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Zambia: First judicial guidance, arm’s length arrangements between related parties

Zambia: Judicial guidance, arm’s length arrangements

The Tax Appeals Tribunal issued a decision generally finding for the Zambia Revenue Authority in a case concerning transfer prices used with respect to certain cross-border related-party transactions and business models.


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The decision provides the first substantive judicial guidance in Zambia with respect to arm’s length arrangements between related parties. The case is: Nestlé Zambia Trading Ltd. v. Zambia Revenue Authority [2018] TAT 03 (30 October 2018, 31 October 2018 and 28 March 2019).


The Zambia Revenue Authority (ZRA) conducted a transfer pricing audit with respect to the taxpayer’s operations in Zambia. The taxpayer had reported losses for the financial years 2010 to 2014, and the ZRA noted that the taxpayer had been continuously declaring losses for the five-year period under review.

The ZRA’s attention was specifically drawn to the following factors:

  • Significant related-party transactions and shared services with related parties
  • Management fee payments
  • Payment for the use of intellectual property

Following the audit, the ZRA adjusted the taxpayer’s profit to ZMW 56,579,048 (approximately U.S. $4.5 million) and levied tax of ZMW 13,860,103 (U.S. $1.09 million).

Three key points outlined by the ZRA as the basis for the additional assessment were that:

  • The taxpayer earned continuous negative operating margins for a period of more than five years.
  • There were continuous losses for a period of five years.
  • Significant volumes of related-party transactions took place.

Judicial appeal

The taxpayer initiated an appeal in early 2018 with the Tax Appeals Tribunal regarding the transfer pricing assessment, and in contesting the tax assessment, asserted that the ZRA had:

  1. Failed to conduct tests to assess compliance with the arm’s length principle
  2. Based its assessment on the premise that the taxpayer could not operate at a loss since its incorporation despite evidence from the taxpayer explaining the losses
  3. Failed to objectively test the related-party transactions, but rather relied on assumptions and estimates that were, as the taxpayer countered, excessive and unreasonable
  4. Re-categorised the taxpayer as a limited-risk distributor despite evidence to the contrary
  5. Performed a benchmarking study that was neither comparable to the nature of its business nor the economic conditions in Zambia
  6. Added back unrealised foreign exchange losses attributable to a loan when these losses were not included as part of expenses in the taxpayer’s financial statements (and not claimed as a deduction).

The ZRA countered that:

  1. Adequate tests were carried out on all related-party transactions, and furthermore, that royalty payments made by the taxpayer were contrary to the arm’s length principle.
  2. The losses were due to significant related-party payments constituting royalties, management fees, and product purchases.
  3. The transfer pricing assessments were made under section 97A(3) of the Income Tax Act, Chapter 323 of the Laws of Zambia and were therefore not estimates or assumptions.
  4. With regards to the reclassification of the taxpayer as a limited-risk distributor, the following factors, inter alia, were considered decisive:
    1. Control of the Zambian entity’s operations were undertaken by a related entity in Zimbabwe
    2. Staff from the Zimbabwe entity oversaw the operations of the taxpayer in Zambia
    3. Sourcing of products and invoicing was performed by a related entity in Ghana
    4. Inventory risk was shared between the taxpayer and other taxpayer group companies
    5. The level of investment in the taxpayer was low
    6. There was a lean staff complement in the taxpayer in Zambia
    7. Customers facilitated their own logistics arrangements when ordering products
  5. The products were already known and available in the Zambian market before the taxpayer was incorporated in Zambia. In the ZRA’s view, the taxpayer was therefore not developing the market.
  6. The foreign exchange loss adjustment was a secondary adjustment which arose from imposing tax on secondary transactions. This was justified so that the allocation of profits was consistent with the primary transfer pricing adjustment of the taxpayer’s operating margin.

Tribunal’s decision

The tribunal addressed the first three grounds together, given that these issues were closely correlated, and concluded that it was erroneous for the ZRA to have aggregated the transaction because they were unrelated and not closely linked.

  • In relation to Ground Two, the tribunal restricted its finding to the provisions of the income tax law (as the prevailing legislation for the period under review). In the absence of legislative guidance or “safe harbours,” adjustments may only be made if the loan was not used for business purposes. The tribunal found the adjustment made by the ZRA as a result of the so-called debt-to-equity ratio was erroneous.
  • In relation to Ground Five, the tribunal held that the benchmarking analysis performed by the ZRA was disproportionate with the consequence that it could lead to an inaccurate transfer pricing adjustment.
  • In relation to Ground Six, the tribunal concluded that there was no basis for the ZRA to add back the unrealized exchange losses.
  • The tribunal found for the ZRA on Ground Four with the re-categorization of the taxpayer as a limited-risk distributor, based in part on the following findings:
    • There was “significant control” exercised by the Zimbabwe entity over the taxpayer.
    • “Essential functions” such as strategic management, sales and marketing support, etc., were provided by related parties.
    • Because the parent corporate entity retained “ownership, property in the products and attendant risk in the know-how,” the ultimate risk in marketing, distribution, storage and/or selling of the products lay with the parent entity and not with the taxpayer in Zambia.

KPMG observation

KPMG transfer pricing professionals in South Africa have noted the following with respect to this tribunal decision:

  • Recognition was given to both the OECD Guidelines and UN Practical Manual on Transfer Pricing for Developing Countries by the ZRA and the tribunal.
  • The approach of the ZRA is in contrast to what has been seen in similar transfer pricing audits. Typically, the limited-risk distributor business model has been routinely challenged by tax authorities with respect to the limited-risk nature of the taxpayer activities and the low profits associated with them. Tax authorities have been asserting, for example, that a company that is being characterized as bearing limited risks “on paper,” (i.e., as per an agreement between the limited-risk entity and a related-party principal) in substance bears significantly more risks and performs more functions than may be stated in the agreement. For example, from a South African perspective, due to its remote location, a South African entity must carry more inventory to service its customers. It is also well documented that South African entities bear currency risks and usually require more local management.
  • The fact that the parent entity retained exclusive ownership of the “know-how” does not change the functional profile of the taxpayer to a limited-risk distributor. For example paragraph 6.2 of the OECD Guidelines states: 

the key consideration is whether a transaction conveys economic value from one associated enterprise to another, whether that benefit derives from tangible property, intangibles, services or other items or activities. An item or activity can convey economic value notwithstanding the fact that it may not be specifically addressed in Chapter VI. To the extent that an item or activity conveys economic value, it should be taken into account in the determination of arm’s length prices whether or not it constitutes an intangible within the meaning of paragraph 6.6. [Emphasis added]

  • Paragraph 8.1.3 of Transfer Pricing Practice Note 02/2018 (Practice Note) deals with the concept of development, enhancement, maintenance, protection and exploitation of intangibles (DEMPE). As the Practice Note and Zambian Transfer Pricing (Amendment) Regulations 2018 were published after the tax period under review, there is a question whether this will usher in detailed analyses and application to mind to the ownership and use of the intangibles being used in the value chain, going forward.
  • Interestingly, from a thin capitalisation perspective, the tribunal noted that the debt-to-equity levels in a company are a business-driven decision based on the cost of financing.
  • Instead of challenging the transactional approach put forward by the taxpayer, the ZRA performed its own benchmarking analysis.
  • The Transactional Net Margin Method (TNMM) was then used on a whole-of-entity basis (referred to as aggregation in the judgement), so as to adjust the results of the taxpayer such that a taxable profit was achieved.
  • While the ZRA ultimately won the reclassification issue (Ground Four), it lost some of the key propositions it had hoped to establish through this litigation.
  • The decision provides the first substantive judicial guidance in Zambia on the difficult territory of establishing arm’s length arrangements between related parties. It gives taxpayers much to consider and apply in evaluating their own arrangements.

In conclusion, the decision would apparently embolden the ZRA—particularly in respect of other transfer pricing cases which currently under audit—in targeting new cases. Furthermore this case could have far-reaching consequences for multinational enterprises from a pan-African perspective, as it may create an international precedent for the approaches of revenue authorities and courts across Africa.

Read an April 2019 report [PDF 132 KB] prepared by the KPMG member firm in South Africa

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