Judgment summary
This is an appeal by Unilever Kenya Limited (UKL), formerly East African Industries Limited, against assessments raised by the Commissioner of Income Tax for the years of income 1995 and 1996. The assessments concerned sales made by UKL to its related company, Unilever Uganda Limited (UUL), formerly Uganda Associated Industries Limited, under a manufacturing and supply contract dated 28th August, 1995.
The Commissioner contended that the prices charged by UKL to UUL were not arm's length prices under section 18(3) of the Income Tax Act, Cap. 470, and raised assessments accordingly. The Local Committee of the Income Tax Department had made adjustments reducing the taxable benefit for 1995 by 5% of a computed taxable benefit of 24.5%, and fixing a taxable benefit of 17.44% for 1996, allowing an assumed EPPO benefit of 5% for each year.
The High Court, per Visram J, found no evidence that the course of business between UKL and UUL was arranged to produce less than ordinary profits, and no evidence of tax fraud or cheating. The Court held that the cost plus method used by UKL, applying a 7% (net of tax) return on capital under clause 3 of the contract, was not a wrong method for arriving at an arm's length price in the circumstances. The appeal was allowed with costs, and the assessments under section 18(3) were annulled.
Background
UKL is engaged in the manufacture and sale of household goods, including foods, detergents and personal care items, and is part of the world-wide Unilever group of companies. Unilever plc, incorporated in the United Kingdom, has a very substantial shareholding in UKL.
UKL and UUL are related companies as defined in section 18 of the Income Tax Act. Under a contract dated 28th August, 1995, UKL manufactured products on behalf of UUL and supplied them in accordance with UUL's orders, with such supplies occurring during 1995 and 1996.
UKL also manufactured and sold goods to the Kenyan domestic market and to the export market, to customers not related to UKL. It was common ground that the prices charged by UKL for identical goods differed between domestic sales, domestic export sales, and UUL sales, with the UUL prices being lower than both the domestic and domestic export prices.
Core dispute
The Commissioner raised assessments against UKL for 1995 and 1996 on the basis that UKL's sales to UUL were not at arm's length prices, relying on section 18(3) of the Income Tax Act, which deems the profits of a resident person to be the amount that might have been expected to accrue if a business conducted with a related non-resident person had instead been conducted by independent persons dealing at arm's length.
UKL argued that the price difference reflected legitimate cost recovery (including Kenyan overheads not incurred on UUL sales, and additional costs borne in Uganda) rather than a 'discount' arising from the relationship. UKL contended that, in the absence of Kenya Revenue Authority guidelines, the OECD Transfer Pricing Guidelines and methods (the Comparable Uncontrolled Price, Cost Plus, and Resale Minus methods) provided a proper basis for determining an arm's length price, and that no Comparable Uncontrolled Price existed because no two sales comprised a similar mix of products in similar proportions. UKL submitted that its own Transfer Pricing Policy, applying a Cost Plus Return Method with a 10% standard pre-tax return on capital (and 7% net of tax under the actual contract), produced an arm's length 'Standard Transfer Price'.
The Commissioner disputed the relevance of OECD guidelines and foreign transfer pricing legislation (from Tanzania, the UK and South Africa), arguing that section 18(3) is clear and self-contained, that such guidelines are not part of Kenyan law, and that UKL had effectively given UUL a discount by absorbing UUL's promotional costs in Uganda. The Commissioner compared average per-tonne prices to UUL against average per-tonne prices to unrelated parties, including buyers in Somalia and Tanzania who were charged higher prices, and alleged a scheme by UKL to reduce its tax liability.
Court findings
The Court held that it could not accept the Commissioner's position that OECD guidelines and foreign transfer pricing legislation were irrelevant simply because section 18(3) was said to be clear. The Court found this approach 'simplistic, and devoid of logic', noting that Kenya operates within a 'global village' and that, in the absence of Kenyan guidelines, the wisdom of taxpayers and tax collectors in other countries should not be overlooked.
The Court considered the key question under section 18(3) to be whether the course of business between UKL and UUL was 'so arranged' as to produce no profits or less than ordinary profits. The Court found no evidence of such an arrangement, and no evidence of tax fraud or tax cheating; the only evidence related to the methods used for computation of tax. The Court held that use of different lawful methods for computing an arm's length price is permissible, so long as there is no fraudulent trading with a view to evading tax.
Applying the dictum of Viscount Simon in Scott v Russell (1948) 2 ALL E.R. 1, as approved in Kanjee Nazanjee v Income Tax Commissioner (1964) E.A. 257 at 262H, the Court held that a taxpayer is entitled to demand that liability to a higher charge be made out with reasonable clarity before being adversely affected. The Court noted that the Indian Income Tax (21st amendment) Rules, 2001, Rule 108, set out detailed guidelines for determining arm's length price, in contrast to the Kenyan Act's silence on methodology, and expressed hope that the Kenya Revenue Authority would similarly issue rules.
The Court concluded that the cost plus method used by UKL was not a wrong method of arriving at an arm's length price in the particular circumstances of the case, and disagreed with the Commissioner's and the Local Committee's method of arriving at an arm's length figure for computation of tax.
Outcome
The appeal was allowed with costs. The assessment was ordered annulled to the extent of tax levied by the Commissioner under section 18(3) of the Act arising from deemed profits from UKL's business with UUL in 1995 and 1996.
The Court further ordered that no tax shall be levied by the Commissioner under section 18(3) of the Act arising from deemed profits from the business with UUL in 1995 and 1996. As Appeals numbered 752 of 2003 and 753 of 2003 were consolidated by consent of the parties, the judgment was ordered to apply to both appeals.
Tp method highlighted
The judgment discusses several transfer pricing methods referenced in the OECD Guidelines: the Comparable Uncontrolled Price (CUP) method, described as the most direct and reliable method where comparable uncontrolled transactions can be located; the Resale Minus Method; and the Cost Plus Method, both indirect traditional transaction methods used where no Comparable Uncontrolled Price exists.
UKL's internal Transfer Pricing Policy applied a 'Cost Plus Return Method' as its preferred method in the absence of a market price, recovering the supplying company's costs plus an appropriate return on capital, with a standard pre-tax return of 10% (said to represent the average return on capital made by Unilever Group companies on sales to unrelated third parties), producing a 'Standard Transfer Price'. Under clause 3 of the actual UKL-UUL contract, the price was the aggregate of fixed and variable costs incurred by UKL plus a return of 7% (net of tax) on capital.
The Court also noted the Indian Income Tax (21st amendment) Rules, 2001, Rule 108, which set out guidelines under section 92C of the Indian Income Tax Act referring to the CUP method, cost plus method, transactional net margin method, and 'most appropriate method', contrasting this with the silence of the Kenyan Act on such methods.
Major issues / areas of contention
- Whether UKL's sales to UUL were made at arm's length prices for the purposes of section 18(3) of the Income Tax Act, Cap. 470.
- Whether the course of business between UKL and UUL was 'so arranged' as to produce no profits or less than ordinary profits within the meaning of section 18(3).
- Whether, in the absence of Kenya Revenue Authority guidelines, the OECD Transfer Pricing Guidelines and methods could properly be applied to determine an arm's length price under section 18(3).
- Whether a Comparable Uncontrolled Price existed between UKL's domestic sales, domestic export sales, and UUL sales.
- Whether the Cost Plus Method applied by UKL under its Transfer Pricing Policy and under clause 3 of the UKL-UUL contract was an acceptable method for computing an arm's length price.
- Whether the Local Committee's adjustments (a 5% reduction of a 24.5% computed taxable benefit for 1995, and a 17.44% taxable benefit for 1996, with an assumed 5% EPPO benefit for each year) were correctly arrived at.