- QUESTION POSTED BY: Student
- PROGRAMME: Postgraduate Diploma in International Taxation
- TOPIC: Transfer PricingTransfer pricing is a fundamental concept in international taxation that defines the pricing methods and rules applied to transactions between related entities within a multinational enterprise (MNE). In the context of tax regulations, it governs how prices for goods, services, or intangibles (such as intellectual property) are set when these items are exchanged between different branches, subsidiaries, or affiliates of... Extended (WEEKS 28, 29 & 30)
- LECTURER: Okkie Kellerman
FULL QUESTION
When it comes to transfer pricingTransfer pricing is a fundamental concept in international taxation that defines the pricing methods and rules applied to transactions between related entities within a multinational enterprise (MNE). In the context of tax regulations, it governs how prices for goods, services, or intangibles (such as intellectual property) are set when these items are exchanged between different branches, subsidiaries, or affiliates of..., 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 methodThe Cost-Plus Method is one of the five primary transfer pricing methods outlined by the OECD Transfer Pricing Guidelines. It is used to determine the arm's length price of intercompany transactions, particularly for services or products provided between associated enterprises. The method applies a standard markup to the costs incurred by the supplier, ensuring that the resulting profit margin reflects... doesn’t this result in double or even triple taxation (not in the sense of corporation taxCorporate Tax refers to the tax imposed by governments on the income or capital of corporations. Corporations, considered separate legal entities, are taxed on their profits, meaning the income generated from their operational activities, investments, and other financial undertakings. This tax is generally a key revenue source for governments, helping to fund public services, infrastructure, and other essential functions. The..., of course)?
ADDITIONAL WRITTEN ANSWER
In Kenya, transfer pricingTransfer pricing is a fundamental concept in international taxation that defines the pricing methods and rules applied to transactions between related entities within a multinational enterprise (MNE). In the context of tax regulations, it governs how prices for goods, services, or intangibles (such as intellectual property) are set when these items are exchanged between different branches, subsidiaries, or affiliates of... primarily addresses the allocation of income and expenses between related entities to ensure transactions occur at arm’s length for corporate income taxCorporate Tax refers to the tax imposed by governments on the income or capital of corporations. Corporations, considered separate legal entities, are taxed on their profits, meaning the income generated from their operational activities, investments, and other financial undertakings. This tax is generally a key revenue source for governments, helping to fund public services, infrastructure, and other essential functions. The... 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 methodThe Cost-Plus Method is one of the five primary transfer pricing methods outlined by the OECD Transfer Pricing Guidelines. It is used to determine the arm's length price of intercompany transactions, particularly for services or products provided between associated enterprises. The method applies a standard markup to the costs incurred by the supplier, ensuring that the resulting profit margin reflects....
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 methodThe Cost-Plus Method is one of the five primary transfer pricing methods outlined by the OECD Transfer Pricing Guidelines. It is used to determine the arm's length price of intercompany transactions, particularly for services or products provided between associated enterprises. The method applies a standard markup to the costs incurred by the supplier, ensuring that the resulting profit margin reflects..., 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 AuthorityTax authorities are fundamental institutions within government frameworks, overseeing tax assessment, collection, and administration. Their operations ensure that tax laws are enforced and public funds are collected efficiently. This article delves into tax authorities' purpose, responsibilities, and structure, offering insights into their essential role in supporting government functions and economic stability. What is a Tax Authority? A tax authority is... (KRA). If these payments are included in the cost base under the cost-plus methodThe Cost-Plus Method is one of the five primary transfer pricing methods outlined by the OECD Transfer Pricing Guidelines. It is used to determine the arm's length price of intercompany transactions, particularly for services or products provided between associated enterprises. The method applies a standard markup to the costs incurred by the supplier, ensuring that the resulting profit margin reflects..., the markup is applied to costs that have already been taxed via withholding. This can lead to an effective increase in the tax burdenTax liability represents the total amount of tax owed by an individual or business to a tax authority, whether local, national, or international. This obligation arises through various forms of income, profits, or transactions subject to taxation laws and regulations. Understanding tax liability is essential for compliance and efficient financial management for corporations and individuals. It influences how businesses structure..., 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 methodThe Cost-Plus Method is one of the five primary transfer pricing methods outlined by the OECD Transfer Pricing Guidelines. It is used to determine the arm's length price of intercompany transactions, particularly for services or products provided between associated enterprises. The method applies a standard markup to the costs incurred by the supplier, ensuring that the resulting profit margin reflects... 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 burdenTax liability represents the total amount of tax owed by an individual or business to a tax authority, whether local, national, or international. This obligation arises through various forms of income, profits, or transactions subject to taxation laws and regulations. Understanding tax liability is essential for compliance and efficient financial management for corporations and individuals. It influences how businesses structure... 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 PoliciesTransfer Pricing Policies refer to the rules and methods established by multinational enterprises (MNEs) to determine the pricing of transactions between related parties, such as subsidiaries or divisions of the same company. These transactions may involve the transfer of goods, services, intellectual property, or financial arrangements. Transfer pricing policies are essential for ensuring that intercompany transactions adhere to the arm’s...: Carefully structuring transfer pricing policiesTransfer Pricing Policies refer to the rules and methods established by multinational enterprises (MNEs) to determine the pricing of transactions between related parties, such as subsidiaries or divisions of the same company. These transactions may involve the transfer of goods, services, intellectual property, or financial arrangements. Transfer pricing policies are essential for ensuring that intercompany transactions adhere to the arm’s... to exclude tax components from the cost base can prevent the amplification of tax burdens through markups.
- Tax PlanningTax planning is the process of organising and structuring one’s financial affairs in a manner that legally minimises tax liabilities while ensuring compliance with relevant tax laws. The primary objective of tax planning is to reduce the amount of taxes paid, optimise the use of available tax benefits, and preserve wealth. It can be applied at various levels, including personal...: Engaging in comprehensive tax planningTax planning is the process of organising and structuring one’s financial affairs in a manner that legally minimises tax liabilities while ensuring compliance with relevant tax laws. The primary objective of tax planning is to reduce the amount of taxes paid, optimise the use of available tax benefits, and preserve wealth. It can be applied at various levels, including personal... to understand and mitigate the interplay between direct and indirect taxes can help in minimizing unintended tax consequences.
In summary, while transfer pricingTransfer pricing is a fundamental concept in international taxation that defines the pricing methods and rules applied to transactions between related entities within a multinational enterprise (MNE). In the context of tax regulations, it governs how prices for goods, services, or intangibles (such as intellectual property) are set when these items are exchanged between different branches, subsidiaries, or affiliates of... regulations in Kenya focus on direct taxes, indirect taxes like VAT and withholding tax can compound the tax burdenTax liability represents the total amount of tax owed by an individual or business to a tax authority, whether local, national, or international. This obligation arises through various forms of income, profits, or transactions subject to taxation laws and regulations. Understanding tax liability is essential for compliance and efficient financial management for corporations and individuals. It influences how businesses structure..., 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 lawsTax laws form the backbone of any nation’s revenue system, setting the rules that govern how individuals and corporations contribute financially to support government functions. These laws define the types of taxes, the applicable rates, and the regulations regarding payment and compliance. They also outline the rights and obligations of taxpayers, ensuring a balanced and fair approach to funding public....
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 methodThe Cost-Plus Method is one of the five primary transfer pricing methods outlined by the OECD Transfer Pricing Guidelines. It is used to determine the arm's length price of intercompany transactions, particularly for services or products provided between associated enterprises. The method applies a standard markup to the costs incurred by the supplier, ensuring that the resulting profit margin reflects....
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 burdenTax liability represents the total amount of tax owed by an individual or business to a tax authority, whether local, national, or international. This obligation arises through various forms of income, profits, or transactions subject to taxation laws and regulations. Understanding tax liability is essential for compliance and efficient financial management for corporations and individuals. It influences how businesses structure..., 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 burdenTax liability represents the total amount of tax owed by an individual or business to a tax authority, whether local, national, or international. This obligation arises through various forms of income, profits, or transactions subject to taxation laws and regulations. Understanding tax liability is essential for compliance and efficient financial management for corporations and individuals. It influences how businesses structure....
5. Final Tax BurdenTax liability represents the total amount of tax owed by an individual or business to a tax authority, whether local, national, or international. This obligation arises through various forms of income, profits, or transactions subject to taxation laws and regulations. Understanding tax liability is essential for compliance and efficient financial management for corporations and individuals. It influences how businesses structure...
- 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 planningTax planning is the process of organising and structuring one’s financial affairs in a manner that legally minimises tax liabilities while ensuring compliance with relevant tax laws. The primary objective of tax planning is to reduce the amount of taxes paid, optimise the use of available tax benefits, and preserve wealth. It can be applied at various levels, including personal....
Potential Issues Highlighted
- Double TaxationDouble Taxation occurs when the same income or financial transaction is taxed twice, typically in different jurisdictions. It can arise in two primary contexts: economic double taxation, where the same income is taxed twice in the hands of different taxpayers, and juridical double taxation, where the same taxpayer is taxed on the same income in more than one country. Double...: 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 PricingTransfer pricing is a fundamental concept in international taxation that defines the pricing methods and rules applied to transactions between related entities within a multinational enterprise (MNE). In the context of tax regulations, it governs how prices for goods, services, or intangibles (such as intellectual property) are set when these items are exchanged between different branches, subsidiaries, or affiliates of...: Including tax costs in the cost base inflates the transfer priceTransfer pricing is a fundamental concept in international taxation that defines the pricing methods and rules applied to transactions between related entities within a multinational enterprise (MNE). In the context of tax regulations, it governs how prices for goods, services, or intangibles (such as intellectual property) are set when these items are exchanged between different branches, subsidiaries, or affiliates of..., 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 pricingTransfer pricing is a fundamental concept in international taxation that defines the pricing methods and rules applied to transactions between related entities within a multinational enterprise (MNE). In the context of tax regulations, it governs how prices for goods, services, or intangibles (such as intellectual property) are set when these items are exchanged between different branches, subsidiaries, or affiliates of... purposes ensures these taxes are not further amplified through markups.
- Tax PlanningTax planning is the process of organising and structuring one’s financial affairs in a manner that legally minimises tax liabilities while ensuring compliance with relevant tax laws. The primary objective of tax planning is to reduce the amount of taxes paid, optimise the use of available tax benefits, and preserve wealth. It can be applied at various levels, including personal... and Policy Review:
A comprehensive review of both direct and indirect tax impacts can align transfer pricing policiesTransfer Pricing Policies refer to the rules and methods established by multinational enterprises (MNEs) to determine the pricing of transactions between related parties, such as subsidiaries or divisions of the same company. These transactions may involve the transfer of goods, services, intellectual property, or financial arrangements. Transfer pricing policies are essential for ensuring that intercompany transactions adhere to the arm’s... with local tax regulationsTax laws form the backbone of any nation’s revenue system, setting the rules that govern how individuals and corporations contribute financially to support government functions. These laws define the types of taxes, the applicable rates, and the regulations regarding payment and compliance. They also outline the rights and obligations of taxpayers, ensuring a balanced and fair approach to funding public..., reducing unintended tax burdens.
By applying these strategies, Company X can minimize the cascading tax effects while ensuring compliance with Kenyan tax lawsTax laws form the backbone of any nation’s revenue system, setting the rules that govern how individuals and corporations contribute financially to support government functions. These laws define the types of taxes, the applicable rates, and the regulations regarding payment and compliance. They also outline the rights and obligations of taxpayers, ensuring a balanced and fair approach to funding public....
VIDEO SCRIPT
You are correct when we think about transfer pricingTransfer pricing is a fundamental concept in international taxation that defines the pricing methods and rules applied to transactions between related entities within a multinational enterprise (MNE). In the context of tax regulations, it governs how prices for goods, services, or intangibles (such as intellectual property) are set when these items are exchanged between different branches, subsidiaries, or affiliates of..., our minds often go straight to direct taxes—corporate income taxIncome Tax is a direct levy imposed by governments on the income generated by individuals, corporations, and other entities within a specific jurisdiction. It serves as a major source of revenue for governments and funds various public expenditures, such as infrastructure projects, healthcare, education, national security, and welfare programs. The tax is generally calculated as a percentage of the taxable..., 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 pricingTransfer pricing is a fundamental concept in international taxation that defines the pricing methods and rules applied to transactions between related entities within a multinational enterprise (MNE). In the context of tax regulations, it governs how prices for goods, services, or intangibles (such as intellectual property) are set when these items are exchanged between different branches, subsidiaries, or affiliates of... equation, especially when they interact with pricing methodologies like the cost-plus methodThe Cost-Plus Method is one of the five primary transfer pricing methods outlined by the OECD Transfer Pricing Guidelines. It is used to determine the arm's length price of intercompany transactions, particularly for services or products provided between associated enterprises. The method applies a standard markup to the costs incurred by the supplier, ensuring that the resulting profit margin reflects.... 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 methodThe Cost-Plus Method is one of the five primary transfer pricing methods outlined by the OECD Transfer Pricing Guidelines. It is used to determine the arm's length price of intercompany transactions, particularly for services or products provided between associated enterprises. The method applies a standard markup to the costs incurred by the supplier, ensuring that the resulting profit margin reflects..., 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 AuthorityTax authorities are fundamental institutions within government frameworks, overseeing tax assessment, collection, and administration. Their operations ensure that tax laws are enforced and public funds are collected efficiently. This article delves into tax authorities' purpose, responsibilities, and structure, offering insights into their essential role in supporting government functions and economic stability. What is a Tax Authority? A tax authority is....
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 methodThe Cost-Plus Method is one of the five primary transfer pricing methods outlined by the OECD Transfer Pricing Guidelines. It is used to determine the arm's length price of intercompany transactions, particularly for services or products provided between associated enterprises. The method applies a standard markup to the costs incurred by the supplier, ensuring that the resulting profit margin reflects... 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 burdenTax liability represents the total amount of tax owed by an individual or business to a tax authority, whether local, national, or international. This obligation arises through various forms of income, profits, or transactions subject to taxation laws and regulations. Understanding tax liability is essential for compliance and efficient financial management for corporations and individuals. It influences how businesses structure....
What we’re seeing here is not traditional double taxationDouble Taxation occurs when the same income or financial transaction is taxed twice, typically in different jurisdictions. It can arise in two primary contexts: economic double taxation, where the same income is taxed twice in the hands of different taxpayers, and juridical double taxation, where the same taxpayer is taxed on the same income in more than one country. Double... in the sense of corporate income taxCorporate Tax refers to the tax imposed by governments on the income or capital of corporations. Corporations, considered separate legal entities, are taxed on their profits, meaning the income generated from their operational activities, investments, and other financial undertakings. This tax is generally a key revenue source for governments, helping to fund public services, infrastructure, and other essential functions. The... being taxed twice across jurisdictions.
Instead, it’s a form of tax-on-tax within the structure of indirect taxes and transfer pricingTransfer pricing is a fundamental concept in international taxation that defines the pricing methods and rules applied to transactions between related entities within a multinational enterprise (MNE). In the context of tax regulations, it governs how prices for goods, services, or intangibles (such as intellectual property) are set when these items are exchanged between different branches, subsidiaries, or affiliates of....
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 policiesTransfer Pricing Policies refer to the rules and methods established by multinational enterprises (MNEs) to determine the pricing of transactions between related parties, such as subsidiaries or divisions of the same company. These transactions may involve the transfer of goods, services, intellectual property, or financial arrangements. Transfer pricing policies are essential for ensuring that intercompany transactions adhere to the arm’s... 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 planningTax planning is the process of organising and structuring one’s financial affairs in a manner that legally minimises tax liabilities while ensuring compliance with relevant tax laws. The primary objective of tax planning is to reduce the amount of taxes paid, optimise the use of available tax benefits, and preserve wealth. It can be applied at various levels, including personal... 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 pricingTransfer pricing is a fundamental concept in international taxation that defines the pricing methods and rules applied to transactions between related entities within a multinational enterprise (MNE). In the context of tax regulations, it governs how prices for goods, services, or intangibles (such as intellectual property) are set when these items are exchanged between different branches, subsidiaries, or affiliates of... methods, and proactively managing their tax obligations to avoid unintended consequences.
So lets just recap. The world of transfer pricingTransfer pricing is a fundamental concept in international taxation that defines the pricing methods and rules applied to transactions between related entities within a multinational enterprise (MNE). In the context of tax regulations, it governs how prices for goods, services, or intangibles (such as intellectual property) are set when these items are exchanged between different branches, subsidiaries, or affiliates of... doesn’t exist in a vacuum.
Indirect taxes, like VAT and withholding tax, are integral to the financial and operational reality of multinational enterprisesWhat are Multinational Enterprises (MNEs)? Multinational Enterprises, commonly referred to as MNEs, are corporations that operate in multiple countries through various subsidiaries, branches, or affiliates. These entities maintain a central management structure while leveraging diverse resources, labour markets, and customer bases across borders. The fundamental aspect that distinguishes MNEs from other corporate forms is their cross-border activity, which can include.... 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.