Page 151 - SAIT Compendium 2016 Volume2

PN 7/1999 Income Tax acT: PracTIce noTes PN 7/1999 9.5.4 Example
A South African company manufactures pasta at its factory in Cape Town. Subsidiaries in Italy and Greece distribute the pasta in their relevant markets after packaging the pasta. The packaging is not a very complicated process since the pasta is shipped from South Africa in units of 500g wrapped in plastic. These individual packets are merely packaged in cardboard boxes by the subsidiaries.
Application of the resale price method:
A search on independent comparable distributors showed that these independent distributors obtain a gross pro t margin of 37 per cent to 40 per cent. The only difference is that these distributors are not involved in packaging the pasta.
The effect of the additional packaging function on the gross pro t margin earned by the subsidiaries should be evaluated. If material, an adjustment should be made. If not material, the subsidiaries would also be expected to earn a gross margin of between 37 per cent and 40 per cent.
9.6 The Cost Plus method
9.6.1 Description
The cost plus method requires estimation of an arm’s length consideration, by adding an appropriate mark-up to the costs incurred by the supplier of goods or services in a controlled transaction. This mark-up should provide for an appropriate pro t to the supplier, in the light of the functions performed, assets used and risks assumed.
9.6.2 Application
This method is best suited to situations where:
(a) services are provided,
(b) semi- nished goods are sold between connected parties,
(c) connected persons have concluded joint facility agreements or long-term buy-and-supply arrangements The mark-up should ideally be determined with reference to the mark-up earned by the same supplier in uncontrolled transactions. If this is not possible, the mark-up should be determined by using the mark-up earned in comparable transactions by an independent supplier performing comparable functions, bearing similar risks and employing similar assets to those of the taxpayer.
An uncontrolled transaction is comparable to a controlled transaction for purposes of the cost plus method if one of two conditions is met:
(a) none of the differences between the transactions being compared or between the enterprises undertaking
those transactions materially affect the cost plus mark up in the open market; or
(b) reasonably accurate adjustments can be made to eliminate the material effects of such differences.
Fewer adjustments are needed for product comparability than under the CUP and the same comparability principles as discussed under the resale price method will apply to the cost plus method.
9.6.3 Practical problems
(a) The application of the cost plus method presents certain dif culties. In particular, the determination of costs, as some companies are more effective than others and will incur lower costs.
(b) In addition there may be circumstances where there is no discernible link between the level of costs incurred and a market price.
(c) Accounting policies also play an important role and appropriate adjustments should be made to ensure that the same types of costs are included for the comparison. The types of cost included in cost to arrive at a gross margin may differ from company to company.
(d) The application of this method sometimes requires access to segregated product data. Whilst this information may be available in respect of the controlled party being examined, it will usually not be available in respect of the uncontrolled entities used as benchmarks.
9.6.4 Example
B, a South African holding company, is responsible for the development of all the software and the purchase of computer hardware to be used by its subsidiaries in Namibia and Botswana. It was clear from the beginning that there was a market for this kind of service in Africa. B also provides this service to other customers throughout Africa. The software and hardware required by each customer are unique and differ from the software developed and hardware supplied to the subsidiaries, but the functions and processes to provide these services are comparable.
Application of the cost plus method
An analysis of the income and costs in respect of the services provided to the independent customers, indicates that costs are recovered and gross pro t of between 22 per cent and 25 per cent is achieved.
B should therefore charge its subsidiaries at cost plus between 22 per cent and 25 per cent for the performance of the information technology function.
9.7 Transactional Net Margin method (TNMM) 9.7.1 Description
The TNMM examines the net pro t margin that a taxpayer realises from a controlled transaction, relative to an appropriate base, for example cost, sales or assets. This ratio is referred to as a pro t level indicator. The pro t level indicator of the tested party is compared to the pro t level indicator(s) of comparable independent parties.
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