. This introduces a fundamental issue.

Without VAT registration, the company cannot charge VAT on its services or reclaim VAT on the goods and services it procures. As a result, the VAT it pays becomes an additional cost that it must absorb.

Now, under the cost-plus method, this non-recoverable VAT forms part of the cost base used to calculate the markup.

Essentially, the VAT, which is already a tax, is treated as a business cost. When the markup is applied, the VAT-inclusive cost is increased further, inflating the price charged to related entities.

This means that the end consumer, or the next party in the chain, effectively bears the burden of the embedded VAT, plus the cost-plus markup on top of it.

Let’s complicate things further by adding withholding tax.

In Kenya, payments made to freelancers or external consultants are subject to withholding tax, which the company must deduct and remit to the Kenya Revenue Authority.

This tax is effectively borne by the freelancers, but it impacts the company as well.

When these consultant costs are included in the cost base, the markup under the cost-plus method is again applied on amounts already taxed—this time via withholding tax.

The result is a compounding effect: VAT becomes part of the cost base, withholding tax adds another layer, and the markup amplifies the overall tax burden.

What we’re seeing here is not traditional double taxation in the sense of corporate income tax being taxed twice across jurisdictions.

Instead, it’s a form of tax-on-tax within the structure of indirect taxes and transfer pricing.

By the time the product or service reaches its final consumer, the cascading tax effect is significant.

So, how do we address this?

For one, VAT registration can make a critical difference. A VAT-registered company can charge VAT on its outputs and reclaim VAT on its inputs, breaking the cycle of cascading tax costs.

Beyond that, transfer pricing policies must be carefully designed to exclude tax components, such as non-recoverable VAT and withholding tax, from the cost base used for pricing calculations. This ensures that the markup is applied only to actual business costs, not to taxes.

Additionally, strategic tax planning is essential.

Companies need to consider the interplay between direct and indirect taxes in every jurisdiction where they operate.

This includes understanding local VAT and withholding tax rules, examining how these taxes interact with transfer pricing methods, and proactively managing their tax obligations to avoid unintended consequences.

So lets just recap. The world of transfer pricing doesn’t exist in a vacuum.

Indirect taxes, like VAT and withholding tax, are integral to the financial and operational reality of multinational enterprises. By recognizing their impact and addressing them strategically, companies can avoid the pitfalls of multiple layers of taxation and achieve a more efficient tax structure.