TRANSFER PRICING IN EAST AFRICA: TANZANIA AND KENYA IN

COMPARATIVE PERSPECTIVE

HELEN BENJAMIN KIUNSI

A THESIS SUBMITTED IN FULFILMENT OF THE REQUIREMENTS FOR

THE DEGREE OF DOCTOR OF PHILOSOPHY IN LAW OF THE OPEN

UNIVERSITY OF TANZANIA

2017
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CERTIFICATION

The undersigned certifies that they have read and hereby recommends and approve

for acceptance by the Open University of Tanzania a thesis entitled ― Transfer

Pricing in East Africa: Tanzania and Kenya in Comparative Perspective” in

fulfilment of the requirements for the degree of Doctor of Philosophy (PhD) in Law

of the Open University of Tanzania.

…………………………………………

Dr. Benhajj Shaaban Masoud

(Supervisor)

………………………………......

Date

…………………………………….

Dr. Alex Boniface Makulilo

(Supervisor)

………………….………………

Date
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COPYRIGHT

No any part of this dissertation shall by any means be reproduced, stored in any

retrieval system, or transmitted in any form being electronic, mechanical,

photocopying, recording or otherwise without prior permission of the author or The

Open University of Tanzania on that behalf.

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DECLARATION

I, Helen Benjamin Kiunsi, do hereby declare that this research paper is my own

work and has not been submitted and to the best of my knowledge is not currently

being submitted in any other university.

……………………..…………..

Signature

................................................

Date
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DEDICATION

To my husband Frank and Children Arnold, Abigail and Aldwin.

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ACKNOWLEDGEMENT

Undertaking on this Thesis has been a major challenge and experience and I thank

God for his Grace, and for giving me the strength, will and perseverance to carryon. I

would like to express my heartfelt gratitude to my supervisors, Hon. Judge Dr.

Benhajj S. Masoud and Dr. Alex B. Makulilo who offered very useful input and

intellectual guidance on substance, methodology and framework of this thesis. Their

encouragement and confidence in me that I can make it, gave strength to undertake

the study and produce this thesis. They have been always my inspiration

academically and I long to follow their way.

My deep gratitude in a very special way goes to my husband Frank Edwin Mbapila

and children Aldwin, Abigail and Arnold for their love, prayers, support, and

encouragement and for always believing in me. Their support always gave me

strength to fulfill my heart desire of having highest academic qualification.

Special thanks to Dr. Alexander B. Makulilo of University of Dar es salaam for

availing a project enabled to finance this study. Thank you very much. I also thank

my brothers and sisters in particular Prof. Robert B. Kiunsi, and wife Debora B.

Kiunsi, My elder sister Joyce Benjamin and her husband Mr. J. Mlendela, and Mr.

Christopher B. Kiunsi for their support and encouragement.

I thank my employer the Open University of Tanzania for support throughout my

studies. Special thanks to Prof. Modest Varisanga and Prof. Deus Ngaruko for their

support. I also thank my family members and my colleagues at Open University of

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Tanzania, Ilala Regional Centre for taking office responsibilities while I was

pursuing my studies. Special thanks to Prof. Bart Rwezaura, Dr Charles Saanane and

Erick Gabriel for proof reading this work in different times.

I would like to acknowledge and thank all institutions which availed me valuable

information for completing this study in Kenya and Tanzania. In particular, my

thanks go to James Charles, Elisha Shiggela, Antony, Dennis Masaki, Paul Mushi

and Modestus Lilungulu.

I remain solely responsible for any errors or shortcomings in this thesis.

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ABSTRACT

The desire for EAC countries to attract MNCs with a view of obtaining tax has

brought challenge in curbing transfer pricing manipulation arising out international

transactions by associated MNCs. In the absence of aggressive tax legislation, human

and financial resources, such countries are at high risk of losing substantial right

share of tax due to this vice. This concern raises question as to what can be done by

EAC countries to address the risk and hence prevent potential tax loss. This study

addresses this concern. It focuses on the adequacy of existing international and

domestic transfer pricing laws in curbing transfer pricing manipulation. The study

examines interplay between transfer pricing and MNCs theories, international

transfer pricing standards, aggressive tax planning and their impact to existing

manipulation of transfer prices. The study brings out the failure of existing transfer

pricing standards in particular arm‘s length principle to curb the vice and the need to

supplement the same. In order to obtain desired results doctrinal legal research

methodology is mainly employed and supplemented by empirical and comparative

methods. This study has found that the existing transfer pricing law in EAC countries

are not adequately curbing transfer pricing manipulation. The study recommends for

amendment of existing laws by offering theoretical insight of important issues which

can be taken in to account in crafting transfer pricing laws.

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TABLE OF CONTENTS

CERTIFICATION ..................................................................................................... ii

COPYRIGHT ............................................................................................................ iii

DECLARATION ....................................................................................................... iv

DEDICATION ............................................................................................................ v

ACKNOWLEDGEMENT ........................................................................................ vi

ABSTRACT ............................................................................................................. viii

LIST OF ABBREVIATIONS ............................................................................... xvii

TABLE OF LEGISLATION.................................................................................. xix

LIST OF CASES ..................................................................................................... xxi

CHAPTER ONE ........................................................................................................ 1

INTRODUCTION ...................................................................................................... 1

1.1 Background to the Problem .............................................................................. 1

1.2 Statement of the Problem ................................................................................. 7

1.3 Literature Review ........................................................................................... 10

1.4 Objectives and Research Questions ............................................................... 21

1.4.1 General Objective ........................................................................................... 21

1.4.2 Specific Objectives ......................................................................................... 21

1.4.3 Research Questions ........................................................................................ 22

1.5 Research Methodology ................................................................................... 22

1.6 Scope of the Study.......................................................................................... 25

1.7 Structure of the Thesis.................................................................................... 26

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CHAPTER TWO ..................................................................................................... 28

CONCEPT AND THEORIES OF TRANSFER PRICING ................................. 28

2.1 Introduction .................................................................................................... 28

2.2 Transfer Pricing Concepts .............................................................................. 28

2.2.1 Transfer Pricing .............................................................................................. 28

2.2.2 Transfer Price ................................................................................................. 37

2.2.3 Multinational Corporations ............................................................................ 39

2.2.4 Tax Havens ..................................................................................................... 42

2.2.5 International Agreement ................................................................................. 44

2.2.6 Transfer Pricing Manipulation ....................................................................... 45

2.3 Theories for Existence of Transfer Pricing .................................................... 46

2.3.1 Economic Theory ........................................................................................... 47

2.3.2 Mathematical Programming Theory .............................................................. 50

2.3.3 Accounting Theory ......................................................................................... 51

2.3.4 Organization Strategy Theory ........................................................................ 53

2.4 Theories for Existence of MNCs .................................................................... 57

2.4.1 The Eclectic Paradigm Theory ....................................................................... 58

2.4.2 Transaction Cost Theory ................................................................................ 62

2.5 Conclusion ...................................................................................................... 64

CHAPTER THREE ................................................................................................. 66

TRANSFER PRICING UNDER INTERNATIONAL LAW ............................... 66

3.1 Introduction .................................................................................................... 66

3.2 International Transfer Pricing under Auspices of International

Tax Law .......................................................................................................... 67

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3.3 Source and Residence as Basis for International Taxation ............................ 69

3.4 Rise and Elimination of Double Taxation ...................................................... 73

3.5 Desire for International Transfer Pricing Legal Regime ................................ 76

3.6 An Overview of UN and OECD Models ....................................................... 79

3.6.1 Transfer Pricing Standards as Set by Tax Convention Models ...................... 81

3.6.1.1 Arms‘ Length Principle .................................................................................. 81

3.6.1.2 Resident Principle .......................................................................................... 86

3.6.1.3 Permanent Establishment ............................................................................... 87

3.6.1.4 Business Profit ............................................................................................... 93

3.7 Methods to Arrive at Arm‘s Length Price .................................................... 102

3.7.1 Comparable Uncontrolled Price ................................................................... 104

3.7.2 Resale Price Method ..................................................................................... 105

3.7.3 Cost Plus Method ......................................................................................... 108

3.7.4 Profit Split Method ....................................................................................... 109

3.8 Transfer Pricing Documentation Requirement............................................. 113

3.9 Transfer Pricing Audits and Risk Assessment ............................................. 115

3.10 Transfer Pricing Dispute Avoidance and Resolution ................................... 117

3.11 Conclusion .................................................................................................... 122

CHAPTER FOUR .................................................................................................. 124

TRANSFER PRICING REGULATORY FRAMEWORK IN EAST

AFRICAN COMMUNITY .................................................................................... 124

4.1 Introduction .................................................................................................. 124

4.2 An Overview of East African Community ................................................... 124

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4.3 Linkage between Trade and Foreign Investment and International Transfer

Pricing .......................................................................................................... 129

4.4 Liberalization of Economy and its Implications to Transfer Pricing

Regulation in EAC ....................................................................................... 131

4.5 International Transfer Pricing Regime in East African Community............ 142

4.5.1 The EAC Treaty ........................................................................................... 142

4.5.2 EAC Agreement on Avoidance of Double Taxation and Prevention

of Fiscal Evasion with Respect to Taxes on Income 2011 (EAC DTA) ...... 143

4.5.2.1 Arms‘ Length Principle in EAC Context ..................................................... 144

4.5.2.2 Resident Principle in EAC Context ............................................................. 147

4.5.2.3 Permanent Establishment in EAC Context .................................................. 149

4.5.2.4 Business Profit for Transfer Pricing Purposes ............................................. 151

4.6 Methods to Arrive at Arm‘s Length Price .................................................... 154

4.7 Transfer Pricing Dispute Resolution Mechanism in EAC ........................... 155

4.8 Conclusion .................................................................................................... 157

CHAPTER FIVE .................................................................................................... 160

AGRESSIVE TAX PLANNING AND TRANSFER PRICING

MANIPULATION IN EAST AFRICA ................................................................ 160

5.1 Introduction ................................................................................................ 160

5.2 Relationship between Tax Treaties and International Transfer Pricing..... 161

5.3 International Transfer Pricing Standards and its Link to Price

Manipulation .............................................................................................. 165

5.3.1 Application of Arm‘s Length Principle ..................................................... 165

5.3.2 Allocation of Taxing Rights....................................................................... 166

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5.3.3 Qualification for DTA Benefits ................................................................. 169

5.3.4 Exchange of Information and Administrative Cooperation ....................... 172

5.3.5 Elimination of Double Taxation ................................................................ 173

5.4 International Tax Planning and its Linkage to Transfer Pricing

Manipulation .............................................................................................. 176

5.4.1 Transfer Pricing Manipulation Schemes .................................................... 180

5.4.1.1 Under or over- Pricing of Prices and Invoices ........................................... 181

5.4.1.2 Thin Capitalization..................................................................................... 182

5.4.1.3 Use of Intellectual Property Rights ............................................................ 183

5.4.1.4 Use of Special Conduit Entities ................................................................. 183

5.4.1.5 Use of Management Fee ............................................................................ 184

5.5 Transfer Pricing in Context of Base Erosion and Profit Shifting

Action Plan 2013........................................................................................ 187

5.5.1 Background to BEPS Action Plan ............................................................. 187

5.5.2 An Overview of BEPS Action Plan ........................................................... 189

5.5.3 Guideline in Applying arm‘s Length Principle in the Context of BEPS

Action Plan................................................................................................. 191

5.5.3.1 Identifying Commercial or Financial Relations ......................................... 191

5.5.3.2 The Contractual Terms of the Transaction ................................................ 193

5.5.3.3 Function Analysis ...................................................................................... 194

5.5.3.5 Economic Circumstances ........................................................................... 200

5.5.3.6 Business Strategies..................................................................................... 201

5.5.4 Recognition of the Accurately Delineated Transaction ............................. 202

5.5.5 Losses ......................................................................................................... 202

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5.5.6 Effect of Government Policies ................................................................... 203

5.5.7 Use of Customs Valuations ........................................................................ 204

5.5.8 Location Savings and Other Local Market Features.................................. 205

5.5.9 Assembled Workforce ............................................................................... 207

5.5.10 MNC Group Synergies .............................................................................. 208

5.6 BEPS Action Plan Measures in Curbing Transfer Pricing Manipulation .. 210

5.7 An Alternative to Arms‘ Length Principle................................................. 220

5.8 Conclusion ................................................................................................. 223

CHAPTER SIX ...................................................................................................... 225

TRANSFER PRICING LEGISLATION IN TANZANIA ................................. 225

6.1 Introduction ................................................................................................ 225

6.2 An Overview of Social, Economic and Political Context.......................... 225

6.3 Transfer Pricing Laws in Tanzania ............................................................ 231

6.3.1 Constitution of United Republic of Tanzania (CURT) 1977 ..................... 231

6.3.2 Income Tax Act, 2004................................................................................ 232

6.3.2.1 Application of Arms‘ Length Principle in Tanzania.................................. 235

6.3.2.2 Associated Parties ...................................................................................... 237

6.3.2.4 Transfer Pricing Adjustment ...................................................................... 243

6.3.3.1 Determination of Arm‘s Length Price ....................................................... 246

6.3.3.2 Transfer Pricing Comparability Factors..................................................... 248

6.3.3.3 Application of Arms‘ Length Principle to Intangibles .............................. 251

6.3.3.4 Application of Arm‘s Length Principle to Intra Group Services ............... 254

6.3.3.6 Advance Pricing Agreement ...................................................................... 257

6.3.3.7 Transfer Pricing Documentation Requirement .......................................... 259

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6.4 Administration and Enforcement of Transfer Pricing Rules ..................... 260

6.4.1 Institutional Framework for Transfer Pricing ............................................ 260

6.4.2 Transfer Pricing Dispute Resolution Mechanism ...................................... 263

6.5 Base Erosion and Profit Shifting Action Plan in Tanzanian Context ........ 266

6.6 Conclusion .................................................................................................... 266

CHAPTER SEVEN ................................................................................................ 268

TRANSFER PRICING LEGISLATION IN KENYA ........................................ 268

7.1 Introduction ................................................................................................ 268

7.2 Overview of Social, Economic and Political Context ............................... 268

7.3 Transfer Pricing Laws in Kenya ................................................................ 272

7.3.1 The Constitution of Kenya 2010 ................................................................ 272

7.3.2 The Income Tax Act 2010 ......................................................................... 274

7.3.2.1 Application of Arm‘s Length Principle in Kenya ...................................... 275

7.3.2.2 Transfer Pricing Adjustment ...................................................................... 280

7.3.3 Income Tax (Transfer Pricing) Rules 2006 ............................................... 282

7.3.3.1 Determination of Arm‘s Length Price ....................................................... 284

7.3.3.2 Transfer Pricing Comparability Factors..................................................... 286

7.3.3.3 Application of Arm‘s Length Principle to Intangibles, Services and

Intercompany Financial Transactions ........................................................ 287

7.3.3.4 Transfer Pricing Documentation Requirement .......................................... 289

7.4 Administration and Enforcement of Transfer Pricing Rules in Kenya ...... 290

7.4.1 Institutional Framework for Transfer Pricing ............................................ 290

7.4.2 Transfer Pricing Dispute Resolution Mechanism ...................................... 292

7.4.3 Court Interpretation and its Impact to Transfer Pricing Law ..................... 296
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7.5 Base Erosion Profit Shifting Action Plan in Kenyan Context ................... 302

7.6 Conclusion ................................................................................................. 302

CHAPTER EIGHT ................................................................................................ 303

CONCLUSION AND RECOMMENDATIONS ................................................. 303

8.1 Introduction ................................................................................................ 303

8.2 Main Insights of the Study and Key Findings ........................................... 303

8.3 Recommendations ...................................................................................... 309

8.4 Suggestions for Future Research ............................................................... 316

BIBLIOGRAPHY .................................................................................................. 317

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LIST OF ABBREVIATIONS

APA Advance Pricing Agreement

BEPS Base Erosion and Profit Shifting Action Plan

CFC Controlled Foreign Company

CISG Convention on International Sale of Goods

COMESA Common Market for Eastern and Southern Africa

CPM Cost Plus Method

CUP The Comparable Uncontrolled Price

CURT Constitution of United Republic of Tanzania

DTA Double Taxation Agreement

EAC East African Community

EACCM East African Common Market

EACCU East African Community Custom Union

ECOWAS Economic Community of West African States

EU European Union

GGM Geita Gold Mining

HC High Court

IMF International Monetary Fund

ITA Income Tax Act

ITU International transfer pricing unit

KRA Kenya Revenue Authority

LDCs Less Develop Countries

LOB Limitation on benefits rule

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MAP Mutual Agreement Procedures

MNCs Multinational cooperation

OECD Organization for Economic Co-operation and Development

PE Permanent establishment

PPT Principle purpose of test rule

PSM Profit Split Method

PWC Price Waterhouse Coopers

RPM Resale Price Method

SADC Southern African Development Community

TAT Tax Appeal Tribunal

TIC Tanzania Investment Centre

TNMM Transactional Net Margin Method

TRA Tanzania Revenue Authority

TRAB Tax Revenue Appeal Board

UK United Kingdom

UKL Unilever Kenya Limited

UN United Nations

UNCTAD United Nations Conference on Trade Development

USA United States of America

UUL Uganda Unilever Limited

WB World Bank
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TABLE OF LEGISLATION
Tanzania

Constitution of United Republic of Tanzania, 1977

Income Tax Act, Cap 332 RE 2008

Tax Administration Act, 2015

Income Tax (Transfer Pricing) Rules, 2014

Tanzania Revenue Authority Act, 2006

Tanzania Investment Act, 1997

Export Processing Act, 2002

Special Economic Zone Act, 2006

Kenya

Constitution of Republic of Kenya, 2010

Income Tax Act, Cap 470 RE 2014

Kenya Revenue Authority Act, RE 2016

Tax Appeals Tribunal Act, 2013

Tax Procedures Act, 2015

Income Tax (Transfer Pricing) Rules, 2006

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Regional Instruments

Protocol for establishment of East African Community Custom Union, 2005

Protocol for East African Community Common Market, 2010

Treaty for the establishment of East African Community, 1999

East African Investment Code, 2006

EAC Agreement on Avoidance of Double Taxation and Prevention of Fiscal Evasion

with Respect to Taxes on Income, 2011

International Instruments

United Nations Convention on International on Contracts for International Sale of

Goods, 1980

United Nations Model Double Taxation Convention between developed and

developing countries, 2011

Model Tax Convention on Income and Capital, 2010

United Nations Practical Manual on Transfer pricing for Developing Countries of

2013

The OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax
Administrations, 2010

Base Erosion and Profit Shifting Action Plan 2013

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LIST OF CASES

African Barrick Gold Plc v Commissioner General TRA, Tax Revenue Appeals

Tribunal Tax Appeal No 16, 2015

Bulyanhulu Gold Mine Ltd v Commissioner General TRA Court of Appeal of

Tanzania, Consolidated Civil Appeal No. 89& 90, 2015

Canada v GlaxoSmithKline Inc., 2012 SCC 52.

Chevron Australia Holding PTY Ltd (CAHPL) v Commissioner of Taxation [2015]

FCA 1092, Federal Court Sydney Australia

CIR v Challenge Cooperation Limited [1987] AC 155, New Zealand Court of

Appeal.

CIR v Lever Brothers ltd 14 SATC1

Commissioner of Income Tax v C.W Armstrong, KE, CA, 1962.

FG München 41 EFG 707 [1993].

IRC v Willoughby [1997] STC 995, 2004

Karguelen Sealing & Whaling Co ltd v CIR [1939] AD 487, 10 SATC:363 Appellate

Division

Keroche Industries v Kenya Revenue Authority & 5 others 2007. High Court of

Kenya, Misc. Civil Application No.743 of 2006

Mbeya Company Ltd v Commissioner General TRA, Court of Appeal of Tanzania,

Civil Appeal no 19, 2008

McDowell & Co. v CTO [1985] 154 ITR 148,Supreme court of India

Millin v CIR [1928] (AD) 207, 3 SATC 170.

München Finanzgericht
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Republic v Kenya Revenue Authority Ex-Parte Abdalla Brek Said T/A Al Amri

Distributors & 4 others 2015 High Court of Kenya, miscellaneous application. NO.

57of 2014.

Rhodesia Metals Ltd (in liquidation) v CoT 11 SATC 244

Sappi v ICT Canda 1992 3 SA 306 (A). South Africa.

Transvaal Associated Hide and Skin Merchants v Collector of Taxes Botswana, 29

SATC 97

Tullow Oil v Uganda Revenue Authority, TAT App no.40 of 2011 Uganda Tax

Appeal Tribunal 1(16 June 2014

Unilever Kenya Ltd v Commissioner of Income Tax. High Court of Kenya, Income

tax appeal no. 753 of 2005

Union of India and Azadi Bachao Andolan [2003] SC 56ITR

Zain International BV v Commissioner General and URA, Uganda High Court ,2011
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CHAPTER ONE

INTRODUCTION

1.1 Background to the Problem

In recent years, the East African Community (EAC) has witnessed an ongoing

discovery of untapped natural resources such as gas, oil and minerals.1 Such

resources have fueled foreign investments by multinational corporations (MNCs)2 in

the sub-region.3 However, availability of natural resources and an increase in foreign

investments do not seem to be translating into increased livelihoods for the citizens

in the EAC countries. Critics of globalization have argued that MNCs‘ investments

in the sub-region are not prompted by fair trade, which would benefit both the

developing countries and the investors, but rather, increased presence of foreign

investors that emanates from factors that seem to be benefiting the MNCs more than

the African regions.4 Borkowski posits that increasingly, sophisticated and complex

economical, political, technological and legal regulatory environments, especially in

developing countries are major factors in the rise of cross border transactions by

associated MNCs.5 Tax incentives including tax holidays given to MNCs by the

EAC countries encompass another factor. In addition, globalization and introduction

of free market economy in developing countries have equally influenced

1
EAC was established in 1999. At present the EAC comprises the following countries: Kenya,
Uganda, Tanzania, Rwanda, Burundi and South Sudan.
2
Multinationals are corporations operating in several countries but managed by from one country.
3
United Nations Conference on Trade Development (UNCTAD), Global Value Chains: Investment
and Trade for Development, World Investment Report, United Nations Publication, 2013, p.40.
4
Sikkaa P and Willmott H., The Dark Side of Transfer Pricing: Its Role in Tax Avoidance and
Wealth Retentiveness, Critical Perspectives on Accounting 21, 2010, 342–356 p. 342.
5
Borkowski S.C., The Transfer Pricing Concerns of Developed and Developing countries, the
International Journal of Accounting,1999 Vol. 32 No. 3 pp 321-336 at 321.
 2

involvement of MNCs in the sub-region.6 In order to attract more foreign investors,

the EAC partner countries formulated various laws to govern and regulate trade

relations among themselves. Accordingly, the East African Community Treaty (EAC

Treaty) requires partner states to take measures to ensure rationalization and

harmonization of investment tax incentives with the view of promoting the

community as a single investment area.7 In fulfilling this requirement, partner states

established the East African Community Custom Union (EACCU) and East African

Common Market (EACCM).8 The objective of EACCU and EACCM, among

others, is to enhance foreign investment in the region.9 The rationale behind this is to

attract many foreign investors so as to obtain revenues through taxes that will arise

from international transactions by MNCs. This is because tax is a necessary

precondition of a functioning state, which in itself is essential for economic growth.10

The impact of the stated measures is an increase in cross-border cooperation in trade

and investment thereby multiplying involvement of associated MNCs in the region.

As cross border trade and investment are enhanced, integration of EAC in global

economy is bolstered such that there will be exposure of countries to cross-border

6
The globalization and removal of international trade barriers and the effort to harmonize sales law by
Convention on International Sale of Goods (CISG) has increased number of companies involved in
international transactions.
7
Article 80 (1) (d) and (f) of the EAC Treaty.
8
Ibid, Articles 2, 75 and 76 respectively.
9
Article 3(c) of the Protocol for the establishment of the EACCU
10
Action Aid., Calling Time: Why SABMiller Should Stop Dodging Taxes in Africa, Action Aid
United Kingdom at p.6, www.actionaid.org.uk/doc_lib/calling_time_on_tax_avoidance , accessed
20th December, 2011. It is worth noting that, tax is very important in running activities of the
country. Over the years tax has been used by various governments in financing public services,
stimulation of economic growth and redistribution of worth; for example tax can be used as a tool to
promote local industries which produce products which are similar to the imported products by
imposing high tax for imported goods and reduce the price for the local products. See also Kibuta
O., Tax Compliance in Tanzania: Analysis of Law & Policy Affecting Voluntary Tax Compliance,
Mkuki na Nyota, Dar es Salaam, 2011 p. 16; Luoga F., A Source Book of Income Tax Law in
Tanzania, Dar es Salaam University Press, 2000, P.5. Ring D.M., International Tax relations
Theory and Implications, Tax Law Review, 2006.p.1.
 3

problems, whose solution(s) might need a transnational approach.11 MNCs import

(inbound investment) as well as export (outbound investment) capital and other

resources in and outside the sub-region.12 For MNCs to be established and operate

their activities efficiently, they require equity or debt capital.13 However, the most

pertinent form of capital by associated MNCs is debt.14 A parent group of associated

MNCs usually divides activities to its subsidiaries or to a permanent establishment.

For example, services and intangible activities may be done in centers operating for

the whole group or specific parts. A finance company may operate like internal

banks, whereas production of parts and assembly of final products may take place in

many different countries.15 In order to manage their intercompany transactions,

MNCs usually sell and buy goods within associated entities or group of companies

through transfer pricing. It has been estimated that two-thirds of the world‘s trade is

done within MNCs and from which transfer pricing is practiced.16

11
Amani H.K., Challenges of Regional Integration for Tanzania and the Role of Research, a Paper
presented at the general convocation meeting of the Open University of Tanzania, 2005.
12
For details of inbound and outbound investments see Olivier L and Honiball M., ‗International Tax:
A South African Perspective‘, fourth edition Ciber Ink Capetown, 2008 p.2; Arnold J.B et al.,
International Tax Primer, Kluwer international, Second Edition, 2002, p.4.
13
According to Business dictionary,‖ Equity capital is investment money that in contrast to debt
capital is not repaid to the investors in the normal course of business. It represents the risk capital
staked by owners through purchase of a company‘s common stock ie ordinary shares. The value of
equity capital is computed by estimating the current market value of everything owned by the
company from which the total of all liabilities. It is also known as share capital. Debt capital is part
of a firms‘ total capital which commonly comprises of loan capital and short term bank loans such
as over draft.‖ available at www.businessdictionary.com/.../equity-capital.html Accessed 20th
February,2013.
14
Adams C. and Coombes R., Global Transfer Pricing: Principal and Practice, Tottel Publishing Inc.,
Haywards Heath 2003 p.49.
15
United Nations, Ad Hoc Group of Experts on International Cooperation in Tax Matters, Tenth
meeting Geneva, 10 - 14 September 2001, ST/SG/AC.8/2001/CRP.6, p.2
16
Awasth R., Transfer Pricing Technical Assistance Global Tax Simplification Program, Global Tax
Simplification Team, A paper presented in Brussels, 24 February 2011.
 4

Therefore, transfer pricing is a set-up of price charged by one segment of an

organization for goods or services that it renders to another segment of the same

organization.17 Gareth extends that transfer pricing includes loan and intangible

assets arranged between associated MNCs.18 However, transfer pricing has become

a potential problem because it has been alleged as means of denying countries their

right share of tax revenue.19 It is done by increasing or reducing profits superficially

or creates losses with a view of concealing profit thereby lessening their tax

burden.20 This is achieved by using interplay of differences of tax avoidance laws

across countries through aggressive tax planning.21 The practice becomes rampant

when a parent company operates from low tax countries, where tax policies made

aim at diverting finances and capital from high to low tax countries.22 Thus, transfer

pricing manipulation becomes an acute problem because MNCs contribute

17
Horngren C.T. and Sundem G.L., ‗Introduction to Management Accounting,‘ 9th Edition Prentice
Hall International Inc 1993 p.336.
18
Gareth, G., Transfer Pricing Manual, BNA international Inc., London 2008, p.5, See also Sikkaa P
and Willmott H., note 4 p. 342; UN Guidelines 2013 para 1.1.6.
19
The Global Financial Integrity report 2014 shows that, EAC lost $1.3 billion between 2001 and
2010 due to manipulation of transfer pricing , led by Uganda $680, Tanzania $333, Kenya $112,
Rwanda $158 and Burundi $ 49 million. See Kar D and Spanjers J., Global Financial Integrity,
Illicit Financial Flows from Developing countries: 2003 to 2012, 2014. The Christian Aid, Death
and Taxes: the True Toll of Tax Dodging, 2008 reports that poor countries loose $160 billion a year
which is more than the aids they receive from donor countries. See also Curtis M., et al, The One
Billion Dollar Question: How Can Tanzania Stop losing So Much Tax Revenue, a Report by
Tanzania Episcopal Conference, National Muslim Council of Tanzania and Christian Council of
Tanzania, First Ed. June 2012. This report points out that Tanzania is losing $150 million through
mispricing; United Nations Economic Commission for Africa, Illicit Financial Flow: Why Africa
Need to ―Track it, Stop it and Get it‖, High Level Panel on Illicit Financial Flows from Africa,
2014, p.3. The report shows that Africa is losing USD 50 billion per year due to transfer pricing
manipulation. Although the figures differ from various sources, all findings show that there is
serious problem with regard to transfer pricing manipulation.
20
Oguttu A.W., ‗Curbing Offshore Tax Avoidance: The Case of South African Companies and
Trusts, PhD thesis‘, PhD Thesis, University of South Africa, 2007 p. 48; See also, Boldman N,
International Tax Avoidance , 35 Bulletin for international fiscal Documentation,1981, p 443;
Arnold, J.B et al , p.53, note 12.
21
This is achieved by concealing authentic documents on the actual costs and transactions between
associated MNCs to tax authorities.
22
OECD Report, Harmful Tax Competition: An Emerging Global Issue, 1998 p.14.
 5

substantially to revenue of the country.23 Therefore, any abuse of transfer pricing by

MNCs may substantially affect revenue of countries. Notably, international trade

and investment have enhanced integration of the EAC countries in global economy

and exposed such countries to international transfer pricing risks, whose solution(s)

may need a transnational legal approach.

The legal response to the rise of transfer pricing manipulation through tax avoidance

schemes is the enactment of tax avoidance legislation. Transfer pricing and thin

capitalization are some of tax avoidance rules aimed at deterring companies from

shifting profits to associated companies through under- or over- pricing of cross

border transactions.24 The rules are enshrined under international and regional

instruments and in countries‘ domestic laws. Transfer pricing regulations require

goods and services to be transferred at an arm‘s length price,25 a transaction in which

buyers and sellers of a product act independently and have no relationship to each

other. The arm‘s length price ensures that both parties in the deal act in their self-

interest and would not be subject to any pressure or undue influence from the other

party. In this context, revenue authorities are empowered to make adjustments where

23
For example in Kenya, it is estimated that MNEs account for a significant percentage of the large
taxpayer population, which contributes to about 75% of total tax revenues; see PWC Report,
Transfer Pricing and Developing Countries, A Project by European Aid Implementing the Tax and
Development Policy Agenda, 2011at p. 19.
24
In United States for Example, the earliest transfer pricing was introduced in section 262 of Revenue
Act, 1921. This provision permitted commissioner to prepare consolidated returns on behalf of
controlled entities so as to enable them to reflect their true tax liability. In United Kingdom, the
earliest transfer pricing regulations are provided under sections 770 to 773 of the Income and
Cooperation Taxes Act, 1988. For more details see Desai N, Transfer Pricing Problems, Strategies
and documentation: Recent Case Law on Transfer Pricing, 2002, p.4 - 5. In East Africa countries,
transfer pricing rules were introduced in very recent years.
25
In Tanzania see for example section 33 of the Income Tax Act, Cap 332 RE2008, Section 18
Income Tax Act, Cap 470 RE 2014 of the laws of Kenya, and Articles 9 of UN model and Article 9
of OECD model respectively.
 6

a special relationship seems to have influenced the determined price. Arguably, this

requires aggressive tax laws and sophisticated revenue authorities including

international cooperation to deal with transfer pricing intricacies.

Internationally, OECD Model Tax Convention on Income and Capital (OECD

model) and United Nations Model Double Taxation Convention between Developed

and Developing Countries (UN Model) are used in regulating transfer pricing. 26

These models have served as a useful tool for revision of domestic transfer pricing

rules. In practice, to date, EAC countries are referring to OECD model rather than

local transfer pricing laws in dealing with intricacies of transfer pricing cases.27

Arguably, EAC is lacking comprehensive and aggressive tax laws to deal with

transfer pricing intricacies. In the absence of proper transfer pricing regulations, both

revenue authorities and the MNCs have limited guidance to refer when dealing with

transfer pricing issues. The OECD model, which is used by EAC and most

developing countries, was developed from the view point of developed 28countries in

preserving their revenue. Indeed, the model is not necessarily relevant to developing

countries.29 Similarly, the UN model, which is made with the view of helping

developing countries, is not very much used by such countries. While there are

challenges in adopting such models, the risk of losing the right of revenues through

26
The purpose of both OECD and the UN model conventions is a uniform basis for solving the
problem of international juridical and economic double taxation primarily to encourage investment
by preventing double taxation of profits.
27
See for example decision in the case of Unilever Kenya Limited v The Commissioner of Income Tax,
Tax appeal number 753 of 2003 High Court of Kenya where the High court applied the
internationally accepted principles of OECD on ground that Kenyan law is not sufficiently
addressing Transfer pricing issues.
28
The founding members are high income economies such as United Kingdom, United States of
America, and Belgium, Netherlands, France, Germany to mention few.
29
See discussion on chapter three at 3.6.
 7

transfer pricing manipulation by MNCs is growing and the transfer pricing laws in

EAC are still lagging behind.

1.2 Statement of the Problem

This study addresses the growing potential of losing tax revenue through

international transfer pricing manipulations by associated MNCs‘ transactions within

EAC. The risk is of three-fold: firstly, failure by legislator to address legal

challenges that are caused by application of arms ‗length principle to arrive at arms‘

length price. Secondly, failure to make appropriate choices commensurate to the

local context while taking into account international transfer pricing standards in

crafting local laws. Thirdly, failure to recognize and draw attention on growing

challenges of international transfer pricing emerging from an increase in foreign

associated MNCs‘ investments. The risk of losing tax is inherent in the MNCs‘

endeavour of maximizing their profits. For that reason, MNCs have discretion to sale

goods and services with each other at specific arrangements. Although associated

MNCs are controlled from one country, they do not pay tax as one company. Each

company is a taxpayer in a country where it operates. The fact that MNCs operate in

different countries, they are at liberty to benefit from different legal systems.

However, tax regulations of a country differ from one country to another. They

include differences between countries‘ tax rate, transfer pricing rules and their

interpretation as well as policy, documentation requirements, standard of

administration reporting and enforcement, confidentiality of financial including

business transactions of tax payer and government attitude towards income derived

from multinationals. Because of these differences, MNCs may not report the same
 8

transfer pricing for a given transaction in all countries. As a result, MNCs may use

tax avoidance rules to avoid tax beyond what is legally accepted by exploiting

variations in law to transfer goods and services within the company.

Given their international nature, multinational transactions between MNCs are made

in different currencies other than EAC currencies. The differences on rules of

conversion of the foreign currency can be used in manipulating transfer prices and

shift profit from one country to another particularly in tax haven countries. Yet, there

is potential for an intercompany loan, which has been regarded as service, to use

interest payable on loan to shift profit from one country to another with the view of

lessening tax liability. Notably, MNCs normally, earn a fixed rate of interest and are

protected by contractual obligations with respect to their investments. Interest

received by a foreign company granting the loan is normally subject to an exemption

in the country where the receiving company is situated. However, contractual

obligations offered to investors ordinarily do not reflect issues of transfer pricing but

rather, they reflect tax incentive. Likewise, MNCs normally hold valuable

trademarks in countries from where they operate and not where they invest. For

subsidiaries or a permanent establishment to use it, they must incur cost. If such

transactions are not well regulated, they may lead to transfer pricing manipulation.

The significant challenge in crafting transfer pricing laws commensurate with the

local context is affected by desire of EAC countries to attract more foreign investors

with a view of obtaining more tax among other things. As a result, such countries

have been enacting laws and policies, which attract more foreign investors without

taking into account risks that may be associated with such steps particularly transfer
 9

pricing. Other factors include constant pressure from developed countries to

developing countries like EAC to strengthen their economies by importing capitals

through MNCs‘ investments. Equally important, requirement by multinational

institutions to developing countries to follow international transfer pricing standards

as benchmark in reforming local transfer pricing laws is another factor. There is

consensus that such standards as set in tax convention models to facilitate foreign

investment as imposed by multilateral institutions have not been working well in

developing countries like EAC. This is due to the fact that they were made without

taking into account specific needs of these countries.30 Hence, standard norms of
31
transfer pricing as set by tax convention models have tended to have adverse

impact on EAC countries that have required embracing them. The adverse impact on

such countries is mainly because application of such laws, in particular, arms‘ length

principle has been benefiting MNCs more than host countries.

Tanzania and Kenya to date, have different and incompatible provisions of law

governing transfer pricing in their respective countries.32 Such laws are of wide

variety ranging from lack of coordination to lack of clarity in some cases. Although

the arm‘s principle has been enshrined in various countries‘ ant-avoidance

legislation, its application is limited to certain areas and it leaves much to be desired.

Furthermore, transfer pricing laws have not largely tested in the court of law33 to

30
McGauran K., Should the Netherlands Sign Tax Treaties with Developing Countries?, SOMO, 2013
p.13 – 15.
31
OEDC and UN models.
32
Each state through its investment laws appears to be competing with the others to attract more
strategic investors to supply its internal market.
33
See for example Tanzania no transfer pricing cases has been taken to the court. It is only Kenya had
opportunity to test transfer pricing case in court of law in land mark case of Unilever Kenya
 10

establish their efficacy. Yet, these countries are largely referring OECD transfer

pricing rules, which are not binding and may not necessarily be relevant in EAC

countries.34 At regional level, the EAC investment code, which regulates investors, is

also silent on matters of transfer pricing.35 In addition, the EAC Agreement on

Double Taxation and Prevention of Fiscal Evasion with respect to Taxes on Income

Agreement, which provides for taxation of associated MNCs be done at arm‘s length

price, its application is not uniform among member countries.

Arguably, manipulation of transfer pricing within MNCs will continue to erode EAC

tax base. This would make EAC member states continue to be denied their right of

tax from international transactions. If manipulation of transfer pricing by MNCs is

not properly governed by nation‘s legislation and international instrument, then

MNCs will continue to shift profits from EAC countries to countries from which a

parent company operates and to the low tax jurisdiction. Hence, EAC will continue

to suffer from deficient tax to the detriment of their national economies. Thus, it was

necessary to study concerns of transfer pricing rules and effectiveness of legislation

and international instrument in curbing manipulation of transfer pricing by associated

MNCs in EAC.

1.3 Literature Review

Several scholars have written on the subject of transfer pricing laws and their roles in

tax revenue in a country or region. McClure posits that transfer pricing and tax

Limited V. Commissioner of Income Tax, Income Tax Appeal No. 753 of 2003[2005] of the High
Court of Kenya.
34
If they are relevant, the OECD model treaty and guidelines may only solve problems caused by
diverse of rules and regulation but not those caused by unsophisticated revenue authorities.
35
East Africa Investment Code 2011.
 11

havens have adversely affected less developed countries‘ (LDCs) ability to raise tax

revenues, primarily from avoidance of corporate taxes.36 He stresses that LDCs are

adversely affected more by capital flight and untaxed foreign earnings than those of

OECD countries. McClure provides four reasons LDCs are maimed by transfer

pricing. Firstly, laws and regulations dealing with transfer pricing are inadequate to

tackle transfer pricing problem.37 Secondly, lack of sound administrative capacity to

deal with transfer pricing problem even where legal framework for monitoring

transfer pricing exists.38 Thirdly, lack of comparable uncontrolled transactions and

relevant evidence on profitability are even less likely to exist for tax administrators

in LDCs than it is in developed countries.39 Fourthly, there are long period that

elapses before transfer pricing cases are settled and uncertainty of unfavorable

outcomes lead LDCs relatively uninterested in pursuing them.40

The adverse effect is greatly felt by developing countries because of reliance on

developed countries to assist them, either because they choose to do so or as a result

of measures to protect their own tax bases. In this context, the LDCs have nothing to

do individually or collectively to stanch outflow because most of the capital flows

from poorer countries are invested in OECD countries, which control means to

taxation reform. He concludes that tax reforms of the last several decades could not

36
Mclure Jr C.E., Transfer Pricing and Tax Havens: Mending the Less Developed countries Revenue
Net, Hoover Institution, Stanford University.
37
Cobham A et al., Transfer Pricing and the Taxing Rights for Developing Countries, Action aid, a
paper presented at the Tax Justice Network Africa Research Conference, Nairobi on April 2010,
p.9. available at www.christianaid.org.uk/images/CA_OP_Taxing_Rights.pdf; accessed 1st May
2013; Monkam N., ATAF Regional Studies on Reform Priorities of Tax Administrations: African
wide Report, November, 2012.
38
Ibid, see also, PWC., Transfer Pricing and Developing Countries, A Project by European Aid
Implementing the Tax and Development Policy Agenda, 2011.
39
Ibid.
40
McClure Jr., p.12 note 36.
 12

have been expected to deal adequately with revenue cracks created by tax havens and

transfer pricing. Hence, whatever action has occurred seems more likely to benefit

developed countries than to help LDCs patch holes in their revenue nets.41 Consistent

with McClure‗s view, a report by Price Waterhouse Coopers (PWC) includes lack of

documentation requirement or inability to enforce existing documents due to lack of

capacity to process as well as evaluate such information, partly because of lack of

technical expertise and necessary resources at their disposal to process the data as a

problem to developing countries.42 A possible resolution is for the European

Community (EU) to render support necessary in helping developing countries to

reform their transfer pricing rules. Support must be offered to enable developing

countries to adopt internationally accepted OECD Guidelines.43 However, support

goes with preconditions that developing countries should improve economic growth

in key sectors including legal services in accepting international tax laws of the

OECD and improvement of both human resource and office facilities by tax

authorities.44 It is argued that if developing countries decide to introduce transfer

pricing regulations on their own, there is a danger that such endeavourr will lead to

emergency of diversity in transfer pricing legislation in various countries in the

globe.45 However, the argument does not hold water because the right to tax belongs

to the country. Therefore, any country, whether developed or developing, has the

right to establish tax laws, which are relevant to its interest. In this context, this

41
Ibid p. 30.
42
PWC. p. 9 note 38.
43
Ibid, p. 5, The report posit that the rationale behind this is to help developing countries to increase
their domestic tax collection by processing tax information better and ensuring tax compliance for
all economic actors, in line with international standards.
44
Ibid p.20-21.
45
Ibid.
 13

study intended to suggest appropriate choices relevant for EAC, which take into

account international transfer pricing norms.

Nyamori offers an analysis of effectiveness of Kenyan‘s transfer pricing regime. The

author‘s analysis takes into account the decision of the court in Unilever case that

applied OECD Guidelines in absence of Kenyan guidelines. 46 Nyamori argues that

Kenya is not a member of OECD and therefore, could not participate in drafting the

Guidelines. He questioned the necessity for the court to rely on OECD Guidelines

instead of resorting to foreign jurisprudence. He is of the opinion that ultimately,

substantive laws of Kenya could be construed and applied. The author analyzes

transfer pricing based on substantive laws, rules and international treaties. He finds

that substantive law provisions are susceptible and insufficient guidelines on how to

arrive at arm‘s length price. Transfer pricing rules, which came to rescue the

situation also, have problems because they fail to make mandatory documentation

requirement and issues of cost arrangement among other things are not mentioned. In

addition, some rules do not exist in the enabling Act. A problem with this is that

rules are subsidiary legislation and cannot override the enabling Act. 47 Moreover, the

rules confer broad discretion powers to the Commissioner on imposing penalty and

on estimating tax to be paid by a tax payer in case of default. He concludes that

complexity of transfer pricing with scarcity of its experts and lack of comparable

data for determining arm‘s length price are impediments to efforts of alleviating

manipulation of transfer pricing by MNCs.

46
Nyamori B., An Analysis of Kenya‟s Transfer pricing Regime, International Transfer pricing Journal
, March/ April 2012.
47
Ibid, p.159.
 14

Policy Forum argue that Tanzania is losing taxes due to mispricing by MNCs not

trading at arm‘s length price as required by the law.48 They find that Tanzania loses

billions of dollars each year due to tax evasion by MNCs through trade mispricing of

profits to subsidiaries in tax haven countries like Canary Island and Cayman to avoid

tax liability in Tanzania.49 Mispricing is done by inflating of deflating import or

export of goods and services traded between associate MNCs. It is estimated that at

least United States of America dollars (US$) 150 million a year are lost through

mispricing.50 To date, transfer pricing laws are largely untested in the court of law.

There are no cases and no procedures on how to investigate transfer pricing issues.51

Thus, it remains a challenge for Tanzanian authorities to identify transfer pricing

manipulations and combat the problem. Its revenue authority should also ensure that

a standard ethical procurement principle for associated MNCs to implement their

transactions at arm‘s length price is adhered to.52 Hans- George Petersen report

analyses general tax system of EAC and found that one of the issues of concern is

transfer pricing manipulation by MNCs.53

The report views transfer pricing manipulation is caused by weaknesses of the

existing transfer pricing laws in that only four member states, namely, Tanzania,

Kenya, Uganda and Rwanda have transfer pricing while Burundi has none. Yet,

member states with transfer pricing laws have divergent approaches in their

48
Policy Forum, How Much Revenue are we Losing, An Analysis of Tanzania‘s Budget Revenue
Projections 2009/2010, Policy Briefing 2.09 p.3., See also Monkam N., note 37.
49
Ibid.
50
Ibid, p. vii-viii.
51
Ibid, p.31.
52
Ibid, p.4.
53
EAC/GTZ, Report of the EAC/GTZ programme, Tax System and Tax Harmonization in EAC:
Hans-Georg Petersen, University of Potsdam, 2010.
 15

application. Although arm‘s length principle enshrined in member state legislation

are in line with OECD Guidelines, other rules consist of vague and general clauses

such that their application is limited to certain transactions and companies.54

Moreover, no specific directives for handling transfer pricing queries. Each case is

handled according to circumstances of particular case and hence, they create

arbitrariness on handling transfer pricing cases.55

Borkowsk argues that serious economic consequences are caused by transfer pricing

manipulation in both developed and developing countries.56 She argues that the

problem of transfer pricing is caused by what constitutes an acceptable method to

arrive at transfer price.57 She cited United Kingdom (UK) and United States of

America (USA) as having their own perception on correct methods and willingness

to challenge tax authorities including risk audits.58 Despite their having detailed and

rigorous sets of transfer pricing regulations,59 the developed countries are also

subject to transfer pricing manipulation. The problem is worse in developing

countries for two main reasons. Firstly, for couple of years, some developing

countries shunned transfer pricing controls for fear from discouraging foreign

investment(s). Secondly, developing countries do not know the true extent of transfer

pricing problem due to difficulties in obtaining physical evidence of transfer pricing

manipulation. This is due to difficulties in ascertaining the true profit or loss of the

54
Ibid, p. 81.
55
Ibid.
56
Borkowski S., note 5.
57
Cobham A et al., note 37.
58
Ibid.
59
Ibid, p.9.
 16

transnational companies‘ residents in their countries and hence, ascertainment tax

liability becomes difficult.

On the contrary, MNCs apply sufficient resources to deal with transfer pricing

transactions using procedures that may be difficult to get exposed by tax authorities

of the developing countries.60 All these create unequal bargaining power between

developed and developing countries when dealing with transfer pricing.

Consequently, developed countries and emerging economies can result in companies

apportioning greater profits to their countries to avoid the risk of transfer pricing

disputes.61The result is that transfer pricing problem in developed countries is lower

than in developing countries.62 Hence, developed countries are in a better position to

deal with transfer pricing than developing countries.63

In this context, it is difficult for developing countries to alleviate manipulation of

prices by using less aggressive transfer pricing laws than the case may be. In solving

such problems, scholars suggest various ways including establishment of global

transfer pricing that will be accepted globally and that OECD and UN Guidelines

may be adopted at government‘s discretion.64 Disclosure of financial statements is

necessary to ensure transparence in order to reduce suspicion on income shifting.65

Other measures include existence of qualified auditors in transfer pricing,

60
Ibid.
61
Ibid.
62
Ibid, p. 2.
63
Ibid, see also OECD, Dealing effectively with the challenge of the Transfer pricing, OECD
Publishing 2012, p.71. available at http://dx.doi.org/10.1787/9789264169493-en accessed 29th
October 2013, p.71.
64
Borkowski S., note 5.
65
Ibid, see also Cobham A. et al., p.11 note 37.
 17

amendment of regulations, cooperation among regional revenue authorities and

effective exchange information.66 Agreeably, the stated solutions are viable. The

researcher endeavoured to study, in detail the legal loop holes in existing transfer

pricing laws which enable MNCs to avoid tax in EAC context.

Osei offers a comparative discussion and analyses of transfer pricing in the African

context in reality of transfer pricing in Ghana.67 He found that the problem of abuse

in transfer pricing is caused by the following; - uncertainties of Ghanaian tax

litigations due to judges being overworked and underpaid; poor court facilities with

lack of computer devices to record proceedings; lack of continuing legal education to

judicial cadres; lack of effective record management as well as storage; and

prevalence of corruption in judiciary system.68 Osei remarks that with such

problems, no wonder Ghana was unable to produce case laws capable of guiding

taxpayers on how they were expected to work in transfer pricing cases.69

Another cause is inherent practical problem of establishing an arm‘s length price

despite international acceptance of arm‘s length standards. In his view, proper

determination of arm‘s length price requires developed national case laws, for

without it, it is difficult to determine arm‘s length price.70 Additionally, weak rule of

law and problem of judiciary produce frequent violation of stare decisis;

66
Ibid.
67
Osei E.K.,Transfer Pricing in Comparative Perspective and the need for Reforms in Ghana,
Transnational law &Contemporary problems, NBr 19-2, 2010.
68
Ibid, p. 628
69
Ibid.
70
Ibid, p 627.
 18

consequently, the arm‘s length standard connotation is largely unknown in Ghana.71

Moreover, weak administrative enforcement of the tax code by Ghanaian revenue

authority due to lack of relevant data to deal with transfer pricing issues enhanced the

problem.72 The result is that the magnitude of transfer pricing in Africa is very high,

for it is estimated that the world‘s poorest countries lose more than development aid

they receive annually.73 To solve such problems, Ghana largely imported OECD and

UN models where there are comparable items.74

In absence of comparables, Ghana uses prices of goods and services in the

international market to determine a tax rate.75 He concludes that many developing

countries that include Ghana perceive OECD model highly appropriate for

negotiations between poor countries but inappropriately suitable for capital

importing countries.76 This is a contradictory argument such that if developing

counties are capital importers, how can OECD model be appropriate for negotiation

and irrelevant, on the other hand? Additionally, Osei did not explain extent OECD

model will help developing countries to obtain the right share of tax arising from

MNCs‘ transactions.

While appreciating developing countries‘ awareness on risk posed by transfer

pricing, the OECD report argues that many developing countries do not understand

the number and type of MNCs operating in their countries together with type of
71
Ibid.
72
Ibid.
73
Ibid.
74
Ibid, p. 622.
75
Ibid, p. 623.
76
Ibid, p. 620; see also UNCTAD, Investment Policy Review of Ghana, at iii, U.N. Doc.
UNCTAD/ITE/IPC/ MISC.14/Rev.1 (Feb. 2003), available at
http://www.unctad.org/en/docs/iteipcmisc14rev1_en.pdf Accessed 2nd May 2013.
 19

transfer pricing risks that are likely to arise.77 This translates into a difficulty of

working out on how to think up transfer pricing rules. As such, countries do not have

full knowledge of issues to be addressed and the problem that can rise from it.78 It is

uncertain whether or not this is true. The assumption is that African countries do not

have any regulation and procedure to govern foreign investment. In the contrary,

there are law and institutions, which govern foreign investors, for example, Tanzania

Investment Act79 and Tanzania Investment Centre that acts as one stop centre to co-

ordinate, encourage, promote and facilitate investment.80 The report further argues

that developing countries lack legal requirements for companies to file accounts to be

publically available.81

In settling transfer pricing disputes, the report argues that disputes normally involve

a significant amount of tax and there is no single right answer. Yet, most transfer

pricing issues are settled through negotiations between tax authorities and MNCs

making compromises.82 This is easily achieved in developed countries because they

have experience in dealing with transfer pricing cases. To the contrary, developing

countries lack experience in dealing with transfer pricing cases through negotiation. 83

One of reasons is that tax auditors may be easily corrupted because most of the

transfer pricing queries involve a huge amount of tax and hence, they cannot give

77
OECD note 63 p.68.
78
Ibid, p. 69.
79
1997.
80
See section 5 of the Act; See also, Kiunsi H.B., Tanzania Investment Act, 1997: Analysis of Law
and practice. A Research Submitted in partial fulfillment of Bachelor of Laws (LL.B) of the Open
University of Tanzania, 2005.
81
Ibid.
82
Ibid, p.75.
83
Ibid.
 20

real results.84 Thus, tax administrators of developed countries can help developing

countries in settling transfer pricing cases like it is done in South Africa.85 It is true

that there is corruption in countries in various sectors.

An overview of literature reveals various problems in relation to transfer pricing in

Africa. First, African countries do not know the extent of transfer pricing problem

and therefore, it is not easy to deal with transfer pricing problems. Second,

inadequate transfer pricing rules and where there are adequate rules, there are no

experts to deal with it. Third, African countries cannot make transfer pricing rules

unless they are helped by developed countries; either they choose to do so or as a

result of measure to protect their own bases. Fourth, uncertainty results from transfer

pricing litigations and unfavorable judgment to many developing countries

discouraged development of transfer pricing rules. Fifth, tax administrators lack

resources, experience and capacity to deal with transfer pricing intricacies. Sixth, the

solution for curbing tax evasion through transfer pricing is by adopting OECD Model

with help from developed countries.

Agreeably, many authors point out transfer pricing problems. However, most

literature sources are based on general developing countries or Africa and nothing

specific for EAC. Studies have been focused on a single country or for general report

purposes, across continental or between developed and developing countries.

Transfer pricing problems including identified and suggested solutions lack clarity as

well as certainty such that in some instances, they contradict themselves.

84
Ibid.
85
Ibid.
 21

Moreover, EAC, at large, is not extensively covered and therefore, there is an

apparent dearth of transfer pricing literature to appropriate solution. Therefore, this

study endeavoured to explore appropriate and implementable approach in curbing

transfer pricing manipulations. A legal solution will be suggested in solving transfer

pricing problems, and where applicable, non-legal solutions will be suggested so as

to fill the research gap.

1.4 Objectives and Research Questions

1.4.1 General Objective

The main objective of this study is to provide an insight into legal loop holes used

by MNCs to avoid tax through transfer pricing manipulation and suggest how might

be plugged to protect tax base of the EAC countries.

1.4.2 Specific Objectives

(i) To examine transfer pricing problems posed by foreign investors in particular

associated MNCs.

(ii) To analyze the adequacy, relevancy and appropriateness of the existing transfer

pricing standards and regulations in dealing with transfer pricing problems in

EAC.

(iii) To suggest ways which could help EAC countries to devise and implement

transfer pricing legislation suited to their strategic needs and environment, so

as to enhance certainty, clarity and predictability in curbing transfer pricing

manipulation by MNCs and protect its tax base.

 22

1.4.3 Research Questions

(i) Do existing transfer pricing rules and standards in EAC adequately curb

transfer pricing manipulation?

(ii) To what extent are the general principles and Guidelines of OECD and UN

model relevant in curbing transfer pricing manipulation in EAC countries?

(iii) What strategies should be considered and employed in formulating an

effective transfer pricing regime for EAC?

1.5 Research Methodology

This study mainly used a doctrinal research method supplemented by empirical and

comparative methods. Doctrinal method was used to review literature on transfer

pricing and evaluate transfer pricing legislation.86 There are two reasons for selecting

doctrinal method. First, primary data for the study were obtained from legislation

through reading the relevant sources. Doctrinal research is the main methodology of

legal research because it primarily focuses on what the law is as opposed to what the

law ought to be.87 Under doctrinal methodology, a researcher‘s main goal is to

locate, collect the law (legislation or case law) and apply it to specific set of material

facts in view of solving legal problem.88 In examining various laws, the researcher

employed historical, analytical and applied perspective approach. Under historical

perspective, the researcher looked into history of the transfer pricing legislation. The

86
Singhal A.K. and Malik I., Doctrinal and Social Legal Methods: Merits and Demerits, Educational
Research Journal, Vol. 2(7) pp 252-256, 2012. p.252.
87
Makulilo A.B., Protection of Personal Data in Sub-Saharan Africa, PhD Theses, University of
Bremen, 2012 at P. 52.
88
McGrath J.E., Methodology Matters: Doing Research in the Behavioural and Social Sciences, in R.
M. Baecker et al., (eds), Readings in Human-Computer Interaction: Toward the Year 2000, Morgan
Kaufmann Publishers, 1995, p. 154, as quoted in Makulilo A, B., note 124. See also, Singhal, note
86 p. 252.
 23

main questions included the following: ―What were issues of the day when

legislation was enacted? What were material conditions of the day? What was

mischief to be cured by particular law?‖ The rationale behind is to establish whether

or not issues, mischief and material conditions of that particular time are still relevant

to the contemporary transfer pricing problems.

Under analytical level, the researcher analyzed whether or not existing transfer

pricing rules give relevant answer(s) to existing transfer pricing problems. Then

under applied level, the researcher critically examined the manner and extent the

existing transfer regulations are sufficient enough to solve existing transfer pricing

problem. Documentary review and analysis were included but not limited to

legislation, policies international instrument such as treaties, conventions, cases,

articles, reports, books, journals, parliamentary hansards, dissertations, thesis; bills,

court decisions and commentaries by various scholars on transfer pricing. As for

documentary review, the researcher used various libraries such as Open University of

Tanzania and University of Dar es Salaam. Websites were also used to access

information from various sources in the world, which are relevant to the current

work. Legislation were used as a primary source of information by analyzing how

they are effective in regulating transfer pricing issues.

To complement doctrinal research, empirical method was employed to establish

external factors that actually affect operation of the law. This method is important in

revealing and explaining practices of legal, regulatory redress and dispute resolution

together with impact of legal phenomenon on a range of institutions, businesses as

 24

well as citizens.89 During field work, the researcher contacted key persons dealing

with or closely connected to transfer pricing laws and policies in government

institutions such as Ministry of Finance Tanzania, In addition, Tanzania and Kenya

Investment Centers, statistics bureaus, and revenue authorities were visited. The

researcher also visited few MNCs such as Geita Gold mine and Vodacom Tanzania

limited. Other visited places included law firms dealing with transfer pricing and

accounting firms responsible for tax planning, like KPMG and Paulclem and

Associates as well as tax tribunals.

The field research intended to establish how the government institutions

administered and implemented the existing transfer pricing legislation in curbing

transfer pricing manipulation by MNCs. Likewise, the study was effected in order to

establish the manner MNCs were affected by application of different transfer pricing

laws in the EAC as a single investment area, on one hand and on the other, to

establish how they comply with existing tax regulations. The field research also

served as a tool to establish factors that contributed the most appropriate means for

government to obtain right share of revenues from MNCs. In data collection, the

researcher used interviews to get insight into institutions‘ experiences in dealing with

transfer pricing problems. In addition to interviews, well crafted questionnaires were

administered to seek for meaningful responses from various institutions. The

questionnaire was administered to government institutions, while interviews were

administered to MNCs and other private sectors entities.90 Comparative analysis was

89
Ibid, p.53 -54.
90
The use of interview to MNCs is due to complexity and sensitivity of transfer pricing issues to tax
payer.
 25

also employed in conducting the research. In particular, the researcher was interested

to make comparison among status of laws and policies in the partner states so as to

detect any positive trends towards complying with the EAC Treaty requirement of

removing trade barrier within EAC. This is because the extent of the problem may

not be the same among all member states because some might have put initiatives

worth being followed by others.

1.6 Scope of the Study

This study was limited to EAC countries only and Tanzania as well as Kenya was

used as case studies. The choice of Kenya was based on her comprehensive transfer

pricing rules and case law. In addition, Kenya is highly experienced in transfer

pricing matters and therefore, it was necessary to examine in answering research

questions. Tanzania was selected because it lacks both comprehensive transfer

pricing legislation and case law and yet, it has more foreign investors than Kenya.91

Uganda was left out because its position in transfer pricing is equivalent to Kenya.

Burundi was left out due to the fact that it lacks comprehensive transfer pricing

legislation, which could have been worth to study. Use of French in Burundi created

language barrier thereby made it difficult to access legal documents and other

literature sources. In addition, Burundi is using civil legal system unlike other EAC

member states, which are practicing common law. Although Rwanda is having

various provisions of transfer pricing, it was not selected because it has same

limitations like Burundi. However, Rwanda is in transition from civil legal system to

common law.

91
UNCTAD Report 2013. Note 2.
 26

1.7 Structure of the Thesis

This thesis organized in eight chapters. Chapter one provides the Problem and its

Context. Chapter two presents concept and theories for international transfer pricing.

In the chapter, relevant transfer pricing concepts and theories for existence of

transfer pricing are explained. Since transfer pricing is practiced in associated

MNCs, the concept and theories of existence of MNCs are also explained and

discussed. The rationale is to show how transfer pricing plays a significant role in

fulfilling objectives of existence of associated MNCs. Problem and issues involved

in international transfer pricing are explained.

Chapter three presents international transfer pricing under auspices of international

tax. The chapter documents source and resident as basis upon, which taxes with

foreign elements can be executed. It also shows standards of international transfer

pricing as enshrined in international tax treaty models. It explains and discusses that

the pivot arm‘s length principle as corner stone to transfer pricing methods to arrive

at arm‘s length price.

Chapter four explains transfer pricing legislation in EAC. It shows how facilitation

of foreign investment enhanced involvement of associated MNCs‘ transfer pricing

practices in the region. Such challenges have forced EAC countries to adjust their

policies and laws to adopt transfer pricing standards including principles to attract

further foreign investors.

Chapter five examines aggressive tax planning strategies and their linkage to transfer

pricing manipulation by associated MNCs. Use of international transfer pricing

 27

standards and principles through aggressive tax planning to facilitate manipulation of

transfer pricing are discussed. The BEPS Action, which came to rescue failure from

existing transfer pricing standards and its efficiency in curbing manipulation in EAC

context is also explained as well as discussed. In addition, alternatives to arm‘s

length principle is discussed explained.

Chapters six review existing transfer pricing laws of Tanzania. It focuses on

examination of Tanzania‘s tax regime in particular Income Tax Act and its adequacy

in curbing transfer pricing manipulation by associated MNCs in the country. The

chapter also makes comparison with Kenya‘s tax regime. It also analyses whether or

not aligning transfer pricing outcomes with value creation principle is enshrined in

Tanzanian‘s law.

Chapter seven reviews existing transfer pricing laws of Kenya. It focuses on

Kenyan‘s tax regime, in particular, Income Tax Acts and their efficiency in curbing

transfer pricing manipulation by associated MNCs in the country. The chapter also

makes comparison with Tanzanian tax regime. It also analyses whether or not

aligning transfer pricing outcomes with value creation principle is enshrined in

Kenyan‗s law Chapter eight provides key findings, conclusion and

recommendations.
 28

CHAPTER TWO

CONCEPT AND THEORIES OF TRANSFER PRICING

2.1 Introduction

Transfer pricing is corner stone for operations of associated MNCs operating in

various countries. For transfer pricing to be performed or implemented, various

issues need to be considered in arriving at actual transfer price. This chapter presents

relevant concepts and theories for existence of transfer pricing and its role in MNCs.

The rationale is to show the manner transfer pricing plays significant role in fulfilling

objectives of existence of associated MNCs and problems as well as issues involved

in international transfer pricing.

2.2 Transfer Pricing Concepts

2.2.1 Transfer Pricing

In a modern economy where volume of associated MNCs is increasing with

globalization, transfer pricing is corner stone of all transactions. Traditionally, it

describes a setting of prices of goods, services and intangibles between associated

MNCs.92 However, scholars have assigned different meanings. There are those who

view transfer pricing as proper means for MNCs to maximize profit through

manipulations while others view it as proper means for obtaining government

92
Elliot J., Managing International Transfer Pricing Policies: A Grounded Theory Study, A PhD
Thesis, University of Glasgow, 1999, p.5, see also Horngren and Sundem p. 336 note 17; Sikkaa
and Willmott note 4 p.332; Gareth note 18 p.5. It is important to note that, for international
transfer pricing to be practiced the following must be established: - there must be associated
corporation in foreign jurisdiction, significant inter corporation transfer of tangible and intangible
goods and services between associated corporations, and that both parties charge each other for
such transfers. There must be intercompany leasing of property, performance of research and
development services and intercompany loans.
 29

revenue through arm‘s length price. In some instances, there are mixed feelings

about transfer pricing between MNCs and governments under their revenue

authorities on what constitutes a real transfer pricing. Additionally, there are scholars

who try to demarcate from realm of transfer pricing by giving both positions as to

when it is a tool of maximizing profit and reduce tax burden, and when it is an

important source of income tax to governments. The problem of defining transfer

pricing is based on its ambiguous character of being capable to give different results

when applied.93 The first group of scholars views transfer pricing as a tool of MNCs

to shift profit so as to minimize overall company tax liability with a view of

maximizing profit.94 This is sought to be achieved by using financial engineers to

manipulate various transactions including business restructuring so as to retain

wealth. In this context, taxation of profit by MNCs is targeted as a cost and that

needs to be avoided.95 Thus, MNCs have freedom to move capital and other

resources to their associates in other countries where they can save cost. Sikka and

Willmott point out that;-

“Reducing or eliminating taxes is attractive to corporations as it

boosts shareholder values, it also increases company dividends and
executive rewards as these are linked to reported earnings. Since
the amount of tax payable is dependent on costs and income,

93
It may either give countries involved right share of tax and right share of profit to MNCs or MNCs
will benefit more than government and vice versa
94
UN,Transfer Pricing: History, State of the Art, Perspectives, Ad Hoc Group of Experts on
International Cooperation in Tax Matters, Tenth Meeting, Geneva, 10-14 September 2001, Sikka
and Willmott note 17 See also Urguidi A.J., An Introduction to Transfer Pricing, New school
Economic Review, Volume 3(1), 2008,27-45 p.1; Plasschaert S.R., Transfer pricing and
Multinational Corporations: An Overview of Concepts, Mechanisms and Regulations,1979, p.19,
describes transfer pricing as a leeway of MNCs to manipulate the prices on intra firm and services
flow for the purpose of making profit; Curtis, M., et al, note 4 p.16. Christian Aid, False Profits:
Robbing the Poor to Keep the Rich Tax-free, A Christian Aid Report, March, 2009 p.4 ; Hearson
M. and Brook, note10; Hasset K. and Newmark, K., Taxation of and Business Behaviour: A
Review of Recent Literature, In Diamond J., Zodrow G., (eds), Fundamental Tax Reform: Issues,
Choices and Implications, MIT Press, Cambridge 2008, 191-2 14.
95
Sikka and Willmott, note 17.
 30

corporate attention becomes more intently focused on transfer

pricing strategies.”96

As most of investments are from developed countries, MNCs‘ parent companies

operate from such countries where there have aggressive transfer pricing laws. Since

their economies are based on long run private investments, they have control over

their associates and companies are benefiting from profits by reducing their overall

tax liability. Accordingly, policies and laws of the investor countries are devised to

stimulate as well as sustain economies through expansion of the economy, and

corporations are legally bound to increase profits as well as dividends for the benefit

of their share holders.97 Therefore, it is becoming difficult to avoid effects of

transfer pricing across countries. This is partly attributed by an increase in associated

MNCs as a result of desire to maximize profit and minimize cost and partly,

implementation of multilateral institutions‘98 policies that require developed

countries to invest in developing countries so as to boost economies of such

countries.99 The effect of losing tax through transfer pricing manipulation is higher in

developing countries including EAC than developed countries. This is because EAC

is capital importer and lacks capacity to invest in the developed world. Due to

differences in economy levels between developed and developing countries, the

returns arising from investment through MNCs are more likely to benefit the

investors‘ countries.

96
Ibid, p. 345.
97
See for example section 172 (1) and (2) of the UK Company Act, 2006.
98
IMF,UN and WB.
99
See discussion in chapter three below.
 31

It is interesting to note that developed countries also view transfer pricing as means

for MNCs to maximize profit and reduce tax liability. For example, in a transfer

pricing dispute between GlaxoSmithKline and United States Government,100 the

Internal Revenue service clearly stated that, ―We have consistently said that transfer

pricing is one of the most significant challenges for US in the area of corporate

administration. Transfer pricing is a practice meant to minimize United States

taxable profits by overpaying foreign subsidiaries for product supplies.‖101 The

same view was given by Sir David Varney when he said that, ―Transfer pricing is

the practice where profits of United Kingdom (UK) based foreign multinationals are

channeled through a Northern Ireland Office without actually bringing any

additional economic activity in the province.‖102

From legal point of view, transfer pricing is described as a system of setting up

prices of goods and services between associated parties at a market price, as if the

parties are operating independently. This is sought to be achieved by applying arm‘s

length principle.103 The principle requires that transfer of goods and services

between associated MNCs should be similar to those made between independent

parties operating in a market.104 Where a special relationship seems to have

influenced transfer price between associated MNCs, revenue authorities are

100
117. T.C. No. 1, United States Tax Court.
101
Reuters, GlaxoSmithKline to settle Tax dispute with US. The New York Times September 12,
2006 available at http://www.nytimes.com/2006/09/12business/world accessed on 16th September
2013.
102
Brown J.M., Corporation Tax blow for North Ireland‖, Financial Times, May 30, 2007 available at
www.ft.com/cms/s/o/444dfoe4a Accessed on 17th September 2013.
103
Arms‘ length principle implies condition that parties to a transaction are independent and on equal
footing.
104
The definition is inferred from international standards of transfer pricing as enshrined under article
9 of UN and OECD Models respectively, and from ant avoidance provisions of domestic laws
which requires goods between associated MNCs be transferred at arm‘s length price.
 32

empowered to make adjustment.105 The principle seeks to ensure that a country

where associated MNCs operate obtains the right share of tax arising from

associated MNCs‘ transactions.

From government perspective, arm‘s length provides legal basis for revenue

authorities to have right share of taxes and right share of profit to associated

MNCs.106 Courts also have been of the same opinion. In Hicklin v SIR, 107
the court

held that, ―dealing at ‗arm‘s length‟ was a useful and often easily determinable

premise from which to start the inquiry. It connoted that each party was independent

of the other and, in so dealing, would strive to get the uttermost possible advantage

out of the transaction for him or herself.‖108 In this context, most countries‘ transfer

pricing laws require goods and services to be transferred at arms‘ length price.109

Consequently, revenue authorities see transfer pricing as a target with potential of

producing very large government revenue through transactions by MNCs.110

Therefore, transfer pricing laws are devised to obtain the stated objective.

However, it is unlikely the objective can be achieved in EAC because the very nature

of transfer pricing laws has been threefold. First, as condition to attract more foreign

investment required by multilateral institutions, tax laws do not necessarily take into
105
PWC, International Transfer Pricing 2013/14, available at www.pwc.co/internationaltp, Accessed
17th September 2013; see also Owens J., Resolving International Tax disputes: The Role of OECD,
2004.
106
De Ruiter M., An Alternative methods of Taxation of Multinationals, a Written Contribution to
Conference, Helsinki Finland, June 2012. See also Arnold et al Note 12, p. 56
107
41 SATC 179(A),South Africa.
108
Ibid.
109
See for example in Tanzania, section 33 of ITA Cap 332 RE 2008 and Section 18 ITA cap 470 RE
2014 of the laws of Kenya.
110
PWC, International Transfer pricing Report 2013/2014 p.13 available at
http://www.pwc.com/gx/en/international-transfer-pricing/assets/itp-2013-final.pdf accessed 1st
May 2014.
 33

account the real desire of EAC to raise tax. Second, the laws are imposed from

developed countries where they were intended to be used between them. Third, the

original purpose of transfer pricing laws was to avoid double taxation.111

Additionally, given complexities involved in applying the arm‘s length principle, the

said principle may not be effectively implemented in EAC. Complexities of transfer

pricing, which are attributed by absence of universal rule for determining right

transfer price have put MNCs at risk of disagreement with tax authorities on taxable

amount reported to tax authorities. Consequently, revenue authorities do not agree

that there are different outcomes to any transfer pricing, as PWC pointed out that,

“There are many different possible outcomes to any transfer pricing

analysis, a number of which may be acceptable and some of which may
not, with the accountants need for a single number to include in
reported earnings and you have what many commentators have termed
the „perfect storm‟. This perfect storm threatens:- the risk of very
large local tax reassessments, the potential for double taxation
because income has already been taxed elsewhere and relief under tax
treaties is not available, significant penalties and interest on overdue
tax, the potential for carry forward of the impact of unfavorable
revenue determinations, creating further liabilities in future periods,
secondary tax consequences adding further cost – for example the levy
of withholding taxes on adjusted amounts treated as constructive
dividends, uncertainty as to the group‟s worldwide tax burden, leading
to the risk of earnings restatements and investor lawsuits.”112

Despite general view that transfer pricing is a tool of maximizing profit and

minimizing tax, some scholars demarcate from that realm. Pogan shows his concern

while reviewing OECD tax force report that,

“The disappointing of Tax force is that it sends a strong signals that

the issue of transfer pricing is still dominated in government circles
by outdated and incorrect view that, it is mainly about
counteracting tax avoidance by MNEs…the order in which issues
are dealt with and the shades of emphasis throughout leave no
doubt that the spectre of tax avoidance looms disproportionately
111
See purpose of OECD and UN Models in chapter three.
112
PWC, note 105.
 34

large. Thus the tax force report provides continuing encouragement

for the incorrect use of the term transfer pricing to mean, in a
pejorative sense, pricing decision by an MNE to deliberately shift
income from one member of the group to another to reduce the tax
liability in the first member country.”113

Other scholars argue that government efforts to minimize transfer pricing risks,

through increasing aggressive transfer pricing laws, increasing expert human

resources and other resources have affected minimization of transfer pricing by

MNCs.114 Not all MNCs are likely to adopt tax minimization. Non-manufacturing

firms are more likely to adopt tax minimization while manufacturing firms and less

internationalized MNCs are focused on tax compliance goal.115 MNCs which focus

on tax minimization goal incur high cost on their tax planning because they require

highly experienced expert personnel in international transfer pricing and more

resources in their departments. To the contrary, the MNCs which focus on tax

compliance do not incur extra expenses. They conclude that most MNCs assess

their transfer pricing practices on compliance based rather than tax minimization

measures, a pattern, which is contrary to the stereotype of being a tool to reduce

MNCs‘ tax burden.116Notwithstanding the foregoing view they agree that transfer

pricing is material tax minimization tool.117

113
Pagan J.C., Indication Future Policy in the Latest OECD Tax Force Report., Bullet in for
international fiscal Documentation, Vol. 47, no.4,1993, pp.181-186 p.181- 182.
114
Klassen K, etal, Transfer Pricing: Strategies, Practices and Tax Minimization. available at
www.tax.mpg.de/.../Paper_Kenneth_Klassen_Petro. Accessed 2 Februar 2014
115
Ibid.
116
Ibid, p.5.
117
Ibid, p. 28.
 35

In additional, revenue authorities see transfer pricing as a soft target with potential of

producing very large government revenue through transactions by MNCs.118

Therefore, transfer pricing laws are devised to obtain this objective. Absence of

universal rule for determining right transfer pricing have put MNCs at risk of

disagreement with revenue authorities on taxable amounts reported to authorities.

Because of desire to obtain revenues from international transactions, revenue

authorities disagree that there are different outcomes to any transfer pricing, as PWC

pointed out that,

―There are many different possible outcomes to any transfer

pricing analysis, a number of which may be acceptable and some of
which may not), with the accountants need for a single number to
include in reported earnings and you have what many
commentators have termed the „perfect storm‟. This perfect storm
threatens:- the risk of very large local tax reassessments, the
potential for double taxation because income has already been
taxed elsewhere and relief under tax treaties is not available,
significant penalties and interest on overdue tax, the potential for
carry forward of the impact of unfavourable revenue
determinations, creating further liabilities in future periods,
secondary tax consequences adding further cost – for example the
levy of withholding taxes on adjusted amounts treated as
constructive dividends, uncertainty as to the group‟s worldwide tax
burden, leading to the risk of earnings restatements and investor
lawsuits,”.119

Consequently, governments, through revenue authorities, have created uncertainty

to MNCs‘ business operations. It is further argued that tax is not a sole issue

considered by MNCs. Other transaction costs such as resource allocation, supply

chain and management compensation, among other costs, are taken into account

118
PWC, note 105.
119
Ibid.
 36

while planning tax.120 Likewise, economic rationale for MNCs to charge transfer

prices is for evaluation of performance of the associated MNCs concerned. This, in

turn, enables MNCs to decide whether to sell or buy goods and services within

MNC or to the open market.121 Hence, most MNCs comply with tax authorities and

the taxable amounts arising out of international transaction are certain and well

documented as required by the law.122 In line with this view, the OECD report states

that, "The consideration of transfer pricing problems should not be confused with

the consideration of problems of tax fraud or tax avoidance, even though transfer

pricing policies may be used for such purposes."123

An overview of understanding of transfer pricing concept reveals the following

conclusions. First, transfer pricing is not defined in laws and therefore, it is deemed

to be not a legal term. However, the terms, which are used between associated

MNCs, affect any transfer of goods and services if they are not set according to the

arm‘s length principle as a requirement of the law. Second, different perceptions of

transfer pricing lay on the fact that when used, they are capable of giving two

different results. It can either give countries‘ right share of tax and associated MNCs‘

right share of profit when prices are set according to the requirement of the law or it

can deny countries‘ right share of taxes when requirement of the law is not followed.

The former entails that when prices between associated MNCs are made at arm‘s

length principle, then the government will get its right share of tax while the MNCs

120
Ibid, p.15.
121
United Nations Secretariat, ―Transfer Pricing: History, State of the Art, Perspectives, ― Ad Hoc
Group of Experts on International Cooperation in Tax Matters, Tenth Meeting, Geneva, 10-14
September 2001.
122
Ibid.
123
OECD., Report on Transfer Pricing and Multinational Enterprises, 1979. Para 3 of the preface.
 37

will be only taxed over the required amount and maintain their profit. The latter

entails that when prices between associated MNCs are set without taking into

account the principle of arms‘ length, MNCs are likely to benefit more and countries

involved lose the right share of tax.

It is in this context that transfer pricing is perceived to be a tool of maximizing

profit and minimizing tax. This is achieved under the auspices of tax planning

whereby MNCs manipulate prices within law parameters in such a way that it is not

easy for a revenue authority to detect that the law is actually infringed. In McDowell

& Co. v CTO,124 the court observed that ―tax planning may be legitimate provided it

is within the framework of the law. Colourable devices cannot be part of tax

planning and it is wrong to encourage or entertain the belief that it is honorable to

avoid payment of tax by resorting to dubious methods.‖ For these reasons, both

MNCs and revenue authorities are required to comply with tax laws when dealing

with transfer pricing.

2.2.2 Transfer Price

Once price set-up is made, the question that follows is, ‗which should be actual

transfer price for a particular transaction?‘ From an economic point of view, transfer

price is "the amount charged by one segment of an organization for a product or

service that it supplied to another segment of the same organization."125 Arguably,

transfer price between associated MNCs does not necessarily reflect the arm‘s length

price. From a legal point of view and for the purpose of tax, transfer price is the

124
[1985] 154 ITR 148. Supreme court of India.
125
Horngren and Sundem note 17.
 38

arm‘s length price obtained by using arm‘s length principle.126 To arrive at transfer

price or arm‘s length price, specific methods need to be followed. The methods are

provided under international Guidelines of the OECD and UN models.

They are comparable uncontrolled price method, resale price method, cost plus

method; transactional profit split method and transactional net margin method.127 In

practice, for a tax payer to rely on any method, functional analysis is required to

establish all activities performed for a particular product in a particular transaction.

In most cases, functional analysis includes functions performed such as design,

assembling, manufacturing, sales activities, inventory, after sale service and any

other relevant function performed.128 Other factors considered include risk assumed

such as financial, market, regulatory, technology and product. Accordingly, assets

used and contributed must be identified, whether they are tangible or intangible

assets.129 The whole process of determining transfer price is based on comparability

to independent parties‘ transactions so as to bring both parties on an equal footing.

Thus, functional analysis is important to identify and understand intra-group

transactions, basis for comparability, points of adjustments in compared transaction,

and to have materials for transfer pricing documentation.

An overview of transfer price definition provides the following conclusion: First,

transfer price is the amount set by applying arm‘s length principle. Second, it is not

126
For more details on arms‘ length principle see discussion in chapter 3.
127
Chapter 2 of the OECD guideline 2010., Although there is no specific hierarch of methods, the
comparable uncontrolled price, resale price, cost plus methods have been referred as traditional
methods as they are commonly used. For more details on the methods see discussion in chapter 3.
128
See UN and OECD Guidelines respectively.
129
Olivier, L and Honiball, M., note 12 p.493, chapter 5 OECD, SARS practice note no. 7, and
OCED Guidelines 2010.
 39

easy to arrive at arm‘s length price such that special and long procedures must be

followed. Functional analysis and comparability are key factors for any chosen

method. Third, there is no right answer for any method used to arrive at transfer

price as per arm‘s length principle. Because such methods are not really legal but

rather, economic mathematical oriented. However, each used method depends on

circumstances of each transaction. Nevertheless, a price determined by using arm‘s

length principle is real transfer price between associate MNCs.

2.2.3 Multinational Corporations (MNC)

An MNC is another concept, which acts as a key player in international transfer

pricing. Traditionally, it refers to corporations operating in various jurisdictions but

controlled from one country.130 Internationally, MNCs are defined as all enterprises,

which control assets, factories, mines, sales, having 10 percent control of voting

stock or 25 percent of assets or sales in more than one country.131 This is equated

with foreign direct investment (FDI). In many jurisdictions, MNCs, for tax purposes,

130
See note 1, see also Dunning J. H., The determinants of international production, Oxford Economic
Papers, 25:289-335, 1973, p.13, Buckley P. J. and M.C. Casson., The Future of Multinational
Enterprise. London: The Macmillan Press.1976, p.1., Hood et al, The Economics of Multinational
Enterprise. London: Longman. 1979,p1.
131
United Nations, Department of Economic and Social Affairs Commission on Transnational
Corporations, Multinational Corporations in World Development. New York, 1973, p. 5. It should
be noted that, MNCs have been given different names like transnational enterprises, international
corporations, firms, and multinational enterprises which share common feature that operates across
borders. For the purpose of this work, MNCs is used, because the concept firm is related to
economic which maximizes certain variables within a competitive market framework. Enterprises
entails creative combination of labour and capital by an entrepreneur a situation which is not
applicable in the contemporary corporation where chief executives and officers are appointed to
lead organizations rather than entrepreneur skills. For more details see Harrod J.W.J., Multinational
Corporations, Global Transformation and World Futures, Knowledge, Economy and Society, Vol.
1.Available at http:/www.eolss.net/Eolss-sampleAllchapter.aspx. Accessed November 2013.
 40

refer to related or associated entities including corporations which can be either

affiliated,132 branch, subsidiary,133 controlled foreign company or intermediary.

In addition, associated MNCs, by using organizational structure, diversify their

investment geographically through special purpose entities.134 To establish whether

an individual or legal entity is an associate, domestic law provides for test either

through voting right, capital share or benefit rights. For example, in Tanzania, a

person other than natural person is said to be associate if directly or through one or

more interposed entities, controls or may benefit from 50 percent or more of the

rights to income or capital or voting power of the entity. 135 Scholars have extended

the meaning of MNCs to include franchise, management contracts and leasing,

which provides for value added activities of which a parent corporation receives

income from such activities.136 To this extent, the MNC is defined as a firm, which

has more than 10 percent of equity or contractual involvement like management

132
An affiliate is an entity partially or wholly owned and controlled by an MNC and includes
subsidiaries, branches, joint ventures or any legal entity under partial or complete control.
133
Subsidiary company is a legal term defined under national laws, generally as a company which is
fully or partly owned and or controlled by another parent company.
134
OECD explains special entities as ― financing subsidiaries, conduits, holding companies, shell
companies, shelf companies and brass-plate companies which are all legal entities that have little or
no employment, or operations, or physical presence in the jurisdiction in which they are created by
their parent enterprises which are typically located in other jurisdictions. They are often used as
devices to raise capital or to hold assets and liabilities and usually do not undertake significant
production. An enterprise is usually considered as an SPE if it meets the following criteria: (i) the
enterprise is a legal entity, a. Formally registered with a national authority; and b. subject to fiscal
and other legal obligations of the economy in which it is resident. (ii) The enterprise is ultimately
controlled by a non-resident parent, directly or indirectly. (iii) The enterprise has no or few
employees, little or no production in the host economy and little or no physical presence. (iv Almost
all the assets and liabilities of the enterprise represent investments in or from other countries(v) The
core business of the enterprise consists of group financing or holding activities, that is – viewed
from the perspective of the compiler in a given country – the channeling of funds from non-
residents to other non-residents. However, in its daily activities, managing and directing plays only
a minor role‖. See OECD Benchmark Definition of Foreign Direct Investment 4 th Edition.
135
See section 3 of the ITA RE 2008.
136
Dunning note 130 p. 5.
 41

contracts, franchising, and leasing agreements in more than one country.137 The

international character of MNCs of having either branch, affiliate, subsidiary or

controlled foreign company or any other relation capable of being recognized by law

are established in country other than where the parent corporation operates. Thus,

associated entities once established for purpose of conducting business, and actually

carryout business, they become permanent establishliment (PE).They may be a

branch, an office, a factory, a workshop, a mine, oil or gas well, a quarry or any other

place of extraction of natural resources,138 and they become tax payers in countries

where they operate. In taxing the business profit of such establishments, the concept

of PE is used to determine whether or not a country has right to tax business profit of

a nonresident tax payer. However, only business profits of a non-resident that may be

taxed by a country are those attributable to a permanent establishment.

The rationale behind this is that the PE is incorporated and situated in that other

country and therefore, it obtains residence of that country as well as becomes a

taxpayer in that particular country. In this context, the PE provides evidence that a

foreign country conducted significant business within the host country and therefore,

the host country should benefit for taxing PE.139 Oguttu and Tladi point out that PE

provided incentive for resident and source to cooperate in reducing international

137
Kusluvan S., A Review of Multinational Enterprises Theories, Cilt:13, Sayı:I, Yıl:1998 pp163-180
p.164.
138
Article 5 of OECD model 2010.
139
Oguttu A.W and Tladi S., The challenges E-commerce Commerce Poses to the Determination of a
Taxable Presence: The Permanent Establishment Concept Analyzed from a South African
Perspective, Journal of International Commercial Law and Technology,Vol.4.Issue 3,2009, pp 213 -
223, p 213, see also Kaufman N.H., Fairness and the Taxation of International Income, 29 Law &
Pol'y Int'l Bus,1998, p. 145; Mclure C.E., Taxation of Electronic Commerce: Economic Objectives,
Technological Constraints, and Tax Laws, 52 Tax Law Review 1997, 269, 361-62; Tillinghast,
D.R., The Impact of the Internet on the Taxation of International Transactions, 50 Bulletin for
International Fiscal Documentation 1996 at 524 – 525.
 42

double taxation thereby promoting international trade.140 It is important to study

MNCs‘ concept in EAC because of the volume of foreign investment investing in

EAC. Thus, when the government encourages foreign investment, it should know the

kind of entities it is going to deal with.

2.2.4 Tax Havens

The main purposes of MNCs are to maximize profit and minimize tax. For that

reason, most of them have been investing in low tax countries commonly known as

tax havens. There is no precise definition of tax havens. However, tax haven

generary refers to a country, which has a lower rate of taxation than that prevails

over other countries.141 OECD describes tax haven as the country, which is able to

finance its public services with no or nominal income taxes that actively makes itself

available to non-residents for tax avoidance that would otherwise be paid relatively

under high tax rate.142 The OECD provides the following four elements in

identifying the tax haven jurisdiction: there is no or nominal taxes on income, lack of

effective exchange information about tax payer benefiting from low tax jurisdiction,

lack of transparence in operation of legislation, legal or administrative provisions and

absence of a requirement that a qualifying activity needs to be substantiated.143

It is important to note that there are variations regarding tax haven from one country

to another. Others call low tax jurisdiction or offshore finance centres.144 Gravelle

points out that even elements identified by OECD exclude low tax jurisdiction like
140
Oguttu and Tladi note 139, p.215-216.
141
IBFD, International Tax Glossary 2001 p.347.
142
OECD, note22
143
Ibid, p. 23.
144
Olivier and Honiball note 12, p.553. For the purpose of this work, tax haven will be used.
 43

Ireland and Switzerland, which are also OECD members.145 Zorome defines offshore

finance centre as a country or jurisdiction that provides financial services to

nonresidents on a scale that is incommensurate with the size and financing of its

domestic economy.146 He describes key elements of offshore finance centres that

they are specialized in supply of financial services on a scale far exceeding needs and

size of their economies.147

Various reasons have been advanced for MNCs‘ investments in tax haven countries.

First, laws of tax haven countries and other measures are used to evade as well as

avoid tax laws or regulations of other jurisdictions. Second, presence of

minimization of tax liability gives advantage to MNCs in profit making. Third,

secrecy in banking and finance business face low regulatory supervision.148

Consequently, tax haven countries have been used by tax planners as an important

tool for generating more profits of associated MNCs. Findings by Christian Aid

reveal that in tax haven countries, there are no substantial economic activities that are

carried on such that the associated corporations in tax haven jurisdiction are there for

purposes of avoiding and evading tax.149 In line with these findings, OECD points

out that profit shifting issues arise when MNCs use existing loopholes, gaps, frictions

145
Gravelle J.G., Tax Havens: International Tax Avoidance and Tax Evasion., Congressional
Research Service, 7-5700 p.3 available at www.crs.gov accessed 27/04/2014, see also Hines J.R.
and Rice EM., Fiscal Paradise: Foreign Tax havens and American Business, Quarterly Journal of
Economics, vol. 109, February 1994, pp. 149-182.
146
Zoromé A.,. Concept of Offshore Financial Centers: In Search of an Operational Definition.
Working Paper 07/87, 2007 Washington DC: IMF.p.7.
147
Ibid.
148
Tax Justice Net work, Identifying Tax Havens and offshore finance, available at
www.taxjustice.net/.../Identifying_Tax_Havens_Jul_0 . Accessed 1 December 2013
149
Christian Aid, Who pays the price? Hunger: The Hidden Cost of Tax Injustice, 2013, p.31.
 44

or mismatch in interaction of countries‘ domestic tax laws.150 Such situation, in

particular, is happening in tax haven countries because the laws are always made to

contrast other countries‘ tax laws. Thus tax haven countries play significant role in

transfer pricing by allowing profits be made in such countries.

2.2.5 International Agreement

When MNCs sell and buy goods from associates, there must be an international

agreement for transfer pricing purpose. The international agreement is an agreement

entered between associated MNCs operating in various jurisdictions indicating terms

and conditions upon which goods and services will be supplied between them. Some

jurisdictions clearly provide for international agreement for transfer pricing

purposes; see, for example Section 31(2) of South Africa Income Tax Act. However,

scholars argue that international agreements under electronic commerce (e-

commerce) are affected because they are vulnerable such that they can be easily

deleted at any time if a data controller wishes to do so for the purpose of tax

evasion.151 Under e-commerce, terms and conditions can be easily altered without

being detected. Moreover, assumed functions and risk(s) may be split by the data

controller, an aspect, which makes difficult to obtain relevant data for comparables to

arrive at arm‘s length price.152 The understanding of international agreement is

important as it plays significant role in transfer pricing adjustment and corresponding

adjustment including avoiding double taxations.153

150
OECD, Action plan on Base Erosion and Profit shifting, 2013, OECD Publishing,
http://dx.doi.org/10.1787/9789264202719 accessed on 1stDecember 2013.
151
Oguttu note 20.
152
Ibid, see also Canadian Tax Foundations, Report of the proceedings of the fifty first Tax
Conference, 1999, para 2-27- 28.
153
See for example section 128 of Cap 332 RE 2008.
 45

2.2.6 Transfer Pricing Manipulation

Transfer pricing manipulation is a process of setting unarms‘ length prices of

transaction between associated parties with a view of maximizing profit of the

corporation and minimizing tax liability. This is achieved by over or under invoicing

of such transactions in order to avoid government tax regulations or to exploit cross

border differences in tax rates, for example, shifting deductable expenses to the high

tax country and revenue to the low tax country in order to reduce overall tax

payment.154 Motivation for manipulation of transfer pricing originates from theories

of MNCs and transfer pricing. The former requires MNCs to establish their

businesses where there is ownership specific advantage, location and internalization

advantage and where the operation cost is low. In this context, management of

MNCs may arrange their structure to take advantage of various laws, incentives and

local market features offered by a particular country. The latter is based on profit

maximization and gives potentials for concealment of relevant information between

associates and parent company. In such circumstances, it easy for MNCs to

manipulate prices so as to reflect their objective of minimization of tax liability as a

whole. This is possible because MNCs take advantage of complicated and long

procedures to setting-up prices, which do not reflect arm‘s length principle.155 In this

context, there is potential for revenue authorities not to discover such manipulation.

Accordingly, where revenue authorities have doubt in whether the price was arm‘s

length price or not, sometimes it may be hard for them to prove. The reasons are

simple. In auditing MNCs, revenue authorities have to rely on bulk documents

154
Eden L., Taxes, Transfer pricing and Multinational, in Alan Rugman and Thomas Brewer, Oxford
Handbook of International Business, London, UK: Oxford University Press, 2001, p. 593.
155
To arrive at arm‘s length price require comparability of various issues, preparation of the
documents and selection of the specific method for transfer pricing in a particular circumstances.
 46

prepared solely by taxpayers in making reassessment for additional tax. All these

take time and sometimes revenue with less aggressive administrative capacity may

not manage.

Transfer pricing concepts as discussed in this study have direct impact on setting

transfer pricing between associated MNCs. Consequently, in counteracting

manipulation of prices, such concepts ought to be taken into account. Notably,

transfer pricing concept is predominantly used in this thesis in two perspectives.

Firstly, it explains transfer pricing in context of arm‘s length principle in which host

countries may obtain the right share of tax. Secondly, it explains transfer pricing in

context of unarm‘s length price indicating transfer pricing manipulation. Likewise,

transfer price is also used to indicate arm‘s length price between associated MNCs.

Other concepts such as international agreements, tax havens and MNCs provide an

insight of important issues that countries under the study have to consider when

dealing with transfer pricing issues.

2.3 Theories for Existence of Transfer Pricing

Generally, transfer pricing is referred to be a byproduct of decentralization by an

organization, whose study requires integration of various disciplines.156 In order to

understand the role of transfer pricing in MNCs, it is important to understand

theories for existence of transfer pricing. At this point, it is important to note that

transfer pricing is of multi- disciplinary nature involving accounting, marketing,

economic, law and taxation. Thus, the study of transfer pricing theories may not

156
Elliot note 92 p.41.
 47

necessarily reflect a legal argument or point of view, but rather, other disciplines, in

particular, accounting and economic disciplines. However, principles developed in

these theories form an important part in determining the relevant arm‘s length price

applicable to transfer of goods and services between associated MNCs. The

following are theories of transfer pricing as developed by various scholars, namely,

economic, accounting, mathematical programming, and organization theories.

2.3.1 Economic Theory

Economic theory provides two assumptions. First, transfer price between associated

MNCs should be one that will lead the corporation to profit maximization. Second,

the central managers from where the parent company operates impose transfer prices

to its associates. Economic theory of transfer pricing was first developed by

Hirshleifer.157 He was concerned with problems of pricing goods and services

between interdependencies of corporations while influencing such divisions to

maximize the profit of corporation as a whole.158 The theory assumed two divisions,

one, manufacturing with no external market for its products and second, distribution

or buying division with competitive external market for its products.159 While taking

into account technology and demand condition, Hirshleifer concluded that transfer of

goods and services between associated MNCs should be made at a market price only

157
Hirshleifer J., On the Economics of Transfer Pricing. Journal of Business, 1956, vol. 29, no. 3, pp.
172-184, p.172.
158
Ibid, p. 172.
159
Ibid, p.173. See also Myers J.K. and Collins M.K., Historical Review of Transfer Pricing: A
dressing Goal Congruence within the Organization, Proceeding of ASBBS Annual Conference,
February 2011, Vol.18 Number 1, p.2.
 48

if a perfectly competitive market exists.160 The assumption is that where there is no

perfect competitive market, the price of goods and services between associates is

marginal cost of producing such goods and services.161 It means that goods and

services between two divisions of the same company must be transferred at a

specified price in order to attain profit as required by the parent corporation while

maintaining their autonomies.

The requirement that divisions should yield profit forms basis for evaluation of

managers‘ performance. In due regard, when divisional managers are evaluated

based on their divisional profits, as it is often the case, the temptation frequently

would exist not to supply truthful, relevant information.162 Kanodia, on basis of

Hirshleifer‘s argument, extended theory by taking external market to a mathematical

programming approach and employed uncertainty conditions. In this context,

Kanodia posits that central management sets transfer price by using linear

programme on the basis of true reports of manufacturing and distribution

divisions.163 The price set by central management is then imposed to divisions of

associated MNCs. The fact that prices are set by central management provides room

not to report honestly because the whole procedure is done by central

management.164 Because of this, Kanodia changed the model for uncertainty with

distribution division facing varied market prices and probabilities for the final

160
Hirshleifer J. note 129, p.176; See also BenkeR. L. Jr. and Edwards J. D., Transfer pricing:
Techniques and Uses, National Association of Accountants 1980. Kanodia C., Risk Sharing and
Transfer Price Systems under Uncertainty, Journal of Accounting Research, Spring 1979, pp. 74-
98.
161
Hirshleifer, note 129.p.179.
162
Avoseh O.O., An Empirical Evaluation of the Advance Pricing Agreement Process in UK, PhD
Thesis, University of Glasgow, United Kingdom, 2014. p.52; Myers and Collins, note 159.
163
Kanodia note 160.
164
Avoseh O.O, note 163, p.53.
 49

product.165 Together with the uncertainty, central management provided divisional

managers with certain percentage of profit generated at the division as an

incentive.166

Consequently, risk was only reflected to distribution division and hence, allocation

of rewards would not be Pareto optimal167 and maximization of the overall objective

of the firm was not guaranteed. In order to balance, Kanodia introduced risk sharing

scheme between manufacturing and distribution divisions situated within the country

and at international level by imposing a vector of values for transfer price and

making it conditional on the final price.168 At international risk sharing scheme,

Kanodia posits that transfer price is determined by equating corporate objectives

with division manager‘s risk aversions. To that extent, linear programme solves total

corporation desires of maximizing profit. Kanodia concludes that both international

and local sharing schemes motivate management to increase profit.169Critics of

economic theory assert that it ignores the autonomy power of division managers in

setting-up the transfer price and yet, the managers are evaluated as if they have

autonomy.170

165
Ibid.
166
Ibid.
167
Pareto is an economic term which refers to an economic equilibrium in which it is impossible to
change the allocation of resources without improving the lot of one agent at the expense of another.
See Microsoft® Encarta® Reference Library 2005. © 1993-2004 Microsoft Corporation. All rights
reserved.
168
Kanodia note 160 p.88. With regard to risk sharing scheme of divisions situated within the country,
Kanodia posits that, the transfer price was attained by forcing a separation between divisional
managers‘ risk aversions. A linear program is run to find the transfer price which is imposed on the
divisions. Hence, the interactions of the divisions will produce the distribution of total firm profits.
169
Ibid, p.3.
170
Kaplan R., Advanced Management Accounting, Prentice-Hall, 1982. See also Eccles R., The
Transfer Pricing Problem: A Theory for Practice, Lexington, MA: Lexington Books, 1985.
 50

Accordingly, the theory highly concentrates on maximization of profit and ignoring

the manager‘s position.171 Moreover, it ignores business strategy because it does not

address the manner the corporation will compete with each other. Despite the critics

raised against economic theory, it can be argued that it is directly applicable to issues

raised today by countries on manipulation of transfer pricing on the view of profit

maximization. This is because manipulation of transfer pricing originates from

concealment of information on part of managers who are afraid of being evaluated

on the basis of their profit performance. The theory also harmonizes fairly with

transaction cost or internalization theory for establishment of MNCs on minimizing

cost and profit maximization.

2.3.2 Mathematical Programming Theory

Mathematical Programming Theory explains that transfer price should be an

opportunity cost of producing goods.172 The theory views profit maximization by

MNCs‘ division as the main constraint, which can be solved by linear programming.

The approach introduced a pricing mechanism that determines allocation of

resources when constraint on operation capacity exists or when multiple buying

divisions exist.173 The division is assumed to be operating under capacity constraints

when there is no competitive external market for the product and thus, mathematical

programming should be used to solve the situation.174 In addition, since goods are

171
Elliot note 92 p. 44; Myers and Collins note 159, p.3.
172
Ibid, p. 43, see also Avoseh, O.O note 162 p. 53.
173
Eccles note 170 .
174
Solomons D., Divisional Performance Measurement and Control, 1965, Homewood, IL: R.D.
Irwin, as quoted from Avoseh O.O, note 162 p. 52.
 51

transferred from one division to another, the buying division is forced to source

internally.175

Like economic theory, mathematical programming theory aims at profit

maximization and transfer prices are set by central management and imposed to

divisions. The theory also has an element of misrepresentation of information when

division managers are evaluated on basis of their profit performance.176 However, the

mathematical programming theory has been criticized on grounds that it ignores

division autonomy of division managers by imposing transfer pricing. 177 Yet, it

provides an incentive on concealment of truthful information.178 In addition, the

theory has been criticized on ground that it is difficult to apply in practice. 179 Despite

the criticism of mathematical programming theory, it remains an important tool for

allocation of resources within MNCs.

2.3.3 Accounting Theory

Accounting Theory is based on an assumption that transfer pricing is one that

motivates division managers to make decisions that benefit the corporation as a

whole. Accounting theorists agree with economists that market price should be used

to transfer goods and services when there is a competitive external market. In its

absence, goods should be transferred at marginal costs.180 Where there is no outside

competitive market and transfers are not a major portion of the distribution division,

175
Ibid.
176
Kaplan note 170, Eccles note 170 ; Avoseh note 162 p.53; Myers and Collins, note 159, p.5.
177
Ibid.
178
Ibid.
179
Elliot note 92 p.43.
180
Myers and Collins, note 159
180
Ibid, Solomon note 174
 52

Solomon suggests two–part tariff price to be used. First, a charge per unit equal to

marginal cost and annual lamp-sum for fixed costs and profit.181 Second, where there

is no outside competitive intermediate market, transfers are significant but the selling

division has capacity constraints and cannot meet all requirements and thus,

programming method should be used to arrive at transfer price.182 Although Solomon

recognized the effect of transfer pricing on performance evaluation, to him, transfer

price was a method of resource allocation.183

Kaplan agrees on use of marginal cost in absence of competitive perfect market. He

is of the view that marginal cost limits profit performance, which makes supplying

division to lack incentive. In this context, negotiated market price can be used in

absence of competitive perfect external market to solve performance evaluation

problem of division managers.184 Benke and Edward, while forfeiting objective of

profit maximization as key for performance evaluation, established a rule that

transfer pricing should prescribe standard variable cost plus lost margin.185 The price

should be applicable in both situations when there is perfect competitive external

market and in absence of external markets. Antony and Deardon, departing from

relying on marginal cost in absence of competitive market, they suggested transfer

price to be based on three cost methods. First, standard variable cost plus a monthly

charge for fixed costs. Second, standard variable cost plus a portion of contribution

earned. Third, dual pricing where the selling division receives an approximation of

outside sales price minus a discount and the buying division pays standard variable

181
Ibid.
182
Elliot note 92 p. 51.
183
Solomons note 174.
184
Ibid.
185
Myers and Collins note 159 p.6.
 53

cost.186 Critics of accounting assert that the theory ignores division‘s strategic

situation that may cause it to operate under different objectives and constrains.187

2.3.4 Organization Strategy Theory

Organization Strategy Theory has its roots in the work by Swieringa and Waterhouse

who analyzed how an organization should handle transfer pricing problem. They

looked into four organization models, namely, behavior model,188 the garbage can

model,189 the organizing model190 and markets hierarchies‘ model.191 Under

organization model, a firm was seen as a coalition of participants with different

goals, expectations and choices. Goals were seen as constraints. In this context,

transfer pricing was seen a result of bargaining processes to solve such constraints.192

In their analysis, Swieringa and Waterhouse argued that transfer pricing rules of

organization are those resulted from goals of cost savings and strengthened

decentralized system.193 Garbage model explains that organization facilitates in

solving problems and conflict resolution through bargaining. In this model, available

choices are seen as a constraint, which depends on available solution. To this extent,

transfer pricing process must reflect these problems altogether. In these models,

Swieringa and Waterhouse argue that resultant transfer price is one that would reflect

problems worked on in the context of choice.194

186
Ibid.
187
Ibid.
188
Developed by Cyert and March 1963.
189
Developed by Cohen and March 1974.
190
Developed by Weick, 1973.
191
Developed by Williamson, 1975.
192
Elliott note 92 p.46 . See also Myers and Collins note 159 p. 8.
193
Ibid.
194
Ibid.
 54

Organization model saw processes of organization as cyclical and members of

organization were seen as creating an environment to which they adopt.195 This is

because retained interpretations largely determined what actions are responded to

and what meanings are given to those actions.196 Thus, transfer price is one that will

be used as means to legitimize members‘ past actions, which shaped their choices.197

The market and hierarchal were the last models reviewed by Swieringa and

Waterhouse. Market model explains exchange of goods and services achieved by

negotiating as well as contracting individuals who are bound rationally and

precluded from foreseeing all possible courses of their contract implications.198

William was of the view that an individual may create problem(s) due to self-interest

and make false claim(s) just like in economic as well as mathematical programming

theories.199 Thus, determination of transfer price by using market model is costly and

time consuming.200 Hierarchal model explains that series of market contracts should

be replaced with single employment contract and common resource ownership. Thus,

the transfer price will be one that will reflect the best results of the organization.201

The authors concluded that all models could be used to view transfer pricing problem

because they complement each other. Consequently, the choice and process of choice

cannot be conveniently abstracted from complications of the context.202

195
Ibid.
196
Ibid.
197
Ibid.
198
Ibid.
199
Ibid.
200
Swierenga R.J. and Waterhouse J.H., Organization view of Transfer Pricing, Accounting,
Organization and Society, Vol.7, no.2, 1982, pp.149 -165, p.156.
201
Myers and Collins note 159 p.8.
202
Sweirenga and Waterhouse note 200, p. 162.
 55

Spicer while considering transfer pricing in organization, considers uncertainty as a

constraint, which causes firms‘ differences and integrations. He argues that, ―an

organization theory of transfer pricing process requires a wider consideration of

relationships among firm‘s diversification strategy, its intra firm transactions,

organization structure, management accounting and control system.‖203 Thus,

internal transfer of goods and services is related to an organization‘s strategic choice

of whether to buy or make them.204 Spicer developed three assumptions that lead to

genuine organization‘s transfer pricing by asserting that,

―Where standardized intermediate products are the subject of

transfer involves product per which the degree of customization
is minor, market prices will be the primary basis for setting
internal transfer prices and for profit centre managers choosing
between internal and external supplies and customers.”205
“Where the internally transferred intermediate product involves
a moderate degree of customization and a material transaction-
specific investment, internal manufacturing costs will play a
greater role in the initial negotiations to set transfer prices and
in ex-post proposal to adjust them.”206
―where the internally transferred intermediate product is
idiosyncratic, and involves a large investment in transaction
specific human and or physical capital, internal manufacturing
cost will be the primary bases for setting transfer prices; and
there will be central control over the make or buy decision.
Whether internal transfers are made at simulated market prices
(cost plus), or simply at measure of cost, is a function of the
degree of uncertainty associated with the intermediate product
and the control strategy adopted by the firm.”207
From the foregoing, transfer pricing theories developed different transfer prices in

context of organization. Such transfer prices purely take interest of the organization

203
Spicer B.H., Towards an Organizational Theory of the Transfer Pricing Process, Accounting,
Organizations and Society, Vol. 13, no 3, p303-322 p. 304.see also Elliott, note 92 p.47.
204
Ibid.
205
Spicer note 203p. 318.
206
Ibid, p.319.
207
Ibid, pp.319- 320.
 56

and countries where they operated are not taken in to account. All along, the transfer

prices suggest maximization of profit and minimization of cost. In addition, such

theories clearly demonstrate potentials of price manipulations for transactions

between associated MNCs. Accordingly, transfer prices suggested focuses on solving

organization‘s problem such as evaluation performance and resource allocation

within the organization. Consequently, the transfer prices developed seem to be more

advantageous to MNCs than countries where they operate.

The fact that suggested transfer prices were developed from MNCs perspective,

countries where MNCs operate would need transfer price which will take in to

account their interest. In this context, market price should be used to transfer goods

and services between associated MNCs. Ordinarily everyone is free to enter in to

market and there may be no possibility of arranging prices in a special manner that

could affect market. In this context, prices of goods and services will be determined

by market forces. If associated MNCs sells at market price whether within or across

borders both countries and MNCs will get their right share of income.208 However,

such endeavor must be governed by the law. It is in this context that arms‘ length

principle comes in to pray to regulate the transaction between associated parties. The

application of arm‘s length is justifiable for two reasons is capable of counteracting

transfer pricing theories and it takes into account interest of countries where MNCs

operates. The former takes into account relevant issues from transfer pricing theories

and counteract by regulate them.209 First, it explains transfer price in context of

208
Right amount of tax on part of government and right amount of profit on part of MNCs.
209
Although transfer pricing theories are highly in favour of MNCs, there are theories that outweigh
others and therefore, it is possible to make preference of a particular theory to suit arm‘s length
 57

market price where competitive perfect market exists. The market context of transfer

price fits well with transfer pricing laws, which lay down arm‘s length principle

under such that any transaction between associates made at a market price is

considered to be in compliance with the law. Second, arms‘ length principle, takes in

to account separate entity principle which requires entities to be treated separately

when determining transfer price between them as enshrined in various laws and

international instruments. Third, it takes in to account functional analysis in

determining transfer price because the principle is based on comparison of different

situations in the market, functions performed and risk assumed as enshrined in

international as well as domestic guidelines. Fourth, the theory provides a leeway to

transfer pricing in absence of a competitive market for comparison purposes. In this

context, associated parties are obliged by arm‘s length principle to transfer goods and

services at market price while following special methods and procedures. It is thus

submitted that transfer price for transfer of goods and services between associated

parties is arms‘ length price.210

2.4 Theories for Existence of MNCs

The philosophical foundation of MNCs can be traced back from MNCs‘ theories,

which explain reasons for their existence, take different forms; operate across

borders and the manner they manage intercompany transactions. Traditionally, there

are two theories in existence of MNCs, namely, Dunning‘s eclectic paradigm and

transaction cost theory also known as internalization theory.

price. Thus, the approach does not take into account other theories that, to a large extent, aim at
profit maximization and tax minimization as costs. In this study, economic theory was preferred
despite its limitation due to the following reasons
210
For more details of arms‘ length price see para 2.2.2.
 58

2.4.1 The Eclectic Paradigm Theory

This theory explains a pattern, which determines the degree to which MNCs engage

into foreign direct investments. The theory explains reasons for firms to conduct

foreign production in a foreign country rather than producing at the home country

and export. This theory includes a number of integrated economic theories such as

international capital theory, which explains reasons a firm moves capital outside the

country.211 Industrial organization theory explains why international firms take place

based on ownership advantage. Location theory explains why the firm produces in a

particular country and theory of firm operates in an imperfect market.212

However, scholars argue that Dunning theories focus on one aspect and have

weaknesses that cannot sufficiently explain theoretical existence of the MNCs. Elliot,

for example, argues that industrial organization theory does not explain the manner a

foreign firm can compete with domestic firms.213 To overcome such weakness, the

firm engaged in foreign production must rely on a set of advantages that are

unavailable in the domestic country. In combining these theories, Dunning came up

with three specific advantages, which a corporation producing across borders should

have, namely, ownership specific advantage (O), location specific advantage (L) and

internalization advantage (OLI). He argued that;

“Firms with headquarters in one country will set up and/or expand

value adding activities outside their national boundaries whenever:
a) They perceive that, due to their nationality of ownership or
degree of multinationality, they possess some kind of competitive

211
Elliott note 92 p.35.
212
Ibid, see also Dunning J.H. Towards an EclecticTheory of International Production: Some
Empirical Tests. Journal of International Business Studies Vol. 11(1) Spring/Summer: no.1 1980, p.
9-3.
213
Ibid.
 59

advantage over indigenous firms (actual or potential) in the host

country;
b) They find it economic to exploit these advantages themselves, i.e.,
to internalize their use, rather than sell the rights to do so to host
country firms, via an arm‟s length transaction (e.g., a technical
service agreement or management contract);
c) They believe that it is in their global interests to produce at least
part of the value added from a foreign rather than a home
location.”214

Under ownership specific advantage, normally, MNCs consider issues, which have

ownership advantage over local corporations and other MNCs operating in a host

country. They include, but not limited to, technology, trademarks and an

organization‘s skills. Thus, capital is moved across countries preferably in countries

where there is low interest rate. For that reason, associated MNCs expand where the

return of investment is higher.215 The MNCs then transfer technology, management,

and organization skills within MNCs and control the same. Under location

advantage, MNCs prefer production and distribution of goods as well as services to

take place where production costs are relatively lower from where the parent

company operates and where its markets are situated.216 In line with Location

Theory, Burkely reiterates that MNCs venture across borders where there is raw

materials, cheap labour, protection and untapped markets.217

Furthermore, location advantage theory may be used as means to overcome trade

barriers in countries where a parent corporation exist. For example, government

restrictions of trade rules within the country where the parent company operates.
214
Dunning J.H., International Production and the Multinational Enterprise, London: Allen and
Unwin, 1980 p.34.
215
Kusluvan note 127, p.165.
216
Ibid.
217
Buckley P. J., A critical view of Theories of the Multinational Enterprise, in P. J. Buckley and M.
Casson (eds.), The Economic Theory of Multinational Enterprise. London: The Macmillan Press.
1985 pp 1-9 see also, Kojima, K., Direct Foreign Investment: A Japanese Model of Multinational
Business Operations. London: Croom Helm, 1978, as quoted from Kusluvan note 127.
 60

Under this perspective, economists view that strict rules affect MNCs‘ decision to

establish associates outside their countries due to strict rules imposed in the country

where they operate.218 For example, the regulation of imported goods, levy on taxes

and profit regulations. Another reason was advanced by Aliber that corporations

from strong currency economies establish associates in weak countries so as to

obtain advantage over a weak currency of the host country.219 Although the

argument was criticized by Hennart on ground that MNCs raise their funds where

the parent companies operate, it is not where the investment takes place and capital

is not the most important component of the MNCs.220 The theory is still relevant in

developing countries like East Africa where the shilling is weak to USA dollar and

most investments are rated in terms of the USA dollar. Some scholars argue that

MNCs exist as a supplement to international trade, since each country has

specialization of a product or resources that can be obtained at a relatively lower

cost. Similarly, demands differ from one country to another. In some cases,

countries may have resources and cheap labour but they are unable to produce

because of lack of technology know how.221 For one country to obtain its demand,

MNCs come to play. As Samuelson and Nordhaus pointed out that,

218
Calvet A. L., A Synthesis of Foreign Direct Investment Theories and Theories of the Multinational
firm, Journal of International Business Studies, 12(1): 1981, 43-59, see also, Ragazzi, G., Theories
of the Determinants of Direct Foreign Investment, IMF Staff Papers, 20(July): 1973, pp 471-498.,
as copied from Kusluvan noted 127 p.166.
219
Aliber R. Z., A ‗Theory of Direct Foreign Investment,‘ in C. P. Kindleberger (ed.), The
International Firm. Cambridge, Mass: MIT Press. 1970, pp 17-34 As quoted from Kusluvan note
214,p. 166.
220
Hennart J. F., A Theory of Multinational Enterprise. Ann Arbor (Michigan): Michigan University
Press, 1982, p142.
221
For example East African countries are endowed with untapped natural resources like gas and oil,
but lacks technological knowhow. Governments are inviting foreign investors to invest which they
come in form of MNCs.
 61

"Each country will specialize in the production and export of those

goods that it can produce at relatively lower cost in which it is
relatively more efficient than other countries, conversely, each
country will import goods which it produces at relatively high cost in
which it is relatively less efficient than other countries.”222

However, Dunning eclectic‘s theory was criticized on ground that only location and

internalization advantage are sufficient to explain existence of MNCs. Ownership

advantage is highly pertinent to survival of MNCs and cannot sufficiently explain

existence of MNCs.223 From the foregoing, Dunning‘s theory provides the following

conclusions with reasons multinationals invest out of their parent countries. First,

ownership advantages such that most MNCs are large firms with annual worth

millions of USA dollars. They are having technology or they have widely recognized

market that other competitors cannot use. Second, is localization advantage whereby

normally, MNCs furnish stock to the nearby market and where raw materials are

available. Third, internalization benefits such that MNCs benefit from owning

technology, brand and expertise. However, most of the MNCs are from developed

countries and EAC countries are mere sources of providing such advantages. As

such, the potential risk that may be caused by volume of foreign investments through

MNCs, in particular, transfer pricing manipulation would be high. This is mainly

because EAC countries are less developed lacking capacity to invest largely outside

the region and, in particular, in developed countries.

222
Kusluvan note 127 p.167.
223
Buckley P.J., and Casson, M.C., The Internalization Theory of Multinational Enterprises: A review
of the Processes of Research Agenda after 30 Years, Journal of International Business Studies,
2009, pp1563-1580 p.1564; Hennart note 219.
 62

2.4.2 Transaction Cost Theory

Transaction Cost Theory, also known as internalization theory224 explains that

corporations expand or source activities outside the country to minimize cost by

exchanging resources with the environment.225 The theory insists on cost

minimization for all transactions done within the corporation. Coase rightly pointed

out that, ―every company has to carry out his functions at less cost within the

company than outsourcing the activities to external providers in the market.‖226 The

theory argues that MNCs is a result of organized individuals with similar or different

interdependencies who pulled together their capabilities to generate income and

become social institutions that endeavor to organize economic activities. When

social institutions become efficient to organize, interdependencies become firm.

Hence, when a firm grows well, it becomes more efficient than external markets and

organizes interdependence with agents across borders hence development of

MNCs.227 Hennart further points out three things for the firm to expand. First, an

interdependency agent must be in a different country. Second, the firm must be the

most efficient way to organize interdependencies. Third, costs incurred by the firm in

organizing interdependencies are lower than benefits of so doing.228

The problem of trading interdependently within the nation poses less serious

problems. Serious problems arise when MNCs operate across countries facing

different legal problems, tax rate, currency, registration requirement(s), and work

224
Ibid, the theory was developed by Buckley and Casson 1976, Hennart J.F., A Theory of Direct
Foreign Investment, PhD Thesis, University of Maryland, 1977, p176.
225
Ibid, p. 208 -209.
226
Coase R., The Nature of the Firm. Economica 5: 386-405, 1937, p.5.
227
Hennart note 223 p.132 .
228
Ibid.
 63

permit for their experts, risk of repatriation, exchange risks and other legal

requirements that increase costs of operation to the MNCs. These are known as

transaction costs that are organized through price and hierarchy.229 Hence, the cost of

each transaction differs, depending on the chosen method.230 The firm‘s

interdependence presupposes that both countries are aware of the firm or

corporation‘s profit to be gained by agreeing on sharing of resources and avoid any

chances that will lead to lose profit by MNC.231 The theory argues further that firms

and markets are instrument used to organize as well as coordinate economic

activities performed within the company. Hennart points out such that markets rely

on decentralized autonomous adjustment by economic agents where price is the key

actor.232 Thus, a decision-maker must be in a position to foresee, correctly, future

prices for goods and services of a firm supplied or offered.233 To this extent, MNCs

normally opt for the least cost location for each activity with other profit and growth

based on continuous processes of innovation of technology, new products, business

methods and commercial applications of new knowledge.234 From legal point of

view, international trade exchange taking place between related parties should be

trading at arm‘s length price at international markets where traders react to market

prices. To the contrary, part of international trade between related MNCs results

from the manager‘s decision and not trading at arm‘s length price. The rationale

229
According to Hennart, hierarchy describes a method of control and not managers, who implement
it in firms, see Hennnart note 223 p.133.
230
Ibid, p.46.
231
Ibid, p. 133.
232
Hennart note 219 p.50.
233
Ibid.
234
Buckley and Casson note 216.
 64

behind is to minimize cost and therefore, all internal policies including rules are

made with intention of reducing cost in the corporation against the market.

From foregoing overview, it can be submitted that the main purpose of MNCs to

expand across countries is to maximize profit and minimize cost. MNCs are very

keen to see the cost of any transaction across border is minimized as much as

possible. Hence, for MNCs, while setting up prices they focus on profit

maximization by making sure that transfer of goods and services between them are

reasonably cheaper than the open market. MNCs always view tax as a cost of doing

business that needs to be avoided whenever possible. To them, tax increases cost not

only from the country where MNCs operate but also the whole group of companies is

affected. This is because transaction of one segment of a corporation is not stand

alone and it affects the whole company. For that reason, MNCs normally invest

heavily on accounting firms and tax advisers to save the tax cost through aggressive

tax planning. The fact that MNCs have sufficient resources to deal with transfer

pricing transactions and procedures may not be easily traced by tax authorities. Thus,

MNCs‘ theories reveal a true colour of MNCs‘ desire such countries under study

ought to take into account when crafting transfer pricing laws.

2.5 Conclusion

Transfer pricing concepts and theories have direct impact on setting transfer prices

between associated MNCs. Accordingly, there are agreements and disagreements

with regard to meaning, scope and approach of such concepts including theories,

depending on context of interpretation. While one approach is seen in favour of

MNCs and from perspective of developed countries for profit maximizing, it was not
 65

seen fovourable to governments unless they are construed in context of arm‘s length

so as to ensure that governments obtain their right share of tax.

These circumstances seem to justify countries to strengthen transfer pricing laws so

as to counter transfer pricing manipulations. Thus, it is important that transfer pricing

theories and concepts should be understood from legal point of view so as to avoid

uncertainty that may occur while determining transfer price. In this context any

transaction between associated parties are to be transferred at arm‘s length price.

Nevertheless, concepts expose true colour of transfer pricing. This might be useful to

be considered when developing laws and other measures to counter manipulation of

transfer pricing in EAC countries.

 66

CHAPTER THREE

TRANSFER PRICING UNDER INTERNATIONAL LAW

3.1 Introduction

The shift of profit by MNCs through transfer pricing manipulation has led to a

serious concern to both developed and developing countries. The desire for countries

to tax profit on investments by MNCs on either source or resident basis has

necessitated countries to harmonize national laws so as to facilitate investment by

MNCs. In order to promote investment through MNCs, countries have found that it

is necessary to eliminate any barrier that impedes cross border trade.

Among barriers they include double taxation on MNCs‘ profits by governments and

profit shifting by MNCs. For taxation of profit by MNCs to be effective and

efficient, substantive laws should be harmonized or unified. This need has facilitated

development of international transfer pricing standards under the umbrella of tax

conventions initiated by multilateral institutions. It is within this context that

attention has been given to transfer pricing standardization so as to regulate

transaction between associated MNCs.

Thus, tax conventions provide standards for transfer pricing laws and serve as a

benchmark upon which countries consider when crafting domestic laws. However,

transfer pricing standards that have emerged as benchmarks for standardising

establishment of domestic transfer pricing laws originate from developed countries

such that they may have some limitations to developing countries like EAC. This

chapter highlights transfer pricing laws as manifested in international law. It starts by

 67

looking briefly about international tax with a view of providing the basis for

international transfer pricing. The principles of international tax as a base for

taxation under international tax are highlighted. Raising and elimination of double

taxation in relation to transfer pricing as enshrined under tax treaties are explained.

The desire to have international transfer pricing standards and overview of tax

models in whereby standards are enshrined is given. Specific transfer pricing

standards are discussed followed by methods to arrive at arms‘ length price. In

addition, international transfer pricing documentation requirements and dispute

mechanisms as enshrined under tax treaties are analysed.

3.2 International Transfer Pricing under Auspices of International Tax Law

It is the fact that MNCs operate across countries becomes the subject of international

tax. International tax is concerned with problems arising when an individual or a

corporation is taxed in more than one country. However, there have been different

opinions on whether or not there is international tax. One group of scholars argues

that no international tax exists. Olivier and Honiball argue that international tax is a

misnomer because no tax laws exist that are applicable to all countries and that right

to tax forms part of a state‘s sovereign powers.235 Similarly, Ring argues that there is

no formal or specific definition of international tax, but it refers to income of a

resident earned outside the country and income of nonresidents earning inside the

country.236

235
Olivier, L and Honnibal, M., note 12 p. 2, .
236
Ring note 10, p.3.
 68

Scholars on another group argue that international tax exists and it is part of

international law. Arnold and McIntyre posit that international tax encompasses all

tax issues arising under a country‘s income tax laws, which include some foreign

elements such as income tax of cross–border trade in goods and services;

investments; manufacturing by MNCs; and taxation of individuals who work or do

business outside the country where they usually reside.237 Other international issues

are recognition of MNCs with foreign subsidiaries in several countries.238 Avi-

Yonah, for example, provides four reasons for existence of international tax. First, a

country can tax nonresidents that have connection to it on foreign income. Second,

non-discrimination norm means that nonresidents from a treaty country should not be

treated worse than residents embodied in all tax treaties. Third, the arm‘s length

standard applies in all tax treaties in determining proper allocation of profits between

related entities. Fourth, there is prevention of double taxation through credit or

exemption methods.239 He further argues that where international national legislation

exists, it overrides customary international law and treaties.240 But in the absence of

legislation, customary international law can be used.

However, Avi-Yonah was criticized on grounds that not all international tax issues

can be answered by using international law, in particular, issues of domicile and

nationality. This is because international law involves an interaction between two

domestic legal systems as opposed to application of legal principles generally

237
Arnold J.B. and McIntyre M.J., International Tax Primer, Kluwer international, second Edition,
2002, p.3.
238
Ibid.
239
Avi- Yonah R. S., International Tax as International Law, Public Law and Legal Theory, Research
paper No. 41, see also Olin, J.M., Centre for Law and Economics; Research paper No. 04-007 p.
12 - 15.
240
Ibid.
 69

accepted internationally.241 However, whether or not international tax exists, both

scholars demonstrate magnitude of the problem in dealing with tax issues involving

foreign element. Hence, international transfer pricing plays as an important part of

international tax as it involves taxation of profit by MNCs operating across countries.

3.3 Source and Residence as Basis for International Taxation

Under international tax law, all income that arises from international transactions can

be taxed either at source or residence basis.242 The work of taxation at source or

residence basis can be traced back from the 1920s. This happened when the

International Chamber of Commerce, under the auspices of League of Nations,

adopted a resolution on prompt agreement between governments of allied countries

to prevent individuals from being compelled to pay tax on the same income in more

than one country.243 The first resolution to solve double taxation was that an

individual or companies should be taxed on both residence and source. 244 In 1923,

there was a remarkable development when it was decided that in classifying and

assigning specific categories of incomes to source or resident, the objective test of

economic allegiance must be used. The test entails to weigh various contributions

made by different countries to production and enjoyment of income. 245 In this

241
Olivier L and Honiball M. note 12, p.2.
242
Avi – Yonah note 239. See also Tax Justice Network, Source and Residence Taxation, September
2005, available at http://www.taxjustice.net/cms/upload/pdf/Sourceresidence.pdf. accessed 1st
January 2014.
243
Herndon, J.G., Relief from International Income Taxation: The development of International
Reciprocity for the Prevention of Double Income Taxation 1932, p.20 as copied from Graetz M. J.
and O'Hear, M. M., The Original Intent of U.S. International Taxation Faculty Scholarship Series.
Paper 1620, 1997, P.1066, available at http://digitalcommons.law.yale.edu/fss_papers/1620.
Accessed 1st January 2014.
244
Ibid.
245
League of Nations, Report on Double Taxation submitted to the Financial Committee by Professors
Bivens, Einaudi, Seligman and Sir Josiah Stamp, League of Nations Doc E.F.S.73 F.19, 1923.
 70

context, the two issues had to be considered, namely, where the wealth originated,

that is, source and where the wealth was spent, that is, residence.246 The source of

production of wealth involved stages up to the point where wealth reached fruition

that may be shared in by different countries on residence basis.247

The rationale for taxation on bases of source and residence was stated in the case of

Karguelen Sealing & Whaling Co ltd v CIR 248that,

“In some countries, residence (or domicile) is made the test of

liability for the reason, presumably, that a resident, for the privilege
and protection of residence, can justly be called upon to contribute
towards the cost of good order and government of the country that
shelters him. In others (as in ours) the principle of liability adopted
is „source of income,‟ again, presumably, the equity of the levy rests
on the assumption that a country that produces wealth by reason of
its natural resources or the activities of its inhabitants is entitled to
a share of that wealth, wherever the recipient of it may live. In both
systems there is, of course, the assumption that the country adopting
the one or the other has effective means to enforce the levy." 249

Since MNCs operate in more than one country, tax may be charged on resident or on

source basis. Under source principal, the country has the right to tax any income

arising within its boundaries, regardless of physical or legal residence of income

recipient.250 The rationale behind is that tax payers are expected to share cost of

infrastructure, which makes possible production of income, its maintenance,

investment and use through consumption.251 Some jurisdiction defines the term

246
Ibid, see also OECD, Addressing Base Erosion and Profit Shifting, OECD Publishing 2013, p.35
available at. http://dx.doi.org/10.1787/9789264192744-en. Accessed 2nd May 2014.
247
Ibid,
248
[1939] AD 487, 10 SATC:363 Appellate Division; see also Ring note 10 pp. 33 – 34.
249
Ibid.
250
Sher C., Taxation of E-commerce, 39 Income Tax Reporter 2000, p. 172. See also Olivier and
Honiball note 12 p.51.
251
Olivier and Honiball note 12 p. 52.
 71

source252 and some do not. However, case law describes source as not a legal

concept but rather, something, which a practical person would regard as a real

source.253 The court also establishes a test upon, which a source can be determined.

First, determinations of original cause and second, location of the cause once

determined.254 The former explains activities that gave rise to taxable income and

the latter explains where activities were actually carried out. However, determination

of source of income depends on nature of the transaction carried out.

Sometimes it is not easy to establish where the source of income originated if

activities that gave rise to such income were partly carried out in both countries. For

example, a corporation, which is situated in Germany has permanent establishment

(PE) in Tanzania. The PE in Tanzania enters a three years contract with the

government to construct roads. The design and capital are from Germany but

services are rendered in Tanzania. Tanzania has the right to tax on source basis

because activities were carried out in Tanzania. Similarly, Germany will tax because

the design and capital, which gave rise to that income, are from Germany. In

determining true source of income, case law laid principle that a true source of

income is the place where activities, which gave rise to such income were carried out

including royalties accrued to investors from patents and similar assets.255

252
See for example sections 67, 68 and 69 of ITA Cap 332RE 2008.
253
Rhodesia Metals Ltd (in liquidation) v CoT 11 SATC 244.
254
CIR v Lever Brothers ltd 14 SATC1. It should be also noted that, determination of source under
international tax depends of a particular activities that were carried out by MNCs. For example
royalty, interest, lease agreement, services, manufacturing activities among others.
255
Millin v CIR [1928] (AD) 207, 3 SATC 170.
 72

Where for any reason it seems that taxable income arises from more originating

cause, the distinction between dominant and incidental cause must be made. In this

context, countries may agree to apportion their incomes.256 In Transvaal Associated

Hide and Skin Merchants v Collector of Taxes Botswana,257 the fact of the case was

that a Transvaal company purchased hides and skins and other livestock by-products

at Botswana where the animals were slaughtered and then disposed in South Africa.

Before skins were transported to South Africa, they were salted and cured. The initial

preparation of treating skins did not change the essential character of the skins. The

issue was whether curing of skins in Botswana amounts to dominant or incidental

original cause of the derived income. The Court of Appeal held that, ―the dominant

factor in deriving income from the disposal of the skins was the curing that had taken

place in Botswana.‖258 It is necessary to establish the source of income because it

affects rules of calculating taxable income derived from source and foreign country.

Residence is another principle in determining the taxable income involving a foreign

element. It entails taxation of residents on their worldwide income without taking

into account sources of such income.259 For a country to tax on resident basis,

various tests are employed in establishing residents of an individual or legal

person.260 First, a corporation is deemed a residence of a particular country if it is

incorporated, established or formed in the particular country even if management and

control of the corporation are not in the country. Second, it entails if management

256
Olivier and Honiball note 12 p. 53.
257
29 SATC 97.
258
Ibid,
259
Oguttu W.A. and Der Merwe B., Electronic Commerce: Challenging the Income Tax Base? 17
South Africa Merchantile Law Journal, 2005, 305 -322 p. 306.
260
For purpose of this work only corporation as legal person will be dealt with.
 73

and control of corporation are exercised in that country under particular year of

assessment. Third, there has to be a declaration by the Minister of Finance that the

particular corporation is residence for tax purposes.261 Likewise, countries also have

rights to tax controlled foreign corporation on resident‘s basis. The general rule is

that so long as the company is incorporated in a particular jurisdiction according to

the company‘s law of that country, it is liable for tax in that country and in its

worldwide receipts.

3.4 Rise and Elimination of Double Taxation

The fact that each country wishes to tax incomes of investment by MNCs operating

across countries on source or resident bases, it causes complex problems not only to

countries involved but also to MNCs. Countries are competing to obtain their right

share of tax arising from cross border transactions, while MNCs are at risk of being

taxed in both countries. Consequently, double taxation may arise. There are various

reasons for double taxation.

First, dual residence whereby a corporation is deemed to have dual residence if it is

incorporated and situated in one country, while its effective management is in

another country where the parent corporation operates. In this context, both

countries feel to have sufficient connection with the tax payer and therefore, they

have the right to tax the profit. Second, source to source conflict may ensue whereby

two or more countries may institute taxes on source basis. Third, residence to source

261
See for example Section 2(1 b) (i ), (ii) and (iii) ITA cap 470 RE 2014; Section 66 (4) (a) and (b)
of ITA Cap 332 RE 2008; USA IRC S.7701 2006. See also Marian O., Jurisdiction to Tax
Corporations, B.S.L. Rev.2013, 1613 – 1665, p.1619-1620.
 74

conflict whereby one country claims rights to tax income on source basis and the

other on residence basis.262

In order to avoid double taxation, tax avoidance rules are employed. However, there

is no hard and fast term of tax avoidance. Fuest and Riebel explain tax avoidance as

an activity that a person or a business may undertake to reduce their tax in a way that

runs counter to the spirit and purpose of the law without being strictly illegal.263

Krishna defines tax avoidance as use of perfect legal methods of arranging one‘s

affairs so as to pay less tax.264 On the other hand, tax avoidance is essentially a

misuse or abuse of the law driven by exploitation of structural loopholes in the law to

achieve tax outcomes that are not intended by the parliament. 265 A court also has

been in the same opinion. In CIR v Challenge Cooperation Limited,266 the court held

that,

“Income is avoided and a tax advantage is derived from an

arrangement when the tax payer reduces his liability to tax without
involving him in the loss or expenditure which entitles him that
reduction. The taxpayer engaged in tax avoidance does not reduce
his income or suffer a loss or incur expenditure but nevertheless
obtains a reduction in his liability to tax as if he had.”

This is achieved by artificial arrangement with little or no economic impact upon the

tax payer that is usually designed to manipulate tax laws in order to achieve results

262
Vogel K, Double Tax Treaties and Their Interpretation,4 Int'l Tax & Bus. Law 1,1986.
P.6.Available at: http://scholarship.law.berkeley.edu/bjil/vol4/iss1/1. Accessed 10th May 2014
263
Fuest C. and Riedel, N., Tax Evasion, Tax Avoidance and Tax Expenditure in Developing
countries: A Review of the Literature, Report prepared by the UK Department for International
Development (DFID), Oxford University Centre for Business Taxation, 2009 p.4. See also Oguttu
note 20, p. 2; Hickey L., What is the Difference between Tax Avoidance and Tax Evasion?
Available at http://www.accountacyage.com/aa/analysis/1775584/what-difference-avoidance-
evasion accessed 10th May 2014.
264
Krishner V., Tax Avoidance: The General Ant Avoidance Rule, 1990 p. 9.
265
Australian Government, Final Report of the Review of Business Taxation: A system Redesigned,
1999, at 6.2. (c).
266
[1987] AC 155, New Zealand Court of Appeal.
 75

that conflict with or defeat the intention of the parliament. 267 Manipulation of tax

laws through artificial schemes that have little economic substance undermines the

ability of national government to set and implement economic as well as social

policies of the country.268 From the foregoing, it is clear that tax avoidance is divided

in two, first, tax avoidance, which is done according to what the law requires and

second, tax avoidance, which is not done according to the requirement of the law but

uses same rules to avoid tax illegally.

The legal response to rise of double taxation for MNCs with respect to avoiding

double taxation is enactment of tax avoidance legislation. Internationally, double

taxation elimination is done through double tax treaties.269 These are agreements

made between countries with a view of capturing taxes arising from international

trade and investment, which cannot be captured by using domestic laws only. Once

countries have signed double tax treaty, invariably, give up some taxing rights,

which are subject to negotiation with another country whereby mutual investments

take place. Double tax treaties set-up standards upon which taxing rights between

contracting states are allocated and avoid double taxation by granting exemption,

credit or tax sparing. Thus, tax treaties regulate types of income, which the source

country is entitled to tax and when residence country is obliged to grant tax relief to
267
South Africa Revenue Authority, Discussion paper on Tax Avoidance and Section 103 of the
Income Tax Act, 1962, 2005, P.4.
268
Brooks, M. and Head, J. ‗Tax Avoidance :In Economic‟ , law and Public Choice‖ in G.S Cooper,
Tax Avoidance and the Rule of Law, p. 71; see also, Groenewegen C.P., ―Distributional and
Allocation Effects of Tax Avoidance ― In D. Collins, Tax avoidance and the Economy 1984, p. 23.
269
The Treaties may be unilateral, bilateral or multilateral .Unilateral treaty entails that domestic tax
laws take into account tax liability borne or presumably borne by their tax payers in countries in
which their foreign source income originated. Therefore taxpayers are entitled to double tax relief
either by full or progression exemption, tax credit and tax deduction. Bilateral treaties Entails that
countries take extra measures to combat tax avoidance and tax evasion by entering tax treaties with
countries where their tax payers are involved. Under bilateral treaties contracting states agrees
that, one country have exclusive right to tax certain type of income while other country agrees to
exempt.
 76

avoid double taxation. In this context, one country‘s tax gain is another country‘s tax

loss ―zero sum game‖ of international taxation.270

As for MNCs, double taxation arises when the same income is taxed to two different

tax payers as a result of adjustment. From MNCs‘ perspective, double taxation

increases cost and it reduces profits. In order to avoid double taxations, MNCs tend

to permanent establishments in countries where there are low taxes or in tax haven

countries so as to maximize profit or where there are ownership, location and

internalization advantages.271 Transactions between parent corporations and the

permanent establishment are normally done through transfer pricing under the

auspices of tax planning. To this extent, MNCs may take advantage of loopholes of

law and treaties to avoid tax beyond law requirements and shift profit through

transfer pricing manipulation. Transfer pricing rules are some of tax avoidance rules

aiming at avoiding double taxation at the same time deterring companies from

transfer pricing manipulation. These rules are enshrined under multilateral and

bilateral tax treaties as discussed in the next section.

3.5 Desire for International Transfer Pricing Legal Regime

The need for MNCs to invest outside home countries has linked economies across

the globe. Growth of technology where communication and transportation are

enhanced has facilitated expansion of MNCs‘ operations. This is achieved by

establishing associated legal entities in various countries but controlled from parent

270
Avi-Yonah R. S., The Structure of International Taxation: A Proposal for Simplification, Texas
Law Review, Vol 74, no. 6, 1996, 1301-1359 p. 1303.
271
See discussion in chapter 2 para 2.4.1.
 77

company. Consequently, MNCs are pursuing many activities, which link production

and distribution of goods as well as services in corporations through transfer pricing.

As noted before, theoretical aspect for existence of MNCs is maximization of profit

and minimization of transaction cost in particular tax. Thus, transactions within

corporation may be driven by common interests of the entity rather than market

forces. In this context, MNCs may manipulate prices and shift profit thereby leading

to non-double taxation or shift taxable income from high tax to low tax country.272 .

Such developments have led enormous policy challenges with regard to allocation of

income and legal loopholes that may be used by MNCs to avoid tax on their world

wide income beyond legal requirements. From financial perspective, transfer pricing

is currently a serious concern on tax worldwide because it puts tax of countries at

stake.273

The fact that MNCs are tax liable in each country where they operate, each country

obtains the right to tax profit and interest arising out of MNCs transactions to the

extent of its contribution. However, if transfer price by MNCs is not set at arm‘s

length price, one of the countries is at risk of losing its right share of tax from such

transactions. In this context, competing interests may arise. First, the country, which

exports capital (the investor), requires a system that will ensure certainty in business

with the view of obtaining profit. Second, the importing capital country may require

protection of its tax base at the same time attract more foreign investors. It is from

272
McGauran K., note 30 p. 11.
273
The rise of many new economies in the developing countries with their infrastructure, skilled
labour, low production costs, conducive economic climate, the round-the-clock trading in financial
instruments and commodities; and the rise of e-commerce and Internet-based business models are a
few of the many reasons why transfer pricing has become such a high profile issue over the last
couple of decades.
 78

these concerns that countries are obliged to harmonize domestic transfer pricing laws

in order to capture their right share of tax and protect tax base.

Transfer pricing standards are reflected in tax convention models as initiated by

multinational institutions.274 The rationale behind is that transfer pricing is one of

avoidance rules and it is not really a standalone issue. Yet, transfer pricing may not

necessarily involve tax avoidance issue but rather, means, which enable associated

MNCs to transfer goods and services. It is within this ambit attention has been given

to international transfer pricing treatment, standardization and indeed, led to debate

on efficacy of transfer pricing laws, in particular, arm‘s length principle. However,

development of transfer pricing standards under the auspices of tax avoidance is

based on the best practices and specific needs of developed countries.

In order to achieve international standards of transfer pricing, model tax conventions

were published by international organization such as United Nations (UN) and the

Organization for Economic Cooperation and Development, (OECD). These are

United Nations Model Double tax Convention between Developed and Developing

Countries (UN model) and the Model Tax Convention on Income and Capital

(OECD) model.275 It is in these instruments that transfer pricing principles, standards

and rules have been enshrined. Objectives of these models are to provide full

protection of taxpayer against direct or indirect double taxation and to encourage free

274
United Nations, United Nations Economic and Social council and United Nations Conference on
Trade and Development and OECD.
275
For the purpose of this work, the OECD model and UN model will be used.
 79

flow of international trade including investment as well as transfer of technology.276

Such models also aim at preventing discrimination between taxpayers in the

international field, and to provide a reasonable element of legal together with fiscal

certainty as a framework within which international operations can be carried out.277

In this context, model conventions are believed to contribute substantially to

development aims of developing countries.278

3.6 An Overview of UN and OECD Models

As indicated before, existing international transfer pricing standards emanate from

multinational institutions, namely, the United Nations (UN) and Organization

Economic Cooperation Development (OECD). The OECD model is the first

international instrument introduced at an international level to deal with issues of

transfer pricing. The OECD Model was established by developed countries to

regulate, among other things, transfer pricing issues specifically addressing concerns

of OECD member countries.279 It should be noted that although OECD model is a

regional instrument, it is highly accepted internationally and it has been applied

across in both developed and developing countries.

The UN model was the first international double taxation convention, which

enshrined standards of transfer pricing. It was established by the United Nations with

276
UN model 2011 Introduction para 2.
277
Ibid.
278
Ibid.
279
Currently OECD has 34 members, see http://www.oecd.org/about/membersandpartners/list-oecd-
member- countries.htm .Assessed 30th May 2014
 80

a view of helping developing countries in dealing with transfer prices. 280 The UN

model was preceded by OECD model and consequently, most of its provisions are

derived from OECD model.281 It is important to note that the UN model was

preceded by the League of Nations Draft Convection of allocation of profits and

property of international enterprises of 1935.282 Although the Draft model was not

officially adopted, it came up with principles, which form the basis of current

transfer pricing laws as enshrined in UN and the OECD models. League of Nations

Draft Convection firstly, defined business income for the purpose of taxation.283

Secondly, it provided principle of income attributable to a permanent establishment

(PE) based on the separate account.284

Thirdly, it provided methods to be followed based on percentage turn over and

fractional apportionment under which net business income was determined by

280
See UN Model 2011 para 1.
281
Internationally there was a concern to eliminate double taxation for corporations operating across
countries. From 1921 to 1928, the League of Nations through its financial committee undertook
various studies on the economic aspect of international double taxation. Nevertheless in 1954 the
United Nations stopped working on the problem of double taxation after setting up a fiscal
committee to study and advice the council in the field of public finance in legal administrative and
its aspects. Consequently, the Europe under OEEC took action on the field of international taxation
and came up with OECD model convention.281 In mid 1960‘s there was an increase of foreign
investment from developed to developing countries. In this context UN saw the foreign need to
revive its interest in dealing with problem of double taxation. This was partly a UN desire to
promote investment in developing countries to complement economic development processes. 281
Hence, it was necessary to have an instrument to regulate economic relation in particular issues of
double taxation, as a consequence the UN Model 2001 was established.
282
Transfer pricing: History, State of Art, Perspective, Ad hoc Group of Experts on International
Cooperation in Tax Matters, Tenth Meeting, Geneva 10 – 14 2001, p.? See also UN Model 2001,
paragraph 23. The aim of the League of Nations Draft was to eliminate double taxation of the
income of business enterprises as provided under Article 1 of the Draft. This was a result of various
studies done by League of Nations between 1920 and 1935, in lieu of eliminating problem of
business income between associated MNCs. See Carroll, , M.B., Methods allocating Taxable
income, Vol. 4 of League Of Nations, Taxation of Foreign and National Enterprises.
283
Article II of the Draft convention.
284
Ibid, Article III (1).
 81

various factors.285 The most important was formulation of arm‘s length

principle.286Nevertheless, both tax models provide standards, guidelines and

commentaries upon, which transfer pricing issues, may be handled as discussed

below. The fact that UN model borrowed a lot from OECD model and discussion of

such models is presented together. However, difference will be made in terms of

scope of such principles.

3.6.1 Transfer Pricing Standards as Set by Tax Convention Models

3.6.1.1 Arms’ Length Principle

The arm‘s length principle is found under Article 9 of OECD model and Article 9 of

UN model, respectively. Notably, the principle was first introduced in OECD model

and reproduced word to world in the UN model. However, the scope of application

of arm‘s length principle differs between the two models because arm‘s length

principle is subject to some limitations under UN model. The principle provides

that,

“(a) an enterprise of a Contracting State participates directly or

indirectly in the management, control or capital of an enterprise of
the other Contracting State, or
(b) the same persons participate directly or indirectly in the
management, control or capital of an enterprise of a Contracting
State and an enterprise of the other Contracting State,

and in either case conditions are made or imposed between the two
enterprises in their commercial or financial relations which differ
from those which would be made between independent enterprises,
then any profits which would, but for those conditions, have accrued
to one of the enterprises, but, by reason of those conditions, have not
so accrued, may be included in the profits of that enterprise and
taxed accordingly.” 287

285
Ibid Article III (3) and (4).
286
Article IV of the draft convention; see also Mexico and London models.
287
Article 9 (1) of OECD model 2010 and Article 9(1) UN model 2011
 82

The arm‘s length principle regulates profits of associated MNCs that for tax purposes

are not made at arm‘s length terms.288 The principle embodies two criteria at a time,

namely, associated enterprises and arm‘s length. The enterprise is regarded as

associate of another if it participates directly or indirectly in either management or

control or capital of an enterprise of another contracting state and should be taxed

accordingly.289 Arm‘s length principle explains requirements that transfer of goods

and services between associated enterprises should be made at a market price.290

Generally, the scope of application of UN and OECD models is on taxation of

income and capital, whose residence of business is in contracting or one of the

contracting countries.291 Consequently, arm‘s length principle applies to taxation of

income and capital of associated MNCs, whose residence of business is in

contracting or one of the contracting countries. This means that for arm‘s length to

apply, the associated corporations must be in different states.292

Accordingly, it applies only when taxable amount by associated MNCs is not

obtained under arm‘s length but rather, influenced by special conditions that exist

288
OECD, ―Commentary on Article 9: Concerning the taxation of associated enterprises‖, In Model
Tax Convention on Income and on Capital: Condensed version 2014, OECD Publishing para 1. The
arms‘ length principle was first established by the League of Nations‘ 1933 Draft Convention on the
Allocation of Business Profits between States. The Fiscal Committee of the OEEC (predecessor to
the OECD) drafted articles 5, 7 and 9 of the 1963 Draft convention.
289
Article 9(1) (a) of the OECD 2010 model and Article 9(1) (a) UN model2011.
290
Article 9(1) para 1 of OECD model and Article (9) para 1of UN model.
291
Article 1 and 2 (1) of the UN model 2011 and Article 1 and 2 of OECD model 2010. It is
important to note that, the term persons are defined under article 3 (a) to include company and
individuals. For the purpose of this work, the word corporation will be used to mean company.
292
The UN model excludes the taxation of associated parties operating within the country. Similarly,
partnership is excluded in the ambit of UN model. The liability of taxation of associated
corporation is limited to profit obtained under arms‘ length rate. The provision also excludes
foreign held companies exempted from tax on their income by privileges tailored to attract conduit
companies. See UN commentary on scope of UN model para 4 and commentary on Article 4 of
UN model para 8. 2.
 83

between them. In case it is established that the taxable profit is obtained under arm‗s

length, then the provision is not applicable. It is also applicable to inter-loans of

associated MNCs in determining the arm‘s length interest. The principle extends to

determine prema facie whether inter loan between associated MNCs should be

regarded as loan for transfer pricing purposes or amounts to other kinds of

payment.293 Additionally, the arm‘s length is also applicable to royalties294 and

dividends.295 The purpose of Article 9(1) of both OECD and UN models is to ensure

that transactions between associated MNCs are treated as if they had been carried out

between two independent enterprises.296

Where it is established that the transfer price between associated is not made at arm‘s

length price, tax authorities of contracting countries are empowered to adjust transfer

prices to be in line with arm‘s length. Where the transfer price is below arm‘s length

price, income or expenses may be imputed and where price is higher than arm‘s

length price, then the expenses and income may be reduced. The increase in income

is called primary adjustment. When adjustment is made between contracting

293
Articles 11 (4) of UN model 2011 and Article 11 (4) of OECD model 2010. See also Commentary
on Article 9(1) of UN model para 5 (b). The arm‘s length is applicable ―if the beneficial owner of
the interest, being a resident of a contracting country, carries on business in the other contracting
country in which the interest arises through a permanent establishment situated therein and the
debt-claim in respect of which the interest is paid is effectively connected with such permanent
establishment‖.
294
If the beneficial owner of the royalties, being a resident of a contracting state, carries on business
in the other contracting state in which the royalties arise through a permanent establishment situated
therein and the right or property in respect of which the royalties are paid is effectively connected
with such permanent establishment. See Article 12 (4) of the UN model and Article 12 (3) of the
OECD model.
295
Articles 10 (4) of OECD 2010 and Article 10 (4) UN model 2011, if the beneficial owner of the
dividends, being a resident of a contracting state, carries on business in the other contracting
country of which the company paying the dividends is a resident through a permanent establishment
situated therein and the holding in respect of which the dividends are paid is effectively connected
with such permanent establishment.
296
Lang .M., Introduction to the Law of Double Taxation Conventions, Linde Verlag, 2010 p. 467,
see also Solilová V. and Steindl M., Tax Treaty Policy on Article 9 Model Scrutinized, Bulletin for
International Taxation, IBFD 2013, p. 131.
 84

countries under conditions stated in Article 9(1) of both models, the results are two-

fold. Firstly, both countries and MNCs obtain their right share of tax arising out of

transactions by associated MNCs. Secondly, associated MNCs may be taxed twice in

the same income if one of the contracting countries made adjustment on taxes

already taxed in another contracting country.297 In avoiding double taxation, both

OECD and UN models provide for corresponding adjustment rule.298

However, adjustment allowed under Article 9 (2) of both models is the one which

considered being exactly profit that could have been obtained under arms length rate.

Thus, any amount of profit obtained, which exceeds actual amounts that could have

been obtained should not be adjusted.299 Notably, Article 9 (2) of OECD and UN

model is silent on methods of adjustment and time limit for procedures on

corresponding adjustment. Contracting countries are left to decide.300 Unlike the

OECD model, the UN model clearly excludes application of the arm‘s length

adjustment if there is a final decision by court in relation to a penalty for fraud, gross

negligence or willful default, to one of the enterprises.301

Thus, the purpose of Article 9(2) of both models is to compensate adjustment of

contracting country by an appropriate adjustment by the other contracting country.

297
OECD para 5 note 71.
298
Article 9(2) of UN model 2011 and Article 9(2) OECD model2010. The provision provides that,
―Where a Contracting State includes in the profits of an enterprise of that State — and taxes
accordingly — profits on which an enterprise of the other Contracting State has been charged to tax
in that other State and the profits so included are profits which would have accrued to the enterprise
of the first mentioned State if the conditions made between the two enterprises had been those
which would have been made between independent enterprises, then that other State shall make an
appropriate adjustment to the amount of the tax charged therein on those profits. In determining
such adjustment, due regard shall be had to the other provisions of this Convention and the
competent authorities of the Contracting States shall if necessary consult each other‖.
299
OECD Commentary on Article 9 para 6.
300
Ibid, para 7 and 10 respectively.
301
Article 9(3) of UN model2011.
 85

Countries are required to make correspondence adjustment while avoiding double

taxation.302 This is achieved by using exemption and credit methods. 303 However, the

OECD model clearly provides that corresponding adjustment is not mandatory.304

Therefore, Article 9(2) applies to profit adjustments, which are not made at arm‘s

length principle.305 Furthermore, no secondary adjustment is allowed under both

models except if domestic laws allow.306 Accordingly, Article 9(2) is silent on period

as to when corresponding adjustment should be made. Consequently, countries are

left to decide on time.307 In case of dispute between countries involved over amount

and appropriateness of the adjustment, Article 25 should be invoked.308 Accordingly,

both models are silent on burden of proof. However, scholars argue that the country

which makes adjustment bears the burden of justifying.309 Yet, adjustments are done

according to domestic law because Article 9(1) of OECD model and UN model is

not self-executing. From the foregoing, it is submitted that allocation norm of both

models is a separate entity approach with arm‘s length principle for transaction

between associated MNCs.310 The role of Article 9(1) of OECD and UN models is to

allocate taxing rights between associated MNCs as well as avoid double tax, which

may arise out of adjustment. Accordingly, it makes sure that transactions between

associated MNCs are made at arm‘s length price. Although Article 9(1) of OECD

and Article 9 (1) of UN model provides for restriction of taxing rights, it does not

302
See commentary on Article 9(2) of OECD Commentary condensed version 2014 para 5.
303
Articles 23A and 23 B OECD model and Articles 23 A and 23 B of UN model respectively.
304
OECD Commentary on Article 9 para 6.
305
Ibid.
306
Ibid. para 9.
307
Ibid, para 10.
308
Ibid, para 11. See also OECD commentary on Article 25, paras 39,40,41,11,10,12,33.
309
Ibid, see also, Wittendorff, J., Transfer Pricing and the Arm‟s Length Principle in International
Tax Law, Series of international taxation, vol. 35, Wolters Kluwer, p. 241.
310
OECD Commentary on Article 9 para 1 and 2; para. 15 of the preface and para. 1.14 of the OECD
Transfer Guidelines.
 86

create taxing rights311 because the same are imposed by domestic laws. In this

context, Article 9(1) of both models ensures that domestic transfer pricing law for

income adjustment complies with arm‘s length principle.

Article 9(1) of OECD and Article 9(1) UN model is silent on methods to arrive at

arm‘s length price. However, it provides for the basis upon which comparability

conditions are imposed between associated and independent enterprises for the

purpose of calculating arms length price. In this context, it helps to find out whether

transfer pricing adjustment can be made to reflect arm‘s length rate or not. This

provision is in line with UN and OECD Guidelines for tax payers and tax authorities

on comparability of functions performed and risk assumed. It is from Article 9(1)

such that methods of determining arm‘s length price are developed.312 From the

foregoing, it can be argued that originally, the purpose of Article 9 is to allocate

taxing rights and avoid double taxation.

3.6.1.2 Resident Principle

Article 4 of OECD and Article 4 of UN model set resident principle as criteria to tax

MNCs operating across countries. The scope of application of both models is the

same because Article 4 of UN model is reproduced from OECD model without any

modification. In both models, a corporation is regarded a resident of contracting state

for tax purpose if it is incorporated according to law of that state or if it has a place

311
Ibid. See also Vogel V.K., note 262 where he states that, Article 9 of the OECD model ―is not an
allocation rule but has a special role. Although this rule has a confining effect similar to that of
allocation rules, it addresses cases of economic double taxation: …‖ this purpose can also be
inferred from origin and development of article 9(1).
312
It should be noted that, in determining the arms length price, comparability is pre requisite
requirement.
 87

of management in that state or any other criterion of similar nature. 313 Where the

corporation has dual residence, the residence of the corporation will be in a state

where effective management is situated.314 Both models do not provide for meaning

of effective management. However, a commentary on Article 4 of UN model posits

that in establishing place of effective management, the following must be taken into

account,

―The place where a company is actually managed and controlled,

the place where the decision-making at the highest level on the
important policies essential for the management of the company
takes place, the place that plays a leading part in the management
of a company from an economic and functional point of view and
the place where the most important accounting books are kept.”315

In due regard, competent authority of contracting states are empowered to determine

residence of corporation by mutual agreement.316 It should be noted that the purpose

of Article 4 is to determine persons covered under models for tax convention

benefits.

3.6.1.3 Permanent Establishment

Article 5 of OECD model and Article 5 of UN model provide principle of permanent

establishment. Although the UN model provision is largely reproduced from OECD,

the scope of its application is limited in terms of duration and context of meaning.

Ordinarily, when a corporation establishes a business in another state, essentially it

operates in two countries. In this context, the residence state wishes to tax on resident

worldwide profit and the host state taxes the same corporation on source basis. In

313
Article 4 (1) of OECD 2010 and Article 4(1) UN model2011.
314
Article 4(3) of OECD model and Article 4(3) of UN model.
315
UN, commentary on Article 4 paragraph 3. 10.
316
OECD commentary on Article 4 para 24.3.
 88

these circumstances, tax disputes may arise between two countries as to extent one

country should tax profit of the corporation operating in both countries. It is in this

context that permanent establishment concept becomes pivotal in allocating taxing

rights between two countries. The rationale for existence of permanent establishment

is that host and investor country agrees not to tax profits arising out of transactions

between associated MNCs unless those profits are attributable to permanent

establishment within their nations. Thus, permanent establishment determines the

extent of contribution for each country involved.

Articles 5(1) and (2) of OECD model and Articles 5(1) and (2) of UN model define

permanent establishment to mean a fixed place of business through which the

business of an enterprise is wholly or partly carried on a place of management; a

branch; an office; a factory; a workshop; a mine; an oil or gas well; a quarry or any

other place of extraction of natural resources.317 From this definition, three

elements can be established, namely, ‗place of business,‘ ‗fixed place‘ and ‗carried

businesses.‘ The places of business presuppose to have physical existence in the host

country in form of premise, equipment or machinery to which a foreign company has

access to it.318 The fixed place of business presupposes a specific geographical fixed

spot and degree of permanence.319 This entails that there must be a connection

between a business place and specific point but not necessarily connected to the

317
A real example of permanent establishment is MultiChoice Tanzania is a permanent establishment
of MultiChoice Africa which is wholly-owned by Naspers Group registered in Mauritius. see
ttps://www.dstv.com/en-tz/news/company-history-1 accessed 2016.
318
UN, Commentary on Article 5 (1) para 1.3, see also OECD, Commentary on Article 5 para 2.
319
Ibid.
 89

ground.320 In München Finanzgericht, the court held that, ―Commercial agents

involved in different affairs were not deemed to form a permanent establishment in

respect of their foreign employers.‖321 On degree of permanence, scholars and court

agree that there must be a certain durability of permanent establishment and that the

business must actually be carried out regularly.322 In essence, if activities are

movable and lack degree of permanence, they cannot constitute permanent

establishment for purpose of both models. The final element ‗through which the

business is carried‘ presupposes that MNCs‘ business is carried out at a fixed place

either partly or wholly at disposal of that enterprise.323

Both models extend definition of permanent establishment to include a building site,

construction or installation project or supervisory activities.324 However, under UN

model, such items are considered permanent establishment if they last for more than

six months.325 Additionally, consultancy services of enterprise by an employee or

personnel engaged by enterprises constitute a permanent establishment if such

activities continue for some or connected project for more than aggregated 183 days

in any twelve months.326 Although the UN model recognizes that construction,

installation and consultancy may constitute permanent establishment, it is silent on

320
Oguttu A. and S. Tladi., note 139 p.214. Olivier and Honiball, note 12 pp.97.
321
FG München 41 EFG 707 [1993].
322
OECD, Commentary on Article 5 para 6., see also Olivier and Honiball note 12 p. 99. Doernberg,
R. l., et al., Electronic Commerce and Multijurisdictional Taxation, 2001 p 206, see also
Transvaal Associated Hide and Skin Merchants v Collector of Taxes, Botswana, 29 SATC 97 p.
115.
323
UN Commentary on Article 5 ( 1) para 1.3; see also Doernberg et al.,p.206 note 97;
Levouchkina K.I., ‗Relevance of Permanent Establishment for Taxation of Business Profits and
Business Property‟ in Hans-Jörgen & Mario Züger Permanent Establishments in International Tax
Law, 2003 pp. 20-21.
324
Article 5(3) (a) UN model 2011 and Article 5(3) of OECD model 2011.
325
Article 5 (3) (a) of the UN model.
326
Ibid, Article 5 (3) (b).
 90

business size and equipment required to constitute a permanent establishment.327

Nevertheless, it is generally agreed that the notion of permanence presupposes to be

linked between fixed place and certain time frame of the particular for which the

establishment is at the control of the enterprise. However, commentary on Article 5

argues that size and equipment to constitute a business place depend on nature of

business.328 Hence, it is unnecessary for the business place to be attached on earth.

329
Similarly, in pipeline case, the court held that it is not a requirement that the

business place should be attached to the earth surface or that it is visible on the

ground. The UN model also recognizes a deemed permanent establishment where an

independent agent is acting on behalf of enterprises and habitually exercises as well

as concludes contracts in the name of enterprises in respect of all undertaken

activities.330

Additionally, the deemed permanent establishment may exist if an agent maintains

goods or merchandise from which delivers and merchandize goods regularly.331

Notwithstanding the provisions, the UN model requires that an enterprise, which

deals with insurance business, is deemed to have permanent establishment in the

state where it collects its premium.332 The rationale behind it is that insurance

enterprises do large scale businesses in the state without being taxed because

sometimes they do not qualify for characteristics offered under Article 5.333

327
Ibid, Article 5(3) (a) and (b).
328
OECD, Commentary on Article 5 para 14.
329
Bundesfinanzhof vorn 30.10.1996, IIR 12.92, BStBI II 1997, S12. Germany
330
Article 5 (5) (a) of the UN model. Examples of deemed permanent establishment are foreign airline
and shipping line services operating in Tanzania.
331
Ibid, Article 5(b).
332
Ibid, Article 5 (6).
333
UN Model, commentary on Article 5 para 6. 29.
 91

The UN model expressly excludes enterprises, which carry on business in

contracting state through broker, general commission agent or any other agent of

independent nature provided they are acting on their ordinary course of their

business.334 However, this rule does not apply when agents devoted wholly or almost

wholly on behalf of enterprises and condition are made between enterprise and agent,

which differ from those would have been made between independent enterprises.335

Moreover, the UN model excludes a controlled foreign company to constitute the

permanent establishment for the purpose of enjoying benefits of the convention.336

Unlike the UN model, the OECD model extends permanent establishment definition

to include a building site, construction or installation project if it lasts for twelve

months.337 To the contrary, the OECD does not extend supervisory activities to

constitute permanent establishment. However, in context of OECD model,

permanent establishment exists even where an independent agent is acting on behalf

of enterprises and habitually exercises as well as concludes contracts in the name of

enterprises undertaken, except those excluded under OECD model.338 Despite

extensive details of what constitutes permanent establishment, both models are silent

on whether or not Article 5 can be applicable on electronic commerce. However,

OECD commentary on Article 5 states that it is applicable.339 In OECD commentary

context, enterprises carrying out electronic commerce may constitute permanent

establishment if,

334
Article 5 (7) of the UN model.
335
Ibid.
336
Ibid, Article 5 (8).
337
Article 5(3) of OECD model.
338
Ibid, Article 5 (5).
339
UN, Commentary on Article 5, para 36.
 92

―The enterprise carrying on business through a web site has the

server at its own disposal, for example it owns (or leases) and
operates the server on which the web site is stored and used, the
place where that server is located could constitute a permanent
establishment of the enterprise if the other requirements of the
Article are met.”340

Computer equipment at a given location may only constitute a permanent

establishment if it meets the requirement of being fixed.341 In order to constitute a

fixed business place, a server will need to be located at a certain place for a sufficient

period of time so as to become fixed within the meaning of Article 5(1) of the OECD

model. In establishing whether or not a business was actually carried on may be

examined according to circumstances of a particular case, keeping in mind that the

websites are in control of the enterprise.342 Commentary on Article 5 points out that,

―Where an enterprise operates computer equipment at a particular

location, a permanent establishment may exist even though no
personnel of that enterprise are required at that location for the
operation of the equipment. The presence of personnel is not
necessary to consider that an enterprise wholly or partly carries on
its business at a location when no personnel are in fact required to
carry on business activities at that location. This conclusion applies
to electronic commerce to the same extent that it applies with
respect to other activities in which equipment operates
automatically, e.g. automatic pumping equipment used in the
exploitation of natural resources.‖343

To the contrary, no permanent establishment is deemed to exist if business conducted

electronically is of preparatory or auxiliary nature such as communication link and

advertisement for goods.344

340
OECD commentary on Article 5 para 42.3.
341
Ibid, para 42.4.
342
Ibid, para 42.5.
343
Ibid, para 42.6.
344
Ibid, para 42.7.
 93

3.6.1.4 Business Profit

Article 7 (1) of OECD and Article 7 of UN model provide for business profit as the

income to be taxed for transfer pricing purposes.345 Accordingly, both models set a

general rule that profit of enterprises should be taxed only in the state where it is

incorporated or formed.346 However, an enterprise may be taxed in another

contracting country through permanent establishment situated in another contracting

country.347 The principle embodies two criteria at a time, taxation of profit where the

enterprise is situated and taxation of only attributable profit where permanent

establishment is situated. Thus, the concept of permanent establishment is an

important determinant factor in establishing the right of a country to tax business

profit. However, there are differences in approach between these two models as

discussed below.

In terms of the UN model, business profit of an enterprise is taxed not only on profit

attributable to permanent establishment but also to sales, merchandize sold and other

activities carried out through permanent establishment.348 Accordingly, the UN

model requires each permanent establishment situated in contracting countries to be

taxed on attributable profit and other profits obtained under arm‘s length rate.349 The

provision applies to any profit obtained by permanent establishment relied on an

internal agreement and becomes subject to adjustment by revenue authorities in

345
It should be noted that, The UN and OECD models provides for income and capital to be taxed, see
Articles 2 (1) of the UN model and Article 2(1) of the OECD model.
346
Article 7(1) of the OECD 2010 and Article 7(1) of UN model 2011.
347
Ibid.
348
Article 7(1) (b) and (c) of the UN Model 2011. For example MultiChoice Tanzania as permanent
establishment will also be taxed on repatriated profit.
349
Ibid, Article 7(2).
 94

accordance with arm‘s length principle.350 Application of arm‘s length extends to

turnkey contracts whereby permanent establishment is established by construction of

a facility in one state done by a contractor who is a resident in another state if the

construction lasts for six months.351 In addition, arm‘s length principle is also

applicable to profit arising out of finance transactions between associated MNCs.

The role of Article 7(2) is to make sure that attributable profits and other profits

obtained through permanent establishment are made at arm‘s length rate.352 The

purpose is to ensure that profits between associated MNCs obtained through

permanent establishment are treated as if they had been carried out between

independent entities.353 In determining attributable profit of permanent

establishment, the UN model sets a general rule that expenses incurred for business

purpose, executive and general administrative cost should be deducted in the state

where the permanent establishment is situated or somewhere else.354 The deduction

allowed under this rule is actual cost without adding any element of profit.355

However, there is exception to this rule that,

“No such deduction shall be allowed in respect of amounts, if any,

paid (otherwise than towards reimbursement of actual expenses) by
the permanent establishment to the head office of the enterprise or
any of its other offices, by way of royalties, fees or other similar
payments in return for the use of patents or other rights, or by way
of commission, for specific services performed or for management,
or, except in the case of a banking enterprise, by way of interest on
moneys lent to the permanent establishment. Likewise, no account

350
UN Commentary on Article 7(2) para 12.
351
Ibid, para 9.
352
UN commentary on article 7(1) para 8.13.
353
The role and purpose of article 7(2) are inferred from arm‘s length principle as enshrined under
Article 9 of both models.
354
Article 7(3) of UN Model. It should be noted that, UN model is silent on means to establish profit
amount of PE for taxes purposed. However, commentaries on article 7 states that revenue
authorities may use trading accounts. See UN commentary on Article 7(2) para 12.
355
UN Commentary on Article 7(3) para 29.
 95

shall be taken, in the determination of the profits of a permanent

establishment, for amounts charged (otherwise than towards
reimbursement of actual expenses), by the permanent establishment
to the head office of the enterprise or any of its other offices, by way
of royalties, fees or other similar payments in return for the use of
patents or other rights, or by way of commission for specific
services performed or for management, or, except in the case of a
banking enterprise, by way of interest on moneys lent to the head
office of the enterprise or any of its other offices.”356

It follows out that all exceptions should be included in determining attributable profit

of the permanent establishment. However, the UN model is silent on deduction of

expenses once attribution is made by permanent establishment. The situation gives

room for contracting states to apply domestic laws if such deduction arises.357 In

establishing true cost incurred by permanent establishment for purpose of

determining attributable amount, arms‘ length principle is employed.358 Thus, it is

agreed that only initial cost incurred by permanent establishment for purpose of

setting the business is considered for deductions. Hence, any expenses or cost, which

seems to minimize overall cost with the view of profit maximization it should not be

considered for deductions.359

In establishing the cost of intangibles, the cost for creation of intangible rights is

regarded attributable to all associates of enterprise, which makes use of them. The

actual cost of creation or acquisition of intangible will then be allocated to all

associated parties without adding any profit margin.360 The rationale behind is that it

is not easy to establish ownership of intangible rights. In establishing the cost of

356
Article 7(3) of UN Model 2011.
357
UN commentary on article 7(3) para 30.
358
Ibid,para 31.
359
Ibid, para 32.
360
Ibid, para 34.
 96

service rendered, a comment provides that the cost of service rendered should be one

charged to outside customers.361 However, there is uncertainty in establishing cost of

services for the purpose of deduction or attribution of profit of permanent

establishment. Therefore, it is resolved that it should be decided on case to case

basis. Although the UN model relies heavily on principle of arm‘s length for

transactions between associated MNCs it compromises. Article 7(4)362 departs from

arms length principle by allowing apportionment method to be applicable in

determining an attributable profit to permanent establishment. However, this method

is applicable only if domestic laws of the contracting states provide so.363 Thus,

apportionment is used even if the result may differ to some extent if the arm‘s length

could have been used. However, the UN model is silent on methods of

apportionment and contracting states are left with discretion to decide according to

their domestic laws.364 In maintaining consistence, the UN model requires that

methods used in establishing attributable profit to PE should be used on yearly

basis.365 The rationale behind is to create certainty about tax treatment to tax payer(s)

in both contracting states. It is worth noting that the UN model clearly states that

whether or not profits should be attributed to a permanent establishment by reason of

mere purchase of goods and merchandise for the enterprise that was not resolved.

Countries may resolve it through bilateral negotiations.366

361
Ibid, para 35.
362
UN Model 2011.
363
Article 7(4) see also, UN Commentary on article 7(4) para 53.
364
Ibid para 55.
365
Article 7(5) of the UN model. See also UN commentary on Article 7(5) para 55.
366
Ibid, Article 7 (6) para 1.
 97

In terms of OECD, business profit liable for taxation is limited to profit attributable

to permanent establishment only.367 In this context, any other profits generated by

other activities through permanent establishment are not business profit for transfer

pricing purposes. It means that a tax authority is not required to tax business profits

that derived from separate sources of the permanent establishment derived from their

country.368 Thus, the tax authority is required to tax on basis of other provisions of

the convention. Article 7(1) of OECD model is applicable to taxation of business

profits, which are only attributed to permanent establishment. The role of Article

7(1) of OECD model is two-fold, first, to grant taxing rights to the country where the

permanent establishment is situated to the extent of its contribution. Second, strive to

prevent the country, which permanent establishment is situated from taxing the

enterprises of the other contracting country on profits not attributable to permanent

establishment.369

The purpose is to limit the right of source country to tax profits of enterprises of

another contracting country. The OECD model sets principle that permanent

establishment situated in a contracting state should be taxed on attributable profit

obtained under arm‘s length rate.370 Arm‘s length enshrined in Article 7(2) of the

OECD model applies to attributable profits, which are not obtained under arm‘s

length rate. The rationale is to make sure that attributable profits of permanent

establishment are obtained under arm‘s length rate. This is to ensure that attributable

367
Article 7(1) of OECD model. See also OECD commentary on Article 7 concerning taxation of
business profit paras 11 and 12.
368
Ibid para 12.
369
Ibid, para 14.
370
Article 7(2) of the OECD model.
 98

profits of associated MNCs obtained through permanent establishment are treated

separately as if had been carried out between unrelated entities.371

In determining attributable profit of permanent establishment, the OECD model sets

a rule that the profit of permanent establishment should be treated as a separate entity

and independent from a corporation, which it is a part.372 It follows that profit may

be attributed to the permanent establishment even though the corporation as a whole

did not made profits. Conversely, in terms of Article 7(2), it may result in no profit

even though the corporation as a whole made profits.373 In determining the

attributable profit, due regard must be given to elimination of double tax either by

exemption or credit.374 The OECD model is silent on inclusion and exclusions of

deductions in calculating attributable profit to permanent establishment.

However, according to commentaries deductions allowed are only those incurred for

purpose of activities performed by permanent establishment375 and modalities of

deductions are to be determined by domestic laws.376 In so doing, both contracting

countries are required to adhere to non-discrimination rule as provided in the

convention models.377 Article 7(3) of OECD model applies to the extent necessary to

eliminate double tax that results from adjustment.378 It also applies with respect to

differences in determination of profit attributable to different parts of the

371
Ibid, Para 15.
372
Ibid, para 17.
373
Ibid,para 17.
374
Article 7(2) of OECD Model 2010. See also OECD commentaries on Article 7 para 18 and 27
respectively.
375
Ibid, Para 34.
376
Ibid, Para 30.
377
Ibid para 33, see also Article 24 (3) of the OECD model 2010, see also OECD commentaries on
Article 24 (3) para 40.
378
Ibid, para 65.
 99

enterprise.379 The role of Article 7(3) is to deal with attribution of profit for the

purpose of allocation of taxing rights between two contracting countries.380 The

rationale is to ensure that there is no unrelieved double taxation of the profits that are

properly attributed to the permanent establishment.381

Despite their different approach, both OECD and UN models clearly exclude

business profit dealt separately in other provisions of the models as a general rule. 382

They include dividends, royalties, interest and other incomes. 383 However, there are

exceptions to these rules. Dividend is taxed as business profit if a beneficial owner

of a dividend is a resident of contracting state, carrying on business in other

contracting state in which the company is paying dividend is resident through

permanent establishment situated therein and holding in respect of which dividends

are paid is effectively connected with permanent establishment.384 Likewise, interest

is taxed as business profit of permanent establishment if beneficial owner of interest

is a resident of a contracting state in which the interest arises through permanent

establishment situated there in. Debt claim in respect of kind of interest to be paid is

effectively connected with such permanent establishment.385 Royalties are also taxed

as business profit of permanent establishment ―if the beneficial owner of the royalties

is a resident of contracting state in which the royalties arise through a permanent

establishment situated therein and the right or property in respect of which the

379
Ibid, para 66.
380
Ibid,para 66.
381
Ibid, para 44.
382
Article 7(6) of the UN Model 2011 and Article 7(4) of the OECD model2010.
383
See Articles 10, 11, 12 and 21 (2) of the UN model 2011 and Articles 10, 11, 12, and 21(2) OECD
model 2010.
384
Article 10 (4) of UN model 2011 and Article 10(4) of the OECD model 2010.
385
Articles 11(4) of UN model 2011 and Article 11(4) of the OECD model2010 .
 100

royalties are paid is effectively connected with such permanent establishment.‖386

Unlike the OECD, the UN model extends the business profit to include profit that

arises from performance of personal services from a fixed base and that dividend,

royalties or interest is effectively connected to permanent establishment or fixed

base.387

In addition, both OECD and UN models tax other business incomes as business

profits of permanent establishment if ―the recipient of such income, is a resident of a

contracting country, carries on business in the other contracting country through a

permanent establishment situated therein and the right or property in respect of

which the income is paid is effectively connected with such permanent

establishment.‖388 Nevertheless, scholars submit that such exception is merely an

application of general international and domestic interpretation rule of ‗generalia

specialibus non delegant,‟ meaning that a subsequent general provision does not

repeal or override an earlier specific provision.389 Similarly commentators posit that

the rule is in conformity with practice generally adhered to in bilateral conventions.

Thus, it is submitted that before taxing business profit of the PE, it is important to

establish whether the business profit falls within the ambit of Article 7 of both

models or not. Failure to establish the business profit may cause dispute to countries

that tax permanent establishment on source basis. However, interest royalties and

other incomes may either be taxed separately or as a business profit according to tax

386
Article 12 (3) of the OECD model 2010 and Article 12(4) of UN model2011.
387
Articles 10 (4), 11(4) and 12(4).
388
Article 21(2) of the UN model 2011 and Article 21(2) of OECD model 2010.
389
Olivier an Honiball note 12 p.91 , see also Khumalo v Director General of Cooperation and DvP
[1991] 158 A ; Sappi v ICT Canda 1992 3 SA 306 (A). South Africa.
 101

laws of contracting states. Where the business profit of permanent establishment falls

within the ambit of Article 7, source country should tax profit attributable to

permanent establishment at arm‘s length principle as if the permanent establishment

is independent.

An overview of international transfer pricing as enshrined under the UN and OECD

models reveals that they have special characteristics, which provide uniform bench

mark rules between developed and developing countries. The paramount

characteristic of such model is international character, which implies that all

transactions of goods and services made between associated MNCs must be made at

arm‘s length price. Such models have solved difficulties caused by multiplicity of

laws, which associated MNCs may face in various countries they operate. This is the

case, in particular, on when different laws become applicable in respect of different

aspects of the transaction. Accordingly, it meets the needs for international

transactions by taking into account costs of production of goods or services together

with involvement of the permanent establishment and agents. Therefore, the models

provide uniform rules aiming at ensuring the same results wherever applied, as

rightly stated that,

“An argument in favour of using the arm‟s length principle is that it

is geographically neutral, as it treats profits from investments in
different places in a similar manner. However this claim of neutral-
ity is conditional on consistent rules and administration of the arm‟s
length principle throughout the jurisdictions in which an
international enterprise operates. In the absence of consistent rules
and administration, international enterprises may have an incentive
to avoid taxation through transfer pricing manipulation.”390

390
UN Commentary para 1.4.6.
 102

3.7 Methods to Arrive at Arm’s Length Price

As pointed in preceding discussions, both UN and OECD models set a principle that

transactions between associated parties should be made at arm‘s length price. Yet,

both models are silent on methods to arrive at arm‘s length price. It is in this context

that both UN and OCED establish specific transfer pricing Guidelines to provide for

methods to arrive at arm‘s length price. These are United Nations Practical Manual

on Transfer pricing for Developing Countries of 2013 (UN Guidelines)391 and The

OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax

Administrations of 2010 (OECD Guidelines). The UN Guidelines is the first efforts

by United Nations to develop concrete Guidelines for handling transfer pricing

issues.

The manual came into force in 2013 and it was preceded by regional instrument

made to regulate transfer pricing issues, namely, OECD Guidelines first published in

1995 and USA transfer pricing regulations.392 It is important to note that the UN

Guidelines is largely influenced by OECD Guidelines because Article 9 (1) and (2)

of UN Model was reproduced from OECD model except Article 9(3).393 394 The UN

391
For purpose of this work UN guideline will be used.
392
UN guideline para 1.3.2.
393
It is important to note that, article 9 of OECD and Article 9 UN model provides bases for transfer
pricing methods. Thus, methods to arrive at arms‘ length enshrined under OECD Guidelines are
same as those enshrined under UN Guidelines. For this reason UN Guidelines will be examined
more in this discussion as was specific made for developing countries. The OECD citation will be
made where necessary.
394
Notably, The UN Guidelines have received little attention by developing countries.his is partly due
to complexity involved in comparability analysis and the process to arrive at arm‘s length price.
Partly, most of investors in developing countries are from OECD countries that prefer their laws to
be applied., the UN Guidelines came after OECD, which have been in place since 1995. To the
contrary, the OECD Guidelines received more attention because they are applied by both
developed and developing countries. Additionally, the content of UN model and Guidelines are
replica of OECD model with minor alterations to suit developing countries‘ requirements. From
 103

Guidelines contains 10 chapters. The main objectives of UN Guidelines are as

follows: first, to provide benchmark of transfer pricing upon which national transfer

pricing legislation of member countries should incorporate.395 Second, is to offer

developing countries a basis for informed method at a practical level on arriving at

arm‘s length price by taking into account their development level.396

The scope and application of the UN Guidelines is limited to associate MNCs

operating across countries in determining arm‘s length price. The Guidelines may

also apply to Advance Pricing Agreement (APA) between the tax payer and revenue

authorities.397 In terms of UN Guidelines, ―the rationale for the arm‘s length

principle is that the market governs most of the transactions in an economy it is

appropriate to treat intra-group transactions as equivalent to those between

independent entities.‖398 To arrive at arm‘s length price, both OECD and UN

Guidelines provide five methods that are not used in any hierarchal manner but

rather, depend on circumstances of particular transactions.

The methods are comparable uncontrolled price, resale price method, and cost resale

method commonly known as traditional methods. Other methods are transactional

net margin method and profit split method commonly known as transactional profit

methods.399 However, selection of a method depends on strengths and weaknesses of

practical point of view, the OECD model prevails over UN model because OECD favours
resident-base taxation, which is in favour of the MNCs.

395
See chapter 3 of UN model.
396
Ibid.
397
Ibid, chapter 9.
398
Chapter 1 of UN Guidelines para 1.4.5.
399
Chapter 6 of UN Guidelines para 6.1.3.1.
 104

each method, the nature of the controlled transaction; availability of reliable

information (in particular, on uncontrolled comparables) needed to apply the selected

method; and the degree of comparability between the controlled and uncontrolled

transactions.400 The starting point of selecting the method is to understand the nature

of transaction between associated MNCs through functional analysis, which entails

analysis of performed function, risk assumed and asset used.

3.7.1 Comparable Uncontrolled Price (CUP)

The method compares price of goods and services of associated MNCs‘ transactions

to the price charged for goods and services of independent corporations in

comparable circumstances.401 The comparison may be made between one associated

corporation and with an independent corporation commonly known as internal

comparison. Similarly, it can be made between independent corporations commonly

known as external comparables.402 In making comparison, required information

encompasses prices for internal and external comparables. The transaction of

associated MNCs is considered comparable to transaction of independent

transactions if there are no differences in the transaction that will materially affect

the price.403

In other words, if there are differences between the said transactions but do not affect

the price for transactions they are deemed to be comparable. Comparability will also

be accepted if a reasonable accurate adjustment can be performed between

400
Ibid, para 6.1.2.1.
401
Ibid, para 6.2.1.1.
402
Ibid, para 6.2.1.4.
403
Ibid, para 6.2.2.1.
 105

transactions of associated MNCs and independent corporations. 404 Reasonable

adjustment is rational if it is made based on type and quality of the product, delivery

terms, volume of sales and related discounts together with product characteristics,

contractual terms, risk incurred and geographical factors.405 Where reasonable

adjustment is not possible, it is envisaged that tax authorities should rely on other

methods.406

In determining the degree of comparability, the UN Guidelines require the following

factors to be considered: characteristics of the property or service provided

contractual terms, economic circumstances, and business strategies. Function

performed, risk assumed and asset used must be taken into account for functional

analysis purposes.407 The CUP method is direct measure of the arm‘s length principle

because it is two sided analysis reflecting different two parties to the transaction. The

method can be used instantly in transaction(s) involving commodity products.408

However, the CUP method may be affected by difficulties in finding comparables

from independent corporations because the method requires certain standards of

comparability to be attained.409

3.7.2 Resale Price Method (RPM)

This method compares profit margins on price of goods and services between

associated MNCs and profit margin of sales by associated parties to an unrelated

404
Ibid.
405
Ibid, para 6.2.2.5.
406
Ibid, para 6.2.2.7.
407
Ibid.
408
Ibid, para 6.2.3.1.
409
For details of standard of comparability required in CUP method, see chapter 5 of UN guideline
2013.
 106

company. The prices of goods and services obtained from associated MNCs are

resold to an independent corporation. To determine an arm‘s length price, resale

price is reduced by resale gross profit margin after taking into account function

performed and the remaining amount is deemed to be a transfer price of associated

parties.410 In other words, there must be two associated MNCs selling goods or

services from each other at a price deemed to be not at arm‘s length price. The

second embodies associated resale goods or services to an independent corporation

with a certain gross profit margin. The gross profit margin obtained is then compared

with the gross profit by an independent corporation in similar circumstance. Once the

gross profit margin of associated MNCs is found to be similar to that of the

independent corporation, the gross profit margin is then added to initial price

between associated MNCs to achieve transfer price.

In comparing gross profit margin between associated MNCs and an independent

corporation, consistency of accounting is required such that in its absence, it renders

application of RPM be difficult.411 In determining the arm‘s length profit earned by

associated MNCs, two methods are employed, namely, transaction and functional

comparison. The former entails transactions between related parties compared with

transactions of an Independent Corporation. The latter entails comparison of function

performed, asset used and risk incurred between associated MNCs and an

independent corporation.412 Under RPM, the transaction of associated MNCs is

considered comparable to transaction of independent transactions if there are no

410
Chapter 6 of UN Guidelines, para 6.2.7.2.
411
Ibid.
412
Ibid. para 6.2.8.2.
 107

differences in the transactions which will materially affect the gross profit margin.413

Presence of minor differences is not an issue. Comparability is also accepted if

reasonable accurate adjustment can be performed between transactions of associated

MNCs and independent corporations to eliminate the effect of such differences.414

However, the Guidelines is silent on what is deemed to reasonable adjustment while

applying RPM. Functions performed between associated MNCs are considered

comparable with functions of the Independent Corporation if the following is taken it

to account: Performed functions must have less effect on price than cost of

performing function, substantial gross profit margin should not be added in the resale

price, an exclusive right of reseller to resale goods should be taken into account and

consideration of accounting practices applies to reseller as well as an independent

corporation.415

The RPM is reliable in situation when demands are not affected by price fluctuation

and can be used without forcing distributors to inappropriately make profit.416

However, in applying this method, it is difficult to find comparables of gross profit

margin from independent corporations due to inconstancy of accounting practices

between associated and independent corporations. Moreover, it is one sided because

it relies on one party in transfer pricing analysis.417 In terms of UN Guidelines, the

RPM can be used where the CUP method is not applicable where sales companies do

413
Ibid. para 6.2.9.1.
414
Ibid.
415
Ibid. 6.2.9.6.
416
Ibid, para 6.2.9.10.1.
417
Ibid, para 6.2.10. 2.
 108

not own valuable intangible properties and where reliable comparison can be

available.418

3.7.3 Cost Plus Method (CPM)

Cost plus Method (CPM) is the third method that involves cost of production of

goods or services transferred or provided between associated MNCs. The CPM

compares the gross profit mark-up earned by the tested party with the gross profit

mark-ups earned by comparable companies.‖419 While taking into account performed

functions, risk assumed and the market condition, an appropriate mark up is added to

the transaction between associates to make an appropriate gross profit.420

Comparison is then made between profit mark-up of associated MNC and that of the

Independent Corporation. Thus, transfer price between associates is the cost of goods

sold plus arm‘s length profit mark-up. In determining the arm‘s length mark up, two

methods are employed, namely, transaction and function comparison.421 The former

entails comparison of gross profit mark up of associates and that of an independent

corporation. The latter entails comparison between gross profit mark‐up earned by

independent companies performing functions and incurred risks to performed

functions and risks incurred by the associated MNCs.422 Under CPM, the transaction

of associated MNCs is considered comparable to transaction of independent

transactions if there are no differences in the transactions that will materially affect

418
Ibid, para 6.2.11.1.
419
Ibid, para 6.2.13.2
420
Ibid.
421
Ibid.para 6.16.2.
422
Ibid.
 109

the gross profit markup.423 Presence of minor differences is not an issue.

Comparability will also be accepted if reasonable accurate adjustment can be

performed between transactions of associated MNCs and independent corporations

to eliminate the effect of such differences.424 However, like in RPM, the Guidelines

are silent on aspects deemed to be reasonable adjustment while applying CPM.

Strength of CPM method is availability of comparables because it is based on

internal costs readily available between associated MNCs. The method is useful in

the following transactions: sale of tangibles, semi-finished goods and transactions

involving a contract manufacturer, a toll manufacturer or a low risk assembler who

does not own product intangibles and incurs little risk.425 However, the weakness of

the method is existence of a weak link between the level of costs and market price,

which affects gross profit mark ups. It requires consistence of accounting as well as

other factors and its absence renders comparable difficult. It focuses only on related

party manufacturer and no incentive to control manufacturer‘s cost.

3.7.4 Profit Split Method

Profit Split Method (PSM) is the fourth method used to determine transfer price

between associated MNCs. It is dived in the following two parts: Transactional Net

Margin Method (TNMM) and the Profit Split Method (PSM). The TNMM examines

the net profit margin relative to an appropriate base (for example, costs, sales and

assets) that a taxpayer realizes from a controlled transaction. This is compared to the

423
Ibid. para 6.2.17.1.
424
Ibid.
425
Ibid,para 6.2.20.1 and 2.
 110

net profit margins earned in comparable uncontrolled transactions. 426 The TNMM

requires identification and comparison of profit net margin realized by associated

MNCs with the gross profit margin realized by independent corporations in

comparable circumstances.427 Comparison may be made between net margins earned

by one associated corporation with net margin earned by an independent corporation

dealing on comparable circumstances or net margins earned between independent

corporations operating in similar circumstances.

This is achieved by comparing transactions or functions performed.428 Unlike RPM

and CPM, in determining arm‘s length net profit margin, under TNMM profit level

indicators429based on operating profit,430 they are used to compare net profit margin

of associated MNCs and the net profit of an independent corporation.431 It is worth

noting that under UN Guidelines, net margins cannot be affected easily by

transactional differences. The method does not employ complex analysis and it can

be used even by one associated party that holds intangibles.432 However, net margins

are easily affected and it is difficult to get reliable information. The profit split

method (PSM) requires first, identification of aggregated profit earned by associated

MNCs. The aggregated profit is then split among associates based on relative value

of each associate‘s contribution based on performed function(s), assumed risk and

426
UN and OECD glossaries.
427
Ibid,para 6.3.2.2.
428
Ibid,para 6.3.8.1.
429
Profit level indicator is a measure of company‘s profitability which explains profitability in
relation to sales, costs or assets. See UN guideline glossaries.
430
Operating profit is a profit from business operation before deduction of interests and taxes.
431
Chapter 6 of UN Guidelines para 6.3.7.1.
432
Ibid, para 6.3.11.1.
 111

assets used by each associate.433 The split profit of an associate is then compared

with split profit that would have been anticipated and reflected in an independent

transaction made at arm‘s length. If the profit is in accordance with profit of an

independent part, then the profit is said to be at arm‘s length.434 The PSM seeks to

―eliminate the effect on profits of special conditions made or imposed in a controlled

transaction by determining the division of profits that independent enterprises would

have expected to realize from engaging in the transaction or transactions.‖435 In

splitting profit, two methods are employed, namely, contribution analysis and

residual analysis. The former entails combined profit of associated MNCs

transactions on the basis of operating profit distributed between associates and then

compared with the same transaction of independent corporations. The latter involves

two steps, first, allocation of sufficient profit to each associated MNC to provide

basic arm‘s length compensation for routine contributions and second, allocation of

residual profit, which remains after sufficient profit is allocated between associates

based on circumstances of a particular case.436

In selecting the most appropriate transfer pricing method and in applying the selected

method, the Guidelines require comparability analysis to be performed.437

Comparability analysis involves two distinct related steps. The first step is to

understand economically significant characteristics of the transaction between

associates and the role of each part in associated MNCs. This is achieved by

analyzing characteristics of the property, function performed, contractual terms,

433
Ibid, para 6.3.13.3.
434
Ibid.
435
UN Guidelines glossaries.
436
Chapter 6 para 6.3.14.2 of UN Guidelines.
437
See chapter 5of the UN Guideline.
 112

economic circumstances and business strategies.438 The second step involves

comparison between conditions of associated enterprises‘ transactions and

transactions between independent corporations.439 In order to understand operations

of associated MNCs and roles of parties to associated, the Guidelines require

functional analysis to be performed.440 It involves identification of function

performed, assets used and risk assumed.441

Comparability conditions between associated and independent parties are regarded

comparable if ―the economically relevant characteristics of the two transactions and

the circumstances surrounding them are sufficiently similar to provide a reliable

measure of an arm‘s length results‖.442 In absence of comparables practical

approach is used to establish degree of comparability so long as it does not affect the

arm‘s length intended.‖443 In absence of reliable comparables, the Guidelines set a

general rule that, ―the transaction is or is not arm‘s length or arm‘s length is not

applicable to the particular transaction.‖444 The UN Guidelines clearly note

complexity and expenses involved in making comparability analysis. However, the

burden of cost should not be the reason to delusion of comparability standards. It is

important to note that the comparison procedure itself is very cumbersome and it

gives room for tax payers to conceal some pieces of information. Comparability is

based on mathematical accounting methods without legal requirements. This brings

uncertainty to application of the law. Comparability analysis adds burden to a tax

438
Ibid, para 5.1.1 and para 5.1.6.
439
Ibid, para 5.1.1.
440
Ibid, para 5.3.2.2.
441
Ibid, 5.3.4.1.
442
Ibid,para 5.1.5.
443
Ibid para 5.1.5. see also OECD Guidelines para 3.35 -3.38.
444
Ibid, para 5.4.3.2.
 113

payer who is required to apply the selected method to arrive at arm‘s length rate. In

practice, both exercises are long, complicated and cumbersome. It involves a lot of

expenses and it imposes serious challenge for tax administrators to establish

anomalies in a transaction because they are not involved from the very beginning.

3.8 Transfer Pricing Documentation Requirement

The UN Guidelines also require a taxpayer to prepare sufficient documentation at the

time of transfer pricing preparations. The document is regarded sufficient if it

contains details demonstrating tax payer‘s compliance with arm‘s length principle.445

The tax authorities are empowered to obtain such document when required.

However, the Guidelines require that the documentation should not impose cost and

burden to tax payers that are disproportionate to the circumstances.446 Few questions

may arise here. ‗What should the tax payer do if the cost of preparation of the

document is disproportionate to the circumstances? What should tax authority do

when found that the transaction has transfer pricing query, and tax payer did not

prepare document due to the cost involved?‘ The Guidelines is silent on all these

questions. In due regard, it may be difficult to implement documentation

requirements as enshrined in the Guidelines.

Generally, the burden of proof of documentation lies on the tax authority.447

However, a taxpayer is required to prove on adequacy of the documents where the

domestic law provides so.448 In handling transfer pricing documents, prudent

445
Chapter 7 of UN Guideline, para 7.1.1.
446
Ibid, para 7.2.1.2.
447
Ibid, para 7.4.1.1.
448
Ibid, para 7.4.1.2.
 114

business principle should prevail between tax payer and tax authority.449

Accordingly, both parties are required to exercise good faith through reasonable

documents of arm‘s length principle.450 It should be noted that the words ‗good faith

and reasonable‘ are not measurable in law and their uses are subjective and hence,

they do not create certainty in law. In both Guidelines, amount of information from

tax payer is limited and rationale behind is that at the time of filling documents, no

particular query would have been raised by the tax authority. Thus, it is burdensome

to prepare documents for purpose of showing appropriateness of transfer pricing

determination only.451 It is interesting to note that the UN Guidelines do not give its

position but rather, reproduced OECD Guidelines on preparation of documentation.

If arriving at arm‘s length price requires full analysis, which needs to be recorded,

why should the Guidelines limit information? Limitation provided in the Guidelines

may create room for a tax payer to conceal relevant information of transfer pricing.

There are also provisions for regulation of penalties to the taxpayer for failure to

comply with document requirements. The Guidelines require that the taxpayer

should be penalized for underpaying due tax and for non-compliance with document

requirements.452 The penalty may be of civil or criminal nature, depending on

circumstances of the case.453 However, in terms of UN Guidelines,‖ it is unfair to

impose sizable penalties on taxpayer exerted reasonable efforts in good faith to

undertake a sound transfer pricing analysis to ascertain arm‘s length price.‖454

Undoubtedly, this requirement limits domestic laws to impose serious penalties on

449
Ibid, para 7.2.1.2.
450
Ibid,para 7.4.1.5.
451
Ibid, para 7.4.2.7, see also para 5.15 of the OECD Guidelines.
452
UN Guidelines Para 7.4.3.1.
453
Ibid, para 7.4.3.3.
454
Ibid, para 7.4.3.4.
 115

tax payer on mentioned offences. In this context, the Guidelines may give loophole

to the tax payer not to comply.

3.9 Transfer Pricing Audits and Risk Assessment

Concerns that associated MNCs take advantage of complexities in arriving at arm‘s

length price to manipulate prices have subjected them to audits by revenue

authorities. The purpose is to increase tax revenue and future compliance with a view

of protecting tax base.455 Generally, transfer pricing audits are time and resources

intensive to revenue authorities such that long and complicated procedures must be

followed to identify risks. Risk identification and assessment are important steps in

ensuring that the most appropriated cases are selected for audit. However,

sometimes, even effective risk identification, assessment tools and processes may not

always guarantee successes in audit.456 The reason is that details available at risk

assessment stage may not be conclusive evidence regarding the arm‘s length nature

of profits or prices.

Identification of transfer pricing risks depends on available data and accessible data

from the taxpayer.457 Once the data are obtained, the revenue authority has to

identify categories of risks. Such risks arise from intergroup transactions that may

include intentional profit shifting through new business structures, restructuring,

incorrect functional classification, use of incorrect methods, thin capitalization and

455
Chapter 8 of UN Guidelines para 8.1.2.
456
Ibid, para 8.3.1.1.
457
Ibid, paras 8.3.1.2 to 8.3.1.5.
 116

unintentional profit shifting.458 In identifying transfer pricing risks, the Guidelines

require transactions, jurisdiction and risk approach to be used.459 In the mentioned

processes, source of information primarily should be provided by the taxpayer.

Publicly available information such as news paper, website and data bases may also

be used.460 The revenue authorities are also required to consider risk indicators such

as consistent and continuous losses by MNCs, lower effective tax rates for associates

in low tax countries and low profit in host country, while high profits are made in

another country where associates operate. Existence of centralized supply chain

companies in low tax country must be considered.461 Special procedures need to be

followed in assessing the transfer pricing risk.

Accordingly, risk assessment tools must be used and findings should be provided.462

The examination team should include economist, lawyer, external examiner and

computer audit specialist.463 The transfer pricing risks examination is subject to

limitation of time as regulated by domestic law.464 To establish whether or not there

is actual risk between associated MNCs, the revenue authority must understand

taxpayers‘ businesses. In this context, revenue authorities are required to understand

taxpayers‘ operations and their associates plus their roles played in a transaction

under the audit.465 This is sought to be achieved by going through a long list of

458
Ibid, paras 8.3.2.2 to 8.3.2.3. The categorization of risks is done with a view of helping revenue
authorities to detect possible value of profit shifting and establish time and resource required to
audit the risk.
459
Ibid, para 8.3.3.1.
460
UN Guidelines chapter 8 , para 8.3.4.2.
461
Ibid, para 8.3.5.
462
Ibid, paras 8.3.7 to 8.3.8.
463
Ibid, paras 8.4.1.1 to 8.4.1.5. These personnel have to perform different duties according to their
areas of specialization.
464
Ibid, para 8.4.7.
465
Ibid, para 8.5.2.1.
 117

documents.466 Where it is found that arm‘s length principle was not followed by the

taxpayer, adjustment may be done by the examination team and the taxpayer will be

informed accordingly.467 Where the taxpayer is dissatisfied with such adjustments,

settlement opportunities are available between the taxpayer and examination team or

appeal officer, depending on countries‘ laws.468 Once all these are done, the audit

case is assumed to be complete and properly documented for future reference and

should be closed.469

3.10 Transfer Pricing Dispute Avoidance and Resolution

Complexity involved in arriving at arm‘s length price provides potentials for disputes

between taxpayer and revenue authorities. In this context, it is necessary to avoid

transfer pricing dispute before it happens and when it does, the proper dispute

resolution mechanisms should be followed. The purpose is to facilitate efficient and

equitable determination and collection of tax revenue at the same time avoiding

double taxation.470Transfer pricing dispute may be avoided by using tax treaty

provisions, either bilateral or multilateral and Mutual Agreement Procedures (MAP).

471
Transfer pricing dispute resolution involves use of mutual agreement procedure

(MAP) and Advance Pricing Agreement (APA). The purpose of MAP is to provide

effective means for reconciling differing treaty positions of contracting countries in

avoiding double taxation.472‖ APA is an arrangement that determines, in advance of

controlled transactions, an appropriate set of criteria (e.g., method, comparables and

466
Ibid, para 8.5.2.2.
467
Ibid, para 8.7.6 to 8.7.7.
468
Ibid, para 8.7.9.1. and 8.9.1.2. for details on transfer pricing dispute see discussion bellow and UN
Guidelines chapter 9.
469
Ibid, para 8.8.1.
470
Chapter 9 of UN Guidelines para 9.1.2.1.
471
Ibid, paras 9.4.1.1 to 9.4.1.5.
472
Ibid, para 9.6.1.
 118

appropriate adjustments thereto, critical assumptions as to future events) for

determination of the transfer pricing for those transactions over a fixed period of

time‖.473 An APA is formally initiated by a taxpayer and requires negotiations

between the taxpayer, one or more associated enterprises and one or more tax

administrations. The APA process comes about as a supplement to traditional

judicial administrative and treaty mechanism for resolving transfer pricing issues.

Such APA is applied where there is considerable problem in establishing the manner

in which arm‘s length principle should be applied and results that may lead to double

taxation.474 The APA is a procedural process involving mutual agreements between a

taxpayer and tax authorities.475 These agreements are contracts usually for multiple

years between a taxpayer and at least one tax authority specifying the pricing method

that the taxpayer will apply to its related company transactions. In essence, the APA

follows same transfer pricing methods to arrive at arm‘s length price.

The only difference is that APA contract is entered before the actual transaction

between associated parties. Accordingly, the APA does not depart from the arm‘s

length principle. Key objective of APA is to eliminate double taxation that may be

caused by uncertainty about acceptability of the applied method. Other related

objectives of APA are to facilitate principled, practical and cooperative negotiations;

to resolve transfer pricing issues expeditiously and prospectively; to use resources of

the taxpayer and the tax administration more efficiently; and to provide a measure of

473
See OECD and UN Guidelines glossaries.
474
Para 4.123 of the OECD Guidelines.
475
The APAs may be unilateral, bilateral of multilateral. The bilateral and multilateral are agreements
between MNC and two or more revenue authorities. 475 Unilateral APA exists where there is
agreement between revenue authorities in country where it operates without including revenue
authority of other country.
 119

predictability for the taxpayer.476 The main advantage of APA is to allow revenue

authorities to obtain much as information as possible from the taxpayer about

transactions between associated parties. That may be useful in detecting risk that

may exist between associated MNCs. To ensure that the Guidelines are complied

with, it calls for every member countries to build transfer pricing capability. This is

sought to be achieved by establishing transfer pricing units in tax authorities. The

Guidelines set eight key features that transfer pricing unit should contain. They

include the following: the relationship between tax policy and tax administration; the

need for evaluation of current capabilities and gaps to be filled; the need for a clear

vision, a mission and a culture that reflects them; Organizational structure;

Approaches taken to build team‘s capability; need for effective and efficient business

processes; advantages of staged approaches to reaching long-term goals; and need

for monitoring to assess effectiveness and for fine tuning.477

Examination of the UN Guidelines reveals that the main aim of the UN Guidelines is

to provide practical solution(s) for developing countries on how to arrive at transfer

price between associated MNCs based on arm‘s length principle. Thus, establishment

of the UN Guidelines intended to bring uniformity in determining transfer price

among developing countries. Since the UN Guidelines are specifically designed for

developing countries,478 it takes into account development level of these countries. It

provide basis upon which transfer prices may be arrived at and hence, it bring

certainty to both associated MNCs and tax administrators in determining arms‘

476
Brem M., Globalization, multinationals and tax base allocation: Advance Pricing Agreements as
Shifts in international tax policies?, IIMA Working Paper, no. 2005-12-01. P.7.
477
Chapter for of UN Guidelines , para 4.1.1.
478
See title of the UN Guidelines.
 120

length price.. Notably, transfer pricing methods take in to account transfer pricing

theories and counteract them. For example, the economic theory and accounting

theory require transfer price to be compared with market price, if available.479 This is

in line with CUP method, which requires comparability of market price. Similarly,

economic theory and accounting theory harmonize well with RPM in establishing the

profit margin for purpose of calculating transfer price in absence of market price.

Cost plus method (CPM) works well with mathematical programming theory in

identifying cost of goods or services provide for the purpose of establishing transfer

price.480 The UN Guidelines were established on the basis of the UN model with the

view of providing practical application on transfer pricing issues for developing

countries. It is surprising to note that the UN Model is made for both developing and

developed countries, while the UN Guidelines are made for developing countries

only.481 It is unclear when developed countries implementing UN Guidelines will use

UN Guidelines or OECD Guidelines. It is not disputed that UN Guidelines borrowed

a lot from OECD and there are various issues specifically focused on developing

countries, which are quite different from OECD.482 Clarity of the law is necessary for

its implementation. However, the UN Guidelines, in some instances, lack consistence

and clarity such that they leave much to be desired.

From practical point of view, the transactions referred in UN Guidelines are of goods

or services.483 Additionally, theories of transfer pricing were methods are derived, in

479
See discussion in chapter 2.
480
Ibid.
481
See titles of UN Model 2011 and UN Guidelines 2013.
482
See discussion in UN Model in particular Article 7 on taxation of profit from business income and
article 9(3).
483
Reference can also made to CISG of 1980 which governs international sales of goods and service.
Also to domestic laws which clearly defines goods.
 121

a kind, referring to transactions of goods or services and not property.484 In the same

spirit, chapters one and two of the UN Guidelines use the word ‘goods‘ consistently.

To the contrary, chapter six of the Guidelines consistently uses the word ‗property‘

to infer transactions carried out between associated or independent corporations for

property.485 The problem is that neither the UN Guidelines nor UN model defines the

term property for transfer pricing purposes. Ordinarily, goods and property have

different meaning. Property means ―anything that is owned by a person or entity.‖

Property is divided into two types: "real property," which is any interest in land, real

estate, growing plants or the improvements on it, and "personal property"

(sometimes called "personality"), which is everything else."486 Furthermore, the UN

Guidelines define the term ‗mispricing‘ to mean a short-term to pricing, which is not

in accordance with arm‘s length standard.

In addition, mispricing in not intended to imply existence of tax avoidance or evasion

motive behind a particular transactions.487 This definition is against spirit of the law,

which requires curbing manipulation of transfer pricing by associated MNCs

achieved through mispricing. Although the UN Guidelines provide for circumstances

upon which mispricing is not necessarily tax avoidance or tax evasion, advanced

reasons do not outweigh the spirit of the law to deter manipulation of transfer

pricing. The UN Guidelines enshrine the notion of good faith in various provisions

requiring both associated MNCs as tax payers and revenue authorities to exercise,

484
See chapter 2 of UN Guidelines.
485
See chapter 6 of UN Guidelines.
486
See legal dictionary available at Legal-dictionary.thefreedictionary.com/individuality.
487
See foreword of UN Guidelines p iv.
 122

thought or practice good faith when determining arm‘s length transfer price.488

There is a possibility for both tax payers and tax administrators to have different

approaches to the notion of good faith. What is considered to be good faith by a tax

payer may not be considered the same by the revenue authority. The problem is that

the UN Guidelines does not provide any guidance as to how broad in scope the duty

of good faith should be and the extent to which it should govern the relationship

between the tax payer and tax administrators. Since no compromise was reached, the

notion of good faith under the UN Guidelines remains vague.

3.11 Conclusion

The review of international transfer pricing under international law leads to the

following conclusions: First, the OECD and UN models expressly spell transfer

pricing principles, which offer strong normative roots for transfer pricing laws of

regional and individual countries. The norms can be well established from

international taxation provisions of such regional and countries‘ domestic transfer

pricing laws. To the country level, frequent reference to arm‘s length principle for

transaction between associated MNCs is made in ant-avoidance provisions.

Similarly, courts of law have been referring to arm‘s length principle in determining

transfer pricing matters. This affirms acceptance and recognition of arm‘s length

principle. Second, there is no single approach in application of methods to arrive at

arms‘ length price. Each method is applied depending on circumstances of a

particular case.

488
See para 3.6.11 where tax payer and tax administrators to exercise good faith in determination of
transfer pricing regardless of who bears the burden of proof. Para 6.1.2.6 good faith in absence of
comparables, para 7.4.1.5 good faith in relation to documentation and para 7.4.3.3 on imposing
punishment when a tax payer exercised reasonable efforts to ascertain arms‘ length price.
 123

Notably, uncertainty and complications involved in arriving at arm‘s length rate give

potentials for manipulation of transfer price between associated MNCs. Accordingly,

risk identification and audit assessment for transfer pricing examination by revenue

authorities are long as well as complicated processes, requiring resources and time.

Such processes which depend to a great extent, on information from taxpayers may

render detection of risks futile. Third, although UN model is made for developing

countries it has not escaped from the influence of OECD model because developing

countries are dominantly relying on OECD model. Forth, both OECD and UN

models provide a uniform basis for solving the problem of international economic

double taxation primarily to encourage investment by preventing double taxation.

Most importantly, the international instruments do not take in to account transfer in

extractive sector which is likely to be a big concern for EAC countries.

 124

CHAPTER FOUR

TRANSFER PRICING REGULATORY FRAMEWORK IN EAST AFRICAN

COMMUNITY

4.1 Introduction

An increase in foreign investments caused by trade and investment has enhanced

challenges for international transfer pricing in EAC. International trade and

investment in EAC are largely caused by trade liberalization and investment that

have direct impact on transfer pricing. This chapter examines various arrangements

of international trade and foreign investments in which EAC countries have been

involved. It considers the extent of implications of international transfer pricing to

EAC countries. The first part surveys socio- economic and political context of EAC

countries. The rationale for looking in socio-economic context is that transfer pricing

is not independent from economic and political forces. The second part covers

linkage between trade and foreign investment as well as international transfer

pricing. The third part comprises liberalization of economy and its impact on transfer

pricing regulation in the region. The forth part reviews transfer pricing laws and

standards as enshrined in regional instruments. It consequently argues that

international trade and investment through such arrangements effectively pull

international transfer pricing framework in EAC countries towards international

stance and away from its local context.

4.2 An Overview of East African Community

The EAC is an intergovernmental cooperation of United Republic of Tanzania,

Kenya, Uganda, Rwanda and Burundi. The United Republic of Tanzania, Uganda
 125

and Kenya are founding members of the East African Community (EAC).489 The

Treaty establishing the East African Community (The Treaty) was signed by heads

of governments of the founding partner states on November 30th, 1999, in Arusha

Tanzania and came in to force in July, 2000.490 The EAC was formally launched on

January 15th, 2001. Rwanda and Burundi acceded to the Treaty and became full

members in July, 2007 and hence, increased membership of the community from

three to five countries. The EAC is located between 5030"N, 120S, 28045"E and 410

50" E, with total area of 1.817.7 thousand kilometer squares.491 The EAC has

recorded population of 145 million in 2013.492 Politically, EAC states have

presidential system of government where the President is both the head of state and

government.

The history of EAC cooperation can be traced back in 1917 when Custom Union

between Kenya and Uganda was established by colonialist.493 That was followed by

the East African High Commission of 1948 to 1961.494 The objective of the

Commission was to administer certain inter territorial services including tax

489
The Foundation of the East African Community is traceable to:- The Establishment of Permanent
Tripartite Commission for East African Cooperation in 1993, and the Treaty for establishment of
the East African Community, 1999. See also Shivji, I.G., ―The Rule of Law and Ujamaa in the
Ideological Formation of Tanzania, Social Legal studies, Vol. 4, London and New Delhi, SAGE,
1995 p. 148.
490
Shivji I.G.et al., Constitution and Legal System of Tanzania: A Civics Source Book, Mkuki na
Nyota Publication, Dar es salaam, 2004, p.136. See also, Ojienda T.O., Understanding the East
Africa Court of Justice, The East African Lawyer, Issue No. 4, 2003, p.17 – 18.
491
East African Community Facts and Figures 2013, p.14.
492
Ibid p.17, see also, East African Investment Guide 2013, p.2.
493
East African Investment Code 2013.p.1, See also, Shivji et al., note 490, the then Tanganyika
joined on the custom union on 1927. The three founding partners of the EAC have many features in
common though they have always been separate and independent entities from colonial period to
post independent era. They have all once been British colonies with basically underdeveloped
agricultural economies. Rwanda and Burundi have also common features as they both colonized by
French and Belgium. These common features made it possible for both colonial and postcolonial
governments to establish political and economic integration through which their common goals
could be achieved. It goes without saying that the goals of political and economic integration
differed between the colonial and post colonial periods.
494
East African (High Commission),1947.
 126

matters.495 During colonialism, the economies of Kenya, Mainland Tanzania (then

Tanganyika) and Uganda were integrated by the British colonialists so as to serve

interests of the colonial power (Britain). Under that system, Kenya received more

investment from Britain than Mainland Tanzania and Uganda.496 Historically, this is

explained by the fact that Kenya, unlike Mainland Tanzania and Uganda, was a

settler and crown colony in which not only many British settlers stayed but also they

meant to stay forever. Hence, they felt assured to invest more in Kenya than in

Mainland Tanzania and Uganda. To implement the goal of attracting more

investments in Kenya than Mainland Tanzania and Uganda, the British colonialists

used the law as a tool for that purpose. By using their colonial legislature, the British

colonialists made some laws that influenced the pattern on investment in East

African countries.

During colonial period, the main source of revenue was the colonial government. In

managing tax issues, the High Commission enacted East African (Income Tax

Management) Act.497 The Act synchronized all EAC countries‘ tax legislation but

excluded tax rates and allowances.498 In 1958, East African Income (Management)

Act499 was enacted. The Act repealed and replaced the 1952 Act. In terms of 1958

Act, tax was levied on residents of East Africa on their incomes derived from sources

within East Africa. Incomes from sources outside the region were taxed to the extent

495
Ibid.
496
Kahama C.G et al., The Challenge for Tanzania‘s Economy, Tanzania Publish House, Dar es
Salaam, 1994, p. 17.
497
No. 8 of 1952.
498
Third schedule of the Order in Council.
499
No. 10 of 1958.
 127

that they were remitted and received in East Africa.500 Although colonialism was

essential an expansion of MNCs from developed countries, transfer pricing issues

were not a concern.

In 1961, 1962 and 1963, Mainland Tanzania, Uganda and Kenya gained their

independence, respectively. After independence, there arose competition over

management of economic issues where Mainland Tanzania and Uganda felt that they

stood to lose more than they gained. Consequently, the East African High

Commission failed and resulted into tension within the East African countries.501 To

address the problem, the East African Common Services Organization (EACSO) was

formed in 1961 by Agreement.502 Emphasis under the EASCO still laid on economic

benefits from cooperation by focusing much on investments. However, the

cooperation collapsed in 1967 due to failure to agree in setting up EAC federation. 503

During that period, tax matters were still regulated by Act Number 10 of 1958. In

1967, East African Cooperation was formed.504 The 1967 Treaty aimed at bringing

about even economic development among the partner counties. 505 Like in previous

cooperation, Act Number 10, continued to be applied on tax matters until 1971when

it was replaced by East African Income (Management) Act of 1971. 506 The desire of

having investments and create even economic development always existed within the

community.

500
Luoga, note 10. p.13.
501
Shivji, et al., note 490 p.135.
502
Ibid.
503
Ibid.
504
East African Cooperation Treaty, 1967. Unfortunately the cooperation collapsed in 1977.
505
Article 2(1) of the Treaty of the East African Cooperation, 1967.
506
Cap 24 of the Community laws.
 128

The existing EAC aims at widening and deepening cooperation among the partner

states through development of policies and programmes in various fields for their

mutual benefits with the view to achieve economic integration, among other

things.507 In order to achieve the said objectives, the Treaty requires the partner

countries to take measures to ensure rationalization and harmonization of the

investments508 with the view of promoting the community as a single investment

area.509 In the implementation process, the partner states established the East Africa

Community Custom Union (EACCU),510 aiming at enhancing foreign investment in

the community.511 Article 5 of the Treaty stipulates objectives of the community to

include attaining, widening and deepening cooperation among the partner states.

This is to be achieved by development of policies and programmes in various fields

with a view of achieving economic, social and political integration. The treaty

provides that,-

“Community organs, Institutions, laws shall take precedence over

similar national ones on matters pertaining to implementation of
the treaty”.512 In pursuance to the provision above, the partner
countries undertake to make necessary legal instruments to confer
precedence of community organs, institutions and laws over similar
national ones.‖513

It means that partner states are obliged to ensure not only domestication of the Treaty

within their countries‘ laws, but also they should ensure timely implementation of its

507
Article 5 of the Treaty for Establishment of EAC 1999.
508
Ibid, Article 8(d).
509
Ibid, Article 80 (f).
510
Ibid, Article 2 and 75.
511
Article 3(c) of the Protocol for the establishment of EACCU.
512
Article 8(4) of Treaty for Establishment of EAC, 1999.
513
Ibid, Article 8 (5).
 129

projection and general adherence to its provisions by instituting all mechanisms and

programmes that relate to cooperation to enhance economic integration.

4.3 Linkage between Trade and Foreign Investment and International

Transfer Pricing

The desire to make EAC as a single investment area and efforts to implement such

desires enhanced an increase in trade as well as investments in the region. Increases

in such investments are from within and outside the EAC countries. Investments

and, in particular, foreign investments have been seen as a key drive that has been

inducing EAC countries to increasingly involve their economies in regional as well

as global levels. Such EAC countries have been taking various steps to facilitate

foreign investment mostly from developed countries.514 This is sought to be achieved

by changing domestic laws and policies by adopting bilateral treaties with countries

where investments are sourced or with their trading partners. Such bilateral treaties

may be tax agreements, investment treaties or trade agreements.

Facilitation of trade and investment in EAC countries is a result of implementation of

liberalization policies of multilateral institutions such as International Monetary

Fund (IMF) and the World Bank (WB). Such institutions required developing

countries to involve their economies in free market economy. Accordingly,

increasingly sophisticated and powerful technological as well as legal regulatory

environments, especially in developing countries enhanced interaction of economies

between developed and developing countries like EAC. This is achieved by

514
The EU, US, United Arab Emirates and emerging economies like India and China are major
trading partners.
 130

removing international trade barriers, which resulted in smoothing movement of

goods and services between countries. In due regard, big cooperation from developed

and emerging economy countries expanded their economic activities to EAC

countries by established associated entities.515 Arguably, most foreign investments in

EAC countries are not completely new but rather, they are mere part of large

corporations operating from countries where they are sourced.

The increase in MNCs in EAC would mean an increase in transfer pricing practices

in the region. In this context, benefits from MNCs are two-fold. First, the difference

between countries‘ tax laws provides potentials for MNCs to avoid tax on their

worldwide income. This is achieved by using legal loop holes that exists in countries

tax laws setting up prices within corporation without necessarily considering arm‘s

length principle as required by the law. Since the aim of MNCs is to maximize

profit, such situation may create a room to under or overprice goods and services

transacted within corporation.516 Second, it provides potentials for reallocation of

market shares through off shore companies with the view of reducing operation costs

and maximizes profit.517 Such situation creates room for MNCs to shift profit from

high to low tax countries or to countries where a parent company operates.

Consequently, countries involved fall in a risk of losing their right share of tax

through manipulation of transfer pricing.Globalization of MNCs has enhanced the

role of transfer pricing legislation in facilitation of trade and investment in the world.

515
See discussion in chapter para 2.4
516
There are other reasons which motivate MNCs to manipulate transfer pricing. These include
managerial, markets and government policy. For more details see Cobham A. et al., note 37 p. 6.
517
Lanzi R. and Miroudot S., Intra-firm Trade: Patterns, Determinant and Policy Implication. OECD
Trade Policy working paper No. 114, 2010, p.22. See also, chapter two on theories for
establishment of MNCs.
 131

This is evidenced by bilateral tax treaties concluded in the past to regulate

international transfer pricing arising between associated MNCs across countries.518

The undertaking view is of four-fold. First, absence of transfer pricing law may

render host countries in which MNCs operate to lose their right share of tax. Second,

ineffective transfer pricing system of law may create loophole for MNCs to avoid tax

beyond legal requirement(s). Hence, in case of conflict between revenue authorities

and MNCs as tax payers, it may render MNCs to be inadequately protected. Third, in

absence of proper transfer pricing law, both tax administrators and MNCs may have

limited reference when dealing with transfer pricing challenges. Fourth, absence of

proper transfer pricing law may discourage foreign investors to developing countries

like EAC.519 It is in this context such that it is important to consider involvement of

EAC in facilitation of MNCs‘ activities influence international transfer pricing

regulations in the region.

4.4 Liberalization of Economy and its Implications to Transfer Pricing

Regulation in EAC

The EAC countries have experienced major economic reforms for more than three

decades. Such reforms caused growth of economy in the region as a result of

liberalization policy implemented under auspices of multilateral institutions, namely,

IMF and WB. Such institutions required EAC countries to privatize state owned and

controlled enterprises together with liberalization of import and export prices of

518
See OECD and UN model tax conventions and UN and OECD Guidelines on transfer pricing
matters.
519
Transfer pricing is one of double tax avoidance measure, Tax treaty models normally enshrines
arms‘ length principle and other standards which are important in regulating transfer pricing.
Developing countries have always put in a dilemma of pleasing capital importers countries that
their laws are capable to protect foreign investment.
 132

commodities including capital flows. In order to achieve liberalization objectives,

such institutions provided policy and legal infrastructures, which EAC countries had

to follow while reforming their economies. Implementation of such reforms was a

condition to attract foreign investments for developing countries. 520 Consequently,

developing countries formulated policies and laws to attract more foreign

investments in their respective countries.521 The result was that EAC countries had to

depend and participate in private sector, in particular, foreign investment.

Existing EAC liberalized its economy by formulating policies and laws to facilitate

high investments as well as trade in the region. Establishment of EACCU and East

African Community Common Market (EACCM) protocols is some steps taken by

EAC to liberalize their economy and make the region as single investment area. Such

step facilitated higher investment flow between member countries and beyond the

region. This is achieved through removal of trade and investment barriers within the

EAC. Facilitation of investment is enhanced through intra – trade on mutual

arrangement basis.522 This is achieved through removal of non-tariff barriers,523

524 525
creation of common external tariff and elimination of internal tariff and

provision of anti-dumping measures.526 Accordingly, promotion of efficiency in

527
production within EAC through fair competition has improved investment of the

region. Furthermore, enhanced domestic, cross border and foreign investments

520
See UN Model preamble.
521
For example in 1992, Tanzania formulated parastatal sector reform policy followed by
establishment of the Parastatal Sector Reform Commission PSRC) as specific institution to deal
with matters of privatization.
522
Article 3 (a) of the EACCU.
523
Ibid, Article 13.
524
Article 12 of the EACCU.
525
Ibid, Article 10.
526
Ibid, Article 16.
527
Ibid, Article 3 (b).
 133

through simplified customs procedure,528 tax incentive on capital goods and zero

tariffs on primary raw materials have brought positive changes to EAC. Moreover,

promotion of economic development and diversification of industries529 have played

an important role in increasing investment in the region. Presence of ready market

with population of almost 150 million made possible through implementation of

EACCM attracted more investments in the region. Establishment of joint institutions

on border control, which plays an important role to deter smuggling, illegal cross

border transactions and control of transit goods has increased operation of associated

MNCs originating from within EAC.530 Presence of such MNCs essentially means an

increase in transfer prices practices from within and beyond the community.

Apart from establishment of EACCU, establishment of East African Community

Investment Model code531 (Investment model) significantly played a great role in

facilitation of investment in the region. The investment Model aims at harmonizing

investment laws in the region thereby reducing harmful investment competition

between member countries. Globalization of investment and trade has made EAC

member countries to take proactive measures to improve regional investment

climate. This is sought to be achieved by pursuing open, liberal and transparent

investment policies to contribute to their economic progress principally through the

private sector led development.532 In this context, investors both local and foreign

528
Ibid, Article 3 (c).
529
Ibid, Article 3(d).
530
See for example Bahresa Group of companies which has branches in Uganda, Rwanda, Burundi,
Malawi, Mozambique and South Africa. For more details see www.bakhresa.com ; Kenya Seed
Company having subsidiaries companies in Uganda and Tanzania, see www.kenyaseed.com; and
Nakumatt Holding supermarket with branches in Tanzania and Uganda, see www.nakumatt.net .
531
2006.
532
Preamble of the East Africa model Investment code, 2006.
 134

are ensured of right to private ownership establishment.533 Most importantly, the

investment code provides tax incentive for investors investing in export processing

zones, manufacturing under bond, free trade zones and technology parks. These

incentives include;,

―10 years corporate tax holiday and 25% tax thereafter,10 years
withholding tax holiday, duty and value added tax (VAT)
exemption, on raw materials, machinery, equipment and other
inputs, stamp duty exemption,100% investment deduction on
capital expenditure within 20 years, complete exemption from
dividend tax, duty and tax free import of goods from domestic
tariff area, duty free import of two motor vehicles for use of
business enterprise allowed under certain conditions, exemption
of income tax on interest on borrowed capital, relief from double
taxation subject to bilateral agreements, exemption of income tax
on salaries of foreign technicians for 3 years subject to certain
conditions and exemption from property tax for 10 years.”534

Arguably, the EAC investment code, which regulates investors, may provide

potentials for transfer pricing manipulation by allowing huge tax incentives to

investors. Facilitation of investment in EAC also has impact on attracting foreign

investments in the region. The EAC has entered in economic partnership with other

regional blocks such as Economic Partnership Agreement (EPA) with European

Union (EU), Trade and Investment Framework Agreement (TIFA) with USA, and

COMESA-EAC and SADC Tripartite free trade area and trade cooperation with

China and India.535 Entering in economic partnership with EU means that EAC have

opened room for 18 developed countries.536 Such kind of relations has potential in

attracting MNCs from EU to invest in the EAC countries and therefore, increase

transfer pricing practices in the region.

533
Article 5(1) of the East the East Africa Model Investment Code, 2006.
534
Ibid, Annex 1 which is made pursuance to Article 17 of the Investment code 2006.
535
See EAC website.
536
See EAC – EU Economic Partnership Agreement.
 135

The EPA, for example, covers trade in goods and development. It adheres to non-

discrimination principles on imports and exports.537 Accordingly, it contributes to

eradicate non–tariff barrier in intra EAC trade.538 The main export from EAC to EU

is dominated by coffee, cut flowers, minerals, fish and vegetables. 539 The imports to

EAC from EU are mainly machinery and mechanical appliance, equipment and parts,

vehicle and pharmaceutical products.540 Although EU may be seen to be supporting

the EAC, in real sense, the trade relation may have impact on tax matters. Imported

machinery and equipment from EU may enjoy exemptions as capital goods. The

trend of export between EAC and EU from 2012 to 2013 shows that EU imported

more than EAC exported to EU.541 Such kind of partnership intensifies involvement

of MNCs‘ operations in EAC, which potentially exposes EAC to the potential effect

of international transfer pricing. Likewise, expansion of a common market within

EAC and tripartite preferential free trade area of EAC–COMESA and SADC

provides a potential market for foreign investments.

Foreign investments in EAC countries are also from other African countries like

South Africa and Mauritius.542 For example, in 2012, South Africa and Mauritius

were leading investors in Tanzania. Mauritius is a tax haven country and provides

potentials for transfer pricing manipulation including profit shifting from EAC. In

this context, foreign MNCs stand to benefit more than local MNCs. This is because

local MNCs are able to invest within the region and very few have invested in

537
See for example Article 128 of the EPA.
538
Ibid, Article 19.
539
See http://ec.europa.eu/trade/policy/countries-and-regions/regions/eac/ . Accessed 20 May 2015
540
Ibid.
541
Ibid.
542
TIC, Tanzania Investment report 2012,
 136

comparative African advanced economies like South Africa and Mauritius.543 To the

contrary, MNCs from such countries have invested heavily in the region. Likewise,

EAC MNCs are lacking capacity to invest in their counter partners like EU, USA and

China. For example, it is a reported that intra-trade within EAC states is 3.8 billion

US dollars, while international trade volume with EAC is 33 billion US dollars.544

The EAC exports volume is 11 billion UD dollars while import volume is 26 billion

US dollars and investment flow is 1.7 billion US dollars.545 From these statistics, it is

clear that EAC trades more internationally than intra-region. The rate of investment

is also high, which means that more MNCs are carrying out business in the region

and therefore, transfer pricing is highly practiced.

Prosperity of the economy of any country or regional integration requires sufficient

tax revenue collected by revenue authorities from tax payers. Such tax authorities

and tax payers are influenced as well as governed by the law, which, as part of the

ideological superstructure, must inevitably not lag behind economic changes in any

society. Tax laws, in particular, constitute the legal regime that applies to local and

foreign investments for promoting economic development of a country or region.

The primary role of tax law is to encourage and regulate taxation in various sectors

of the economy. Thus, tax laws play a great role in success or failure of effective tax

collection of countries. As far as EAC countries are concerned, transfer pricing

standards were introduced after liberalization of the economy. 546 To a significant

543
Except for few companies like Bakhresa Group of companies.
544
East African Investment Guide 2014 p.2.
545
Ibid.
546
Tanzania introduced transfer pricing law in 2004 and its transfer pricing regulation on 2014,
Kenya 1995 and its regulation on 2006, and Rwanda 2005, Uganda transfer pricing regulation came
in 2011, Burundi 2009.
 137

extent, domestic laws have tended to incorporate arm‘s length principle and other

standards contained in the model conventions.547 This is in line with the requirement

of multinational institutions as rightly pointed out that,

„„A drafting issue for the domestic [tax] law is that the arm‟s length
principle should be provided for both branches and subsidiaries.
This is most easily done by using language similar to that found in
tax treaties. Such an approach ensures that there is a basis in
domestic law for making transfer pricing adjustments. In many
countries, it is not clear whether tax treaties on their own would
provide a sufficient basis for such adjustments, and, in any event, it
is necessary to have the rules in the case of residents of countries
with which there is no tax treaty in force. Using statutory language
based on treaties has the added advantage of giving a clear signal
that the country intends to follow international norms.‟‟548

Introduction of transfer pricing provision in EAC countries was mainly to avoid

double taxation and allocate taxing rights to countries where MNCs operate.

Accordingly, this was done with a view to attract more foreign investors in their

respective countries so as to keep up pace with requirement of international taxation

norms. Additionally, by abiding by these standards, it is believed that governments

provide potentials in obtaining the right share of tax arising from MNCs‘ transactions

for countries‘ economic development. Arguably, foreign investments have been seen

as major means of obtaining huge taxes that will help governments to enhance

economy and provide public services.549 Accordingly, importation of transfer

pricing standards from developed countries significantly limits options available to

547
See for example, section 33 of Tanzania Income Tax Act, 2004, section 18 of Kenya Income Tax
Act, cap 470 of the laws of Kenya and Article 30 of the law No. 16 of 2005 of Rwanda. See also
Article 9 of the Agreement Between the Government of the Republic of South Africa and the
Government of the United Republic of Tanzania for the avoidance of Double Taxation and
Prevention of Fiscal Evasion with Respect to Taxes on Income.
548
Vann R., ‗International Aspects of Income Tax, in Tax Law Design and Drafting‟, in V. Thuronyi
(ed.), Vol.2, International Monetary Fund, 1998, P. 782.
549
See for example, the role of President Kikwete of Tanzania in encouraging foreign investors.
 138

EAC countries as tax policy choices seem not to be influenced by countries‘

economic structure and administrative capacity.

With ongoing discovery of natural resources and implementation of the policy of

making EAC as the single investment area supported by liberalization of market,

involvement of MNCs‘ operations is likely to increase. Most likely, such MNCs are

from developed countries. There is an emerging pattern of MNCs from emerging

economies such as China and India as well as among developing countries like

Nigeria, South Africa and Mauritius.550 Consequently, arm‘s length principle is

becoming highly applicable. Growing of MNCs‘ activities seems to be derived from

their desire to obtain profit and reduce overall corporations‘ tax liability.

Such desire reflects objectives for which MNCs are established551 and in the

magnitude of Bilateral Investment Treaties (BITs) concluded by EAC countries with

their trade partners.552 Although the argument for having BITs and Double Tax

Treaties (DTAs) is to attract more foreign investments in the region, it is

questionable whether or not tax losses caused by loopholes in such treaties can be

compensated by the increase in volume of MNCs investments in the region. It is

common knowledge that attraction of foreign investment and protection of the same

is another thing. There is consensus from scholars and investors that investing in

Africa generally is unsafe because of weakness in adherence to the rule of law and

that investors are insufficiently protected in Africa.553 The investors are of the view

550
See the SADC, COMESA and EAC tax tripartite treaty of the said regions.
551
See discussion in chapter two above.
552
For example recently Tanzania has concluded BITs with several countries like China and Morocco
553
Hicks G., BITs for Africa, Centre for International studies, 6 June 2014, available at http:csis.org
Accessed September 2014, see also, Leo B., Where are BITs? How US Bilateral Investments
 139

that developing countries like EAC are lacking proper tax laws, in particular, transfer

pricing to protect their business profits. Hence, home countries of MNCs had to find

a way of protecting and capturing profits that may arise out of MNCs‘ operations

across countries. It is generally accepted under international taxation principle that

countries have the right to tax income either on source or resident bases. Thus,

countries, which host investments, have the right to tax on source, while countries

where investments are sourced, they tax on resident basis.

Equally important, another great concern for foreign investors is payment of double

tax for their investments, which seems to increase transaction costs that need to be

avoided. Likewise, a host country may require effective mechanisms for exchange of

information between countries in relation to economic activities of MNCs for tax

purposes before acceptance of investment. It is in this context that home countries of

MNCs negotiated and concluded Double Tax agreements with EAC countries.554

From investors‘ countries, DTAs are seen mainly as means to protect and capture

their profits and partly as means to remedy local institutions‘ deficiency together

with governance.555 It is within this context that transfer pricing standards have been

enshrined in EAC DTAs. Such standards were seen as a condition to avoid double

tax to investors so as to obtain intended profit at the same time facilitating more

capital imports by MNCs in the region. From EAC countries‘ perspective, the

Treaties with Africa can Promote Development‘, Centre for Global Development, August 2010,
available at http://www.cgdv.org. Accessed on 1st September 2014.
554
Number of DTAs is signed between EAC countries and Developed countries. For example
Tanzania has signed DTA with Canada, Denmark, Finland, Italy, Norway, Switzerland and
Sweden. Kenya has signed DTA with Norway, German, Denmark and Canada.
555
Ginsburg T, International Substitutes for Domestic Institutions: Bilateral investments and
Governance, Int‘l Rev& Econ, 2005 p.107.
 140

conclusion of such DTAs seems to connote the following: first, as means to attract

more foreign investors in the region.556 Such desire seems to be derived from the

notion that foreign investment plays an important role in generating tax for economic

development, among other things.557 By signing DTAs, EAC countries will be in a

position to obtain the right share of tax from MNCs‘ profits.

Second, it is a way to impress foreign investors that EAC countries are not unsafe

destination.558 Third, it is as a mechanism for exchange of information between

countries in relation to economic activities of MNCs in case of tax dispute for

purpose of tax compliance. This was seen important because developing countries

like EAC are seen as having weak tax law and administrative capacity in regulating

international tax.559

The increase in DTAs involving EAC countries plays an important role in promoting

MNCs‘ operations, in general. The EAC countries are becoming interdependent and

connected to MNCs‘ operations, but they face challenge of reflecting in their tax

regimes global standards in dealing with international transfer pricing. Transactions

of MNCs through transfer pricing impose challenges for EAC countries to align

transfer pricing laws so as to abide by their desire to attract more MNCs to countries

with which they signed DTAs. The fact that liberalization of economy was
556
McGauran, K., note 30, p.5 See also, Neumayer E., Do Double Taxation Treaties Increase Foreign
Direct Investment to the Developing Countries?, Journal of Development Studies. 43 (8) 2007, pp
1501-1519 available at http://ssrn .com/ abstract=766064, p.2; Accessed September 2013. See also
Ahmed S.A.S and Giafri R.N.M., The Role of Double Taxation Treaties on Attraction of Foreign
Direct Investment: A Review of Literature. Research Journal of accounting, ISSN 2222-
2847online Vol 6, no 12, 2015.
557
Like importation of technology, employment opportunities etc.
558
Masot V., Bilateral Investment Treaties and a Possibility Multilateral Framework on Investment
and WTO; Are Poor Countries Caught in Between? 20 NWJ Int‘l L &Bus (2005 -2006) pp 95 and
114.
559
Mclure, Jr., C.E., note 36.
 141

influenced by multilateral institutions is highly influenced by policies, rules and

programmes of developed countries‘ standards.560 Consequently, such rules, policies

and programmes suitable for developed countries‘ economies and administrative

capacity were imported in EAC countries.

On the basis of the importation, EAC countries formulated policies and laws, to a

great, extent reflect requirements of foreign investments. Arguably, laws,

programmes and standards on transfer pricing were not set and implemented to

reflect specific needs including administrative capacity of EAC in handling transfer

pricing intricacies. To this extent EAC countries were opened for potential transfer

pricing challenges. Such countries may consider foreign investment as one of the

means to obtain taxes necessary for economic and citizens‘ development. However,

EAC countries laws are may be ineffective and inefficient in capturing their tax

potentials that may arise out of international transactions by MNCs.

For example, it is estimated that developing countries capture only 40 percent of

their potentials and lose US dollars 160 billion a year through international transfer

pricing manipulations.561 Arguably, the desire for attraction of foreign investment

has put EAC countries to institute transfer pricing laws, which reflect MNCs‘

desires, a situation, which may preclude them from making proper analysis of

consequences that may be caused by application of the arm‘s length principle.

560
Kelley T.A., Exporting Western Law to the Developing World: The Troubling Case of Niger‟ 7
Global Jurist (Frontiers) Article 8, 2007 available at http://wwwbepress.com/gj/vol7/issu3/art8.
Accessed 2nd December 2014.
561
International Tax Compact, ―Benefits of computerized integrated system for Taxation‖, Tax case
study, Bonn Feb 2011.
 142

4.5 International Transfer Pricing Regime in East African Community

4.5.1 The EAC Treaty

The EAC treaty has nothing explicit related to transfer pricing between associated

MNCs. However, it contains provisions upon which transfer pricing laws can be

inferred and form basis for transfer pricing laws. Article 5 of the EAC Treaty

stipulates objectives of the community to include attaining, widening, and deepening

cooperation among the partner states. From economic and tax perspective, the treaty

provides for cooperation in investment and industrial development.562 To achieve

such requirement, the EAC treaty necessitates harmonization and rationalization of

investment of tax incentives with a view of promoting EAC as a single investment

area.563 Accordingly, it requires avoidance of double taxation for investments across

borders564 and harmonization of tax policies with a view of removing tax distortions

so as to bring about efficient resource allocation within the region.565 In addition, the

treaty allows free movement of capital so as to encourage cross–border trade and

financing instrument.566

This is to be achieved by developing policies, laws, institutions and programmes in

various fields with a view to attain economic, social and political integration.

Accordingly, the EAC Treaty requires ―community organs, institutions, laws to take

precedence over similar national ones on matters pertaining to implementation of

562
Article 79.
563
Article 80(f).
564
Article 80(h).
565
Article 83(e).
566
Articles 80 - 87 respectively.
 143

the EAC treaty.‖567 Pursuant to this provision, the partner countries are required to

undertake necessary legal instruments to confer precedence of community organs,

institutions and laws over similar national ones.568 This means that the partner states

are obliged to ensure not only domestication of the EAC treaty within their domestic

laws, but also ensure timely implementation of its projection and general adherence

to its provisions by instituting all mechanisms, laws and programmes that relate to

cooperation to enhance economic integration. It is within this ambit the EAC

countries have entered in Agreement for Avoidance of Double Taxation and

Prevention of Fiscal Evasion with Respect to Taxes on Income (EAC DTA). The

EAC DTA contains arm‘s length principle and other standards of transfer pricing as

enshrined in model conventions. Examination of standards and principles contained

in the EAC DTA including clauses demonstrates the extent to which EAC countries

have bound themselves in obligation that potentially affect as well as shape their

policy choices in transfer pricing regulations.

4.5.2 EAC Agreement on Avoidance of Double Taxation and Prevention of

Fiscal Evasion with Respect to Taxes on Income 2011 (EAC DTA)

The East African Community Double Taxation Agreement (EAC DTA) is a

multilateral treaty for avoidance of double taxation and prevention of fiscal evasion

with respect to taxes on income.569 Such taxes, which the EAC DTA applies, are

taxes chargeable in accordance with provisions of the income tax laws of member

567
Article 8(4) of the Treaty for the Establishment East African Community, 1999.
568
Ibid,Article 8(5).
569
Article 2 of the EAC DTA. It was established on 2010 and came in to force on 2011.
 144

countries.570 The treaty seeks to eliminate double taxation among countries by

imposing an obligation on the resident state to give credit to source country against

the resident country‘s tax on income or exempt the income from tax. The parties to

the treaty are the Republics of Kenya, Uganda, Burundi, Rwanda as well as the

United Republic of Tanzania and it is applicable to residents or one of the residents

of contracting countries.571 In context of transfer pricing, when stakeholders need to

establish whether or not the prices are made at arm‘s length, the EAC DTA provides

for requirements that need to be followed while setting transfer price between

associated MNCs operating within the region. Such provisions are discussed in the

next sub-sections.

4.5.2.1 Arms’ Length Principle in EAC Context

Arm‘s length principle is a corner stone of regulating transfer pricing between

associated MNCs enshrined under the EAC DTA.572 The principle provides that,

“… and in either case conditions are made or imposed between the

enterprises in their commercial or financial relations which differ
from those which would be made between independent
enterprises, then any income which would, but for those
conditions, have accrued to one of the enterprises, but, by reason
of those conditions, have not so accrued, may be included in the
income of that enterprise and taxed accordingly.‖573

570
Ibid, Article 2(3). These laws are Income Tax Act, Cap 470 RE 2014 of the laws of Kenya,
Income Tax Act Cap 332 RE 2008 , of Tanzania, Income Tax Act, Cap 340 of the Laws of Uganda,
Rwanda Law no 16/2005 of 18/08/2005 and law no 17/2005 and Burundi Income Tax act of 2008.
571
Ibid, Article 1.
572
Ibid, Article 9(1) (b).
573
Article 9(1) para 1 of EAC DTA. It is worth noting that, the wording of Article 9 (1) para 1 are
identical with wording of Article 9(1) of OECD and Article 9(1) UN model, except that, the EAC
DTA uses the word ‗income‘ and the OECD and UN model uses the word ‗profit‘. However, for
purpose of transfer pricing, Article 7 of EAC DTA uses the word profit throughout for transfer
pricing purposes.
 145

The principle requires that transfer of goods and services between associated

enterprises should be made at market price like those would have been made

between independent parties.574 In context of this principle, the enterprise is regarded

as associate of another if it participates directly or indirectly in either management or

control or capital of an enterprise of another contracting state. 575 Or the same persons

participate directly or indirectly in the management, control or capital of an

enterprise of a contracting state and an enterprise of the other contracting states.576

Notwithstanding such requirement, there are no clear guidelines under circumstances

a person is said to control the other for transfer pricing purposes. However, scholars

posit that the notion ‗control‘ should be used in its broader sense to include sufficient

degree of control in relation to participation in management whether or not legally

enforceable, directly or indirectly, whether horizontal or vertically. 577 However, in

practice, the degree of control is different from member countries. For example, the

threshold for control in Kenya for transfer pricing purposes is 25 percent of the share

holding or voting power in the entity.578 To the contrary, threshold control in

Tanzania is 50 percent or more of the rights to income or capital or voting power

through one or more corporations.579 Generally, the arm‘s length principle applies to

taxation of income to persons who are residents of one or any of the other

574
Article 9(1) (b) of the EAC DTA.
575
Ibid, Article 9(1) (a).
576
Ibid, Article 9(1) (b).
577
Blank M. et al., note 589 p.128.
578
paragraph 32(1) of part IV of the second schedule of ITA CAP 470 RE 2014. For more details see
discussion in chapter seven at para 7.3.2.1.
579
Ibid, Section 3 (i) (bb). For more details see discussion on chapter six at para 6.4.3.2.
 146

contracting states.580 It means that for arm‘s length to apply, associated enterprises

must be in different states. For that reason, associated parties operating within a

country are excluded from the ambit of EAC DTA. The provision also excludes

foreign controlled companies for transfer pricing purposes. In context of EAC

countries, the purpose of arm‘s length principle is first, to secure appropriate tax base

in each country where MNCs operate; second, to avoid economic double taxation

and to attract foreign investors as well as cross border trade to the region.581

In essence, transfer pricing rules are avoidance rules aiming at elimination of double

tax and encourage foreign investors in the region. The principle applies only when

transfer price between associated MNCs is not at arm‘s length because of their

special relations between them. It is in this context that Article 9(1) empowers

revenue authorities of contracting states to adjust transfer pricing in accordance with

arm‘s length principle. However, the EAC DTA is silent on modalities of adjustment

for purpose of obtaining arm‘s length price. To the contrary, the EAC DTA clearly

provides for corresponding adjustments with a view of elimination of double

taxation.

The arm‘s length principle requires adjustment where one contracting state includes

in the income of enterprises of the other state arm‘s length profits, which have been

580
Ibid, Article 1. This means that non EAC enterprise related to an enterprise of EAC shall be subject
the EAC DTA. This is important as EAC is not trading within its member states only; it also trades
with other third countries including those in other regional communities such as COMESA and
SADC. Similarly, foreign direct investments among EAC member countries are becoming
increasingly important. Just like other regional integration such as ECOWAS 580 and European
Union (EU) who have established specific transfer pricing laws to keep pace with requirement of
raising revenue from profit of associated MNCs.
581
Blank M. et al., The Double Taxation Avoidance Agreement of the EAC hand book, p.125.
 147

charged in other state prices.582 To this extent, the state, which made such

inclusion, shall make an appropriate adjustment to the amount of the tax charged

therein on that income. The adjustment can be made through deduction583 or

exemption584 methods. However, corresponding adjustment cannot be made if it is

time bared according to countries‘ laws of limitations,585 except where there are

fraud, default and neglect.586 Likewise, where there is judgment duly made by

judicial, administrative or other legal proceedings, adjustment of income of

enterprises cannot be made.587

4.5.2.2 Resident Principle in EAC Context

In context of EAC, for arm‘s length to apply there must be a transaction between

residents associated MNCs between contracting countries. A corporation is regarded

a resident if it is incorporated under the laws of that state or if place of effective

management is situated therein or any other criterion of similar nature. 588 Where the

corporation has two or more contracting countries, the resident of such corporation is

regarded to be where effective management is situated.589 However, the EAC DTA is

silent on meaning of ‗effective management.‘ The income tax laws, which are

referred to are also silent on meaning of effective management.590 There is serious

concern with determination of a residence of a company by using phrase ‗effective

582
Article 9(2) of EAC DTA
583
Ibid, Article 24(1).
584
Ibid, Article 24(2).
585
Ibid, Article 9 (3).
586
Ibid, Article 9(4).
587
Ibid, Article 9 (5).
588
Ibid, Article 4(1). This article clearly excludes any person who is liable to tax in respect only of
income from sources in that state.
589
Ibid, Article 4 (3).
590
See for example section 10 of ITA, Cap 340 of the laws of Uganda, Section 66 of ITA, Cap 332
RE 2008 of Tanzania and Section 2 (1) of ITA Cap 470 RE 2014 of the laws of Kenya.
 148

management‘ to determine tax liability of MNCs. Van de Merwe, for example,

argues that the phrase ―effective management‖ is ambiguous because it ether refers

to nature of management or level of management and management decision.591 It is

difficult to apply because each case is determined according to circumstances of a

particular case.592 On level of management, it is not clear at what level of

management can residence of a company be determined, either at the place where

activities are managed or at the place where actually broader, strategic decision are

taking place.593 He further posits that in determining residence of a company by

using effective management, the following questions arise:- ―who manages the

company? At what management level is it important to determine residence? What is

the nature of effective management? Is there any guidance to be instituted from

management and control? Can there be more than one place of effective

management?‖594

Arguably, the notion of effective management is relevant to traditional trade where

decision makers of companies used to meet physically at a particular place. 595 With

the modern technology development in communications, decision makers of the

companies are using video conference, electronic mails (e-mails), phone and the like.

Furthermore, an idea of residence as a central key on principles and policies in

relation to international taxation of foreign investment seems to be both outdated and

591
Van de merwe B.A., Residence of A Company: Meaning of effective Management, South Africa
Mercantile Law Journal, 2002, pp79-92, p.81.
592
Ibid.
593
Ibid.
594
Ibid 79.
595
Oguttu A. W., Resolving Double Taxation: The Concept of „Effective Management‟ Analyzed from
South African Perspective, XLI No 1 The Comparative and International Law Journal of Southern
Africa, 2008, pp 80-104p.86.
 149

unstable.596 Likewise, Kirsch points out that there is no substance connection

between corporate tax residence and corporate economic attributes in a global

economy.597Avi Yonah concludes that charging tax on residence basis is not very

meaningful.598 Scholars further argue that taxation on residence basis is easy and

vulnerable to tax manipulations, in particular, for MNCs in shifting profit from one

country to another.599 The issue is, ‗what will happen if profit of a whole company is

generated by subsidiary of company X in country C but the such subsidiary is

managed wholly in country Y? In context of transfer pricing, it creates room for

manipulation of prices where the profit will be made in another country and

therefore, the tax base in which subsidiary company operates may be eroded.

4.5.2.3 Permanent Establishment in EAC Context

In determining taxing rights of residents of associated MNCs and whether or not the

corporation has presence in contracting countries, permanent establishment concept

is employed. The East African Community Double Taxation Agreement (EAC

DTA) defines permanent establishment as a fixed place of business through which

596
Graetz, M. J. and O‘Hear, M. M., The Original Intent of U.S. International Taxation, Faculty
Scholarship Series. Paper 1620, 1997, P.1066, available at
http://digitalcommons.law.yale.edu/fss_papers/1620.Accessed 30th th August 2014.
597
Kirsch M. S., Taxing Citizens in a Global Economy, Scholarly Works, 2007 Paper 547, p.480-483.
available at http://scholarship.law.nd.edu/law_faculty_scholarship/547 Accessed 30th December
2014.
598
Avi-Yonah R. S., International Tax as International Law, University of Michigan Law, Public Law
Research Paper No. 41; Michigan Law and Economics Research Paper No. 04-007, 2004.
Available at SSRN: http://ssrn.com/abstract=516382 or http://dx.doi.org/10.2139/ssrn.516382 ,
Accessed 30th December 2014
599
Graetz, M.J., Taxing International Income: Inadequate Principles, Outdated Concepts, and
Unsatisfactory Policies,54 Tax Law .Review , 2001 p.261 and 320, Kirsch note 95, Kleinbard
E.D., The Lessons of Stateless Income, 65 Tax Law Review 2011, p.99, Tillinghast D.R., A Matter
of Definition: „Foreign „and „Domestic‟ Taxpayers,‘2 International Tax & Business Law, 1984,
pp239, 267, Avi-Yonah, R.S Tax Competition and the Trend Onward Territoriality, University of
Michigan Public Law Research Paper No. 297, 3 2012, available at http://papers.ssrn. 2191251.
Accessed 20TH December 2014
 150

the business of enterprises is wholly or partially carried out. 600 Such permanent

establishment includes place of management, a branch, an office, a factory, a

workshop, a warehouse for storage facilities for others, a mine, a gas or an oil well, a

quarry or any other place of extraction of natural resources. 601 Permanent

establishment also encompasses a building site or construction, installations other

than mines and natural resources, assembly or supervisory activities, which last for

more than six months.602 Furnishing of services and consultancy services through

employee as well as other persons engaged if such activities continue for the same

connected project for a period of aggregated more than six months within any twelve

months constitutes a permanent establishment.603

For an insurance company, permanent establishment exists in a country where it

collects premium or insured risks are situated.604 Likewise, permanent establishment

also can be formed if a person habitually exercises a general authority in the first-

mentioned country to conclude contracts in the name of the enterprise, unless his

activities are limited to purchase of goods or merchandise for the enterprise; or

maintains in the first mentioned country a stock of goods or merchandise belonging

to the enterprise from which he regularly delivers goods or merchandise on behalf of

the enterprise.605 The EAC DTA clearly excludes activities of preparatory or

auxiliary character to form permanent establishment.606 Likewise, permanent

establishment cannot exist if it carries on business through broker, general

600
Article 5 (1) of the EAC DTA.
601
Ibid, Article 5 (2) (a) to (h).
602
Ibid, Article 5 (3) (a).
603
Ibid Article 5 (3) (b).
604
Ibid, Article 5 (6).
605
Ibid, Article 5 (a) and (b).
606
Ibid, Article 5 (4) (a) to (f).
 151

commission agent acting on the ordinary cause of their business.607 From the fore

discussions, it is clear that the concept of permanent establishment as a tax payer in

the host country presupposes physical existence. However, with development of

modern technology where communication is enhanced, it makes the physical

requirement of permanent establishment as enshrined in EAC DTA to be applicable

to physical permanent establishment only. It means that an existing requirement of

existence of permanence as enshrined leaves out electronic transactions by MNCs.

Consequently, MNCs may take advantage of the situation by conducting their

international transactions through electronic means.608 By using internet, MNCs are

able to transfer goods and services between themselves all over the world without

being easily interfered with revenue authorities of countries where transactions

occurred.

4.5.2.4 Business Profit for Transfer Pricing Purposes

The EAC DTA sets a general rule that profit of enterprises should be taxed in the

country where it is situated.609 However, there are exceptions to this rule. Where an

enterprise operates in another country through permanent establishment, it requires

business profit attributable to permanent establishment to be taxed in the country

where it is situated.610 Article 7(2) requires each permanent establishment situated in

contracting states to be taxed on attributable profit obtained under arm‘s length

607
Ibid, Article 5 (7).
608
Commonly known as e-commerce, which is defined as processes of carrying out commercial
activities through electronics means by using internet where by voice, data and images take place in
cyber space with little or no physical activities in absence of geographical boundaries. For more
detail see Doernberg R and Hinnekens L., Electronic Commerce and International Taxation, 1999,
p.3.
609
Article 7(1) of EAC DTA.
610
Ibid.
 152

rate.611 It means that any attributable profit between associated enterprises operating

through permanent establishment relied on internal agreement will be subject to

adjustment by revenue authorities in accordance with arm‘s length principle. In

determining attributable profit amount, the EAC DTA sets a general rule that

expenses incurred for business purpose, executive and general administrative cost

should be deducted in the country where the permanent establishment is situated or

somewhere else.612 Accordingly, it prohibits any deductions, which are not allowed

as deduction under laws of the country where the permanent establishment is

situated.613

However, in determining profits of permanent establishment, amounts charged by

head office of the corporation or any of its offices by way of royalties or fees in

return for use of certain rights are not taken in to account except for banking

enterprises.614 Such loop holes may provide potentials for associated MNCs to

manipulate prices. The agreement also excludes profit obtained by mere purchase of

goods or merchandise by permanent establishment615 Moreover, the EAC DTA

requires that methods used to determine the profits attributable to the PE should be

used on yearly basis unless there is sufficient reason to depart.616 The rationale

behind is to limit contracting states to change methods used so as to create certainty

and consistency. However, the rule does not prevent contracting states to impose

additional requirements in preventing duplications of accounting methods. EAC

611
Ibid, Article 7(2).
612
Ibid, Article 7(3) (a).
613
Ibid.
614
Ibid, Article 7(3) (b).
615
Ibid, Article 7(5).
616
Ibid, Article 7(6).
 153

DTA clearly excludes business profits dealt separately in other provisions as a

general rule.617 They include dividend, interest, royalties and other incomes.618

However, there are exceptions to this rule. In terms of dividend, where a beneficial

owner of a dividend is a resident of the contracting state, carrying on business in

other contracting state in which the company is paying dividend is resident through

permanent establishment situated therein and holding in respect of which the

dividends are paid is effectively connected with permanent establishment, Article 7

shall apply.619 The EAC DTA defines the term dividend to mean income from shares

or other rights, not being debt claims, participating in profits as well as income from

other corporate rights subjected to the same taxation treatment like income from

shares by laws of the contracting state of which the company making a distribution is

a resident.620

Likewise, interest is taxed as business profit of permanent establishment if the

beneficial owner of interest is a resident of a contracting state in which the interest

arises through permanent establishment situated there in and the debt claim in respect

of which the interest paid is effectively connected with it.621 The term interest is

defined to mean income from debt claims of every kind whether or not secured by

mortgage and whether or not carrying a right to participate in the debtor's profit, and,

in particular, income from government securities as well as income from bonds or

debentures including premiums and prizes attaching to such securities, bonds and

617
Ibid, Article 7(7).
618
Ibid, Articles 10, 11, 12 and 23 respectively.
619
Ibid, Article 10(4).
620
Article 10 (3).
621
Ibid, Article 11 (5).
 154

debentures.622 Accordingly, royalties are taxed as business profit of permanent

establishment ―if the beneficial owner of the royalties is a resident of contracting

state in which the royalties arise through a PE situated therein and the right or

property in respect of which the royalties are paid is effectively connected with such

PE.‖623

4.6 Methods to Arrive at Arm’s Length Price

The EAC DTA is silent on methods to arrive at arm‘s length price. Generally, such

methods are enshrined under domestic transfer pricing regulations of contracting

states.624These are comparable uncontrolled price, resale price method, cost plus

method and profit split method.625 Notably, the handbook is for training purposes for

officials working in revenue authorities and Ministry of Finance of respective

countries.626 The purpose is to bring uniform application and interpretation of the

DTA in all EAC partner states. This means that there are no transfer pricing

guidelines at community level. Therefore, countries have discretion to make their

own guidelines in determining arm‘s length price.

Likewise, the EAC DTA is silent on comparability aspect. However, in context of

EAC DTA practical point of view, it is not necessary that comparables should be

622
Ibid, Article 11(4).
623
Ibid, Article 12 (4).
624
Income Tax (Transfer Pricing Rules) 2014 of Tanzania, Income Tax (Transfer Pricing) 2006 of
Kenya, and Income Tax (Transfer Pricing) 2011 of Uganda respectively. For details of methods of
countries under study see chapter six and seven respectively.
625
Rule 5 (1) (a,b,c,d,and e) of Income Tax (Transfer Pricing Rules) 2014 of Tanzania, Rule 7 (a,
b,c,d,and e) of Income Tax (Transfer Pricing) 2006 of Kenya; See also, Blank M. et al., Double
Taxation Avoidance Agreement of EAC handbook, W.B. Druckerei GmbH, Hochheim am Main,
Germany, p.123.
626
Ibid, p.ix.
 155

identical.627 Thus, the comparability aspect is based on none of the differences that

can materially affect the price or reasonable accurate adjustment that can be made.628

Adjustments arising out of comparability may result in different arm‘s length price.

It may be more or less the same with price between related parties. From practical

point of view, different ranges of prices are allowed as transfer prices provided they

are within the range of price compared.629 Comparability analysis is based on OECD

Guidelines because the EAC DTA is based on the OECD model. Consequently,

domestic transfer pricing regulations are interpreted in line with OECD Guidelines.

For example, Rule 9 of Income Tax (Transfer Pricing Rules) of 2014 of Tanzania

clearly requires such rules to be interpreted in line with OECD and UN models. To

the contrary, such requirement does not exist in Kenyan transfer pricing law. In

addition, issues related to documentation requirement and transfer pricing audits are

regulated by individual countries‘ domestic laws. While the EAC aims at bringing

uniform interpretation within its member states, lack of clear transfer pricing

Guidelines of the community may impede such desire from being obtained.

4.7 Transfer Pricing Dispute Resolution Mechanism in EAC

MNCs‘ operations in various countries have not been very smooth. While struggling

to obtain profit in a cause of their businesses, they found engaging in dispute with tax

authorities. It is common knowledge that tax avoidance is lawful and the tax payer is

allowed to arrange tax affairs to minimize tax liability. However, MNCs have taken

627
This can be inferred from Income transfer pricing regulations of member states which requires
adjustment to be made on comparables provided do not affect the expected arm‘s length price. See
discussion in chapter 6 at para 6.4.3.2; See also Blank M. et al., note 633 p.146.
628
Ibid.
629
An interview with TRA officials. See also Income Tax (Transfer Pricing Rules) 2014 of
Tanzania.For more details see discussion on chapter 6 at para 6.4.3.2
 156

advantage of loopholes that are found in law to avoid tax beyond legal requirements.

Accordingly, MNCs have been manipulating transfer prices by using the same laws

either by over- or under- pricing goods and services transacted between them. To this

extent, tax revenue of the host countries where MNCs operate comes in to play by

auditing accounts of a particular company to establish such manipulation. When the

revenue authority is satisfied that there is existence of any special arrangement,

which amounts to manipulation of prices, the revenue authority makes adjustment to

such prices by reflecting arm‘s length price. Thus, transfer pricing cases happen

when the revenue authority is claiming its right share of tax, which it believes to be

lost because the arm‘s length was not taken in account by MNCs, while MNCs claim

that the arm‘s length principle was adhered to and no tax needs to be adjusted.

Generally, the EAC DTA does not provide specific transfer pricing dispute

resolution mechanism. In case of any dispute arising out of this agreement, the

person may take the matter to the competent authority within two years from the first

date of notification. The person can take the matter for two reasons only. First, if it is

being taxed not in accordance with the agreement and second, if a person is not

handled according to nondiscrimination principle.630 Arguably, there are no special

provisions or guidelines in handling transfer pricing. Each country is handling such

disputes according to its domestic transfer pricing laws.

630
Article 26 of EAC DTA.
 157

4.8 Conclusion

The preceding analyses lead to conclusion that EAC instruments provide arms‘

length principle in regulating transactions between associated parties. Currently the

arms‘ length principle has been explained and applied in the context of OECD

model. This is partly because such principle is derived from OECD model. It was

imported to developing countries including EAC through liberalization of economy

policies as a way of attracting foreign investors. Essentially, transfer pricing laws of

EAC is a replica of OECD and UN models with slight modification. The EAC

instruments do not take in to account issues related to extractive sector which its

impact to transfer pricing manipulation is big.

Accordingly, rules related to taxation on source basis are weak compared to

residence principle. Moreover, the instruments do not provide limitation of benefits

provisions to limit other person to benefit from treaty. There is potential for such

DTA to impose some problems in relation to transfer price manipulation like those

caused by such models. This is because legislators seem to have failed to recognize

and draw attention on growing legal challenges of international transfer pricing

emerging from an increase in foreign associated MNCs‘ investments.

Accordingly, they have failed to make appropriate choices commensurate to the local

context while taking in to account international transfer pricing standards in crafting

domestic laws. The significant challenge in crafting transfer pricing laws

commensurate with the local context is affected by desire of EAC countries to attract

more foreign investors with a view of obtaining more tax, among other things. As a

result, legislators have been enacting laws and policies, which attract more foreign
 158

investors without taking in to account risks that may be associated with such steps, in

particular, transfer pricing issues. Apart from desire to attract foreign investment,

constant pressure from developed countries to follow international transfer pricing

standards as a benchmark in reforming local transfer pricing laws has greatly

influenced legislators to adopt such standards.

The five partners of the EAC, to date, have different provisions of law governing

transfer pricing in their respective countries as discussed in this chapter. Each state,

through its investment laws, appears to be competing with others to attract more

strategic investors to supply its internal market.631 It is clear that EAC member

states, while showing interest in economic cooperation, they do not seem to be taking

measures towards a common transfer pricing regime. The essence of the matter is

that transfer pricing laws of the partner states are of wide variety, lacking

coordination even clarity in some cases. Although arm‘s principle has been enshrined

in various countries‘ anti- avoidance legislation its application is limited to certain

transactions only. Furthermore, in EAC, issues of transfer pricing have not largely

been tested in the court of law.632 Arguably, EAC countries would need effective

transfer pricing regime to contribute towards facilitation of foreign investment in the

regional. The main concern is to find the best and appropriate approach

commensurate with the level of economic development of EAC countries. Linked

with this concern is relatively lack of capacity for EAC countries to invest across

631
See discussion in chapter six and seven below.
632
See for example Tanzania, Burundi Uganda and Rwanda. Only Kenya tested transfer pricing case
as was in Unilever Kenya Limited v Commissioner of Income Tax, Income Tax case No. 753 of
2003 of the High Court of Kenya.
 159

633
borders in particular, in developed countries Yet, EAC countries have been

involved in massive investment and market liberalization measures in promoting

foreign investment such that they may be regarded as reaffirmation of their support

for global approach of transfer pricing standards. Whilst the argument inherited from

such focus might be valid, the implication arising from implementation of foreign

investment facilitation arrangements may suggest a different conclusion. EAC tax

administrators may sometimes find that complying with international accepted

standards of transfer pricing as often developed at OECD level may put them to the

disadvantage.634 Consequently, it may be difficult for them to object the global

approach in international transfer pricing regulations, which have enclosed standards

that have already been accepted.

633
UNCTAD, World Investment Report 2014, pp. 37-39. It is stated that Kenya has crossed to Asia
countries.
634
Ali-Nakyea A. et al., International Transfer Pricing in Developing Countries, International
Transfer Pricing
Journal, 2013 (Volume 20), No. 6 November/ December 2013 pp 395 to 399 p. 395.
 160

CHAPTER FIVE

AGRESSIVE TAX PLANNING AND TRANSFER PRICING

MANIPULATION IN EAST AFRICA

5.1 Introduction

Traditionally, international transfer pricing law has evolved as tax avoidance

legislation with respect to intercompany transactions by MNCs. The rationale is to

allocate taxing rights and avoid double taxation for MNCs operating in more than

one country. From developing countries‘ perspective such as EAC, transfer pricing

laws were developed as means to promote greater inflow of foreign investments.635

Hence, policies and laws are made to reflect such objective. 636 The tax avoidance

laws on transfer pricing are mainly based on arm‘s length principle, which OECD

and UN have agreed upon as international standards for transactions between MNCs.

This has been reflected in domestic tax laws and multitude of DTAs concluded

between countries on income and capital. However, underlying policies, approaches

and interpretations seem to vary from countries to countries and in some instances it

is unclear.637

This chapter invokes theoretical aspect of transfer pricing standards in considering

the way associated MNCs have been using such standards to manipulate transfer

635
Para 4 of the UN model 2011, see also, United Nations Trade and Development, the 2002
Monetary Consensus Conference on Trade and Development , available at United Nations 2002,
A/CONF/198/11 .
636
See chapter one above.
637
Riedel N et al., The Increasing Importance of Transfer Pricing Regulations: a worldwide
overview, Oxford University Centre for Business Taxation Said Business School, Park End
Street, Oxford.OX1 1HP p. 6.
 161

pricing under the auspices of tax avoidance. Use of transfer pricing standards and

principles through aggressive tax planning to facilitate manipulation of transfer

pricing is discussed. It is argued that existing transfer pricing standards provide

potentials for associated MNCs to manipulate transfer prices. The BEPS Action plan,

which came to rescue failure of existing transfer pricing standards is reviewed and

analyzed. The chapter concludes by showing that the existing international efforts

through BEPS action plan to curb transfer pricing manipulation essentially are not

departing from arm‘s length principle.

5.2 Relationship between Tax Treaties and International Transfer Pricing

The increase of MNCs‘ operations in the globe and desire to attract foreign

investments has brought enormous policy challenges with regard to international

taxation. Such operations have put countries on how to allocate taxing rights on

income generated out of MNCs‘ transactions in countries where they operate.

Difference in tax laws between countries, which were normally exploited by MNCs

to avoid tax beyond legal requirement, is another challenge. Ordinarily, countries

have the right to tax income arising within the country. 638 In this context, foreign

investment in the host country in which income is attributable to permanent

establishment initially derived would have the first right in taxing such income.

Consequently, the home country of foreign investor would be left with no taxing or

residual taxing rights.639 Consistent with this there is no contractual obligation

638
This is according to territorial principle of international law.
639
Michael L., The UN Model Tax Convention as Compared with the OECD Model Tax Convention –
Current points of Differences and Recent Development, Asia – Pacific Tax Bulletin, January
/February 2009, p.4.
 162

between the foreign investor and the host country to enforce taxing rights in the

investor‘s country in case of tax dispute. If the resident country would use unilateral

exemption system to prevent double taxation, no tax would be collected on income

derived from the source country. Likewise, if unilateral credit system is used it

would only collect tax to the extent if any, that its tax rate exceeds that of the source

country.640 Thus, the DTAs came in to play to capture taxes having foreign elements,

which countries are unable to capture. Consequently, it necessitated countries to

change unilateral and domestic laws to adopt double tax agreements (DTAs) to

capture such tax. The OECD and UN conventions are tax treaties made as models

upon which countries refer when crafting their transfer pricing laws. Both UN and

OECD models present an important form of technical assistance upon which existing

and future bilateral tax treaties commonly known as double tax agreements (DTAs)

are based.641 From developed countries‘ perspective, the conclusion of tax treaties

between them is seen as an important aspect to trade and investment. 642 Developed

countries were also investing in developing countries felt that the then existing tax

treaties between them were not working well to developing countries as rightly

pointed out by Fiscal Committee of the Organization for Economic Co-operation and

Development that,

―Existing treaties between industrialized countries sometimes

require the country of residence to give up revenue. More often,
however, it is the country of source which gives up revenue. Such
a pattern may not be equally appropriate in treaties between
developing and industrialized countries because income flows are
largely from developing to industrialized countries and the

640
Ibid. See also Mc Gauran K., note 30, p.11.
641
Economic and Social Council resolution 1541 (XLIX).
642
OECD., Fiscal Incentives for Private Investment in Developing Countries: Report of the OECD
Fiscal Committee, Paris, 1965, para 163.
 163

revenue sacrifice would be one-sided. But there are many

provisions in existing tax conventions that have a valid place in
conventions between capital-exporting and developing countries
too.”643

Developed countries also were of view that tax treaties could benefit developing

countries in a way they do to developed countries.644 It is in this context that UN

Economic and Social Council set an ad hoc group of experts and tax administrators

to formulate tax treaty guidelines645 between developed and developing countries.

The result was that the UN model as model convention for developing countries

came in to play. From developing countries‘ conclusion of DTAs, it is seen as means

to attract foreign investments and to avoid double taxation.646

Generally, DTAs are enabled by substantive laws of a particular country. 647 By

signing DTAs, states invariably give up some taxing rights, the extent of which is

subject to lengthy and complex treaty negotiations with another state whereby

mutual investment takes place.648 Contracting countries expect equal rights on

apportionment of tax that arises from international transactions. This is possible if

both countries have more or less the same level of investment.

643
Ibid, para 163 and 164.
644
Ibid, para 163. On its opinion Fiscal Committee of the Organization for Economic Co-operation
and Development stated that ―the traditional tax conventions have not commended themselves to
developing countries‖. Therefore there was a need to help developing countries to develop tax
treaty guideline. see para 164.
645
Economic and Social Council of the United Nations, Resolution 1273 (XLIII) adopted on 4 August
1967. From Africa, Ghana, Tunisia and Sudan were members to the ad hoc group. These efforts
were influenced by developed countries.
646
see for example DTA between Denmark and Tanzania for avoidance of double taxation and the
prevention of fiscal evasion with respect to taxes on income and capital, 1976 which came in to
force 1st January, 1977, see also Agreement between Canada and United Republic of Tanzania for
the Avoidance of Double Taxation and Prevention of Fiscal Evasion with Respect to Taxes on
Income and Capital, 1996 which came in to force 29th August 1997.
647
See for example section 41 of ITA Cap 470 RE 2014.
648
Mc Gauran, note 30p.12
 164

Accordingly, the invariably given up taxing rights may be offset by reduction in

administrative burden in investment and hence, accrue revenue for both countries.649

The situation is different when DTA is signed by two countries with different

investment levels, particularly between developed and developing countries. The

developing countries most likely are mere capital importers and therefore, trading off

taxing rights might not be the same. This is because home countries where

investments are sourced retain taxing rights on profits earned by their corporations in

host countries through resident principle. Since countries have given up some taxing

rights, it is not easy for developing countries like EAC to offset such taxing rights.

The situation becomes worse when developing countries signed DTA with tax haven

countries650 whereby there is possibility for MNCs to use for treaty shopping

purposes.651 The fact that arm‘s length is enshrined in model tax conventions in

which countries have adopted in their respective countries, DTAs and domestic laws

provide a direct link with transfer pricing. Accordingly, other standards that link with

determination of arm‘s length price are also enshrined in the convention models.

Application of such standards provides potential challenges in applying arm‘s length

principle to curb transfer pricing manipulation.

649
Ibid.
650
See DTA between Tanzania and Switzerland, Uganda and Netherlands.
651
Treaty shopping is a ―graphic expression used to describe act of resident of a third country taking
advantage of a fiscal treaty between two contracting states‖ see Union of India and Azadi Bachao
Andolan [2003] SC 56ITR India P. 113; In EAC for example, Uganda has DTA with Netherlands
which is regarded as tax haven country, there is possibility of MNCs to set conduit entities for
purpose of enjoying favorable terms of the treaty resulting in profit shifting through transfer
pricing.
 165

5.3 International Transfer Pricing Standards and its Link to Price

Manipulation

Although every DTA has a particular language, several standards are shared between

majorities of double tax instruments. Standards that are commonly found in DTAs

include allocation of taxing rights between contracting countries, defining persons

who are entitled benefits of treaty, tax avoidance and relevant tax principles between

contracting countries, exchange of information, mutual agreement, non-

discrimination and anti-treaty shopping provisions.652 Although such standards are

not expressly addressing transfer prices, they provide basis upon which both tax

authorities and MNCs consider when dealing with transfer prices. Accordingly, they

are the same standards and laws that may be used by MNCs under the umbrella of

tax avoidance to manipulate transfer prices. The following part examines principles

and standards as they link and implicate international transfer pricing

manipulation.653

5.3.1 Application of Arm’s Length Principle

The EAC countries have included arm‘s length principle in their DTAs and domestic

laws.654 The principle is premised in comparability of transactions between

associated and independent parties based on their economic or financial relations.

The principle requires transactions between associated MNCs to be delineated first

and then compared to an independent transaction. This is achieved by using

functional analysis through relevant economic factors. Methods to arrive at arm‘s

652
See OECD and UN models. For more details see chapter 3.
653
This particular part is discussed in context of EAC.
654
See article 9 of DTA between Tanzania and Canada, Kenya and UK, Uganda and Netherland, EAC
double tax agreement.
 166

length are employed in making such comparison.655 Where it is established that a

delineated transaction is more or less the same with transaction of independent

parties, then transfer price between associated parties is said to be arm‘s length price.

The fact that arm‘s length principle is based on comparability; arguably, in absence

of comparables it may render application of arm‘s length inapplicable. In due regard,

associated MNCs may take advantage of the situation. For example, it is common

knowledge that in developing countries like EAC countries, most investors import

technology on their area of investment. It is likely that such technology may miss

comparables.

Apart from comparables, there is no requirement for hierarchal application of

methods to arrive at arm‘s length price and the taxpayer is at liberty to choose any

method that deems fit for its transaction. The problem is that the taxpayer may

choose a method that may favour its interest even if other methods could be highly

appropriate for such transaction.656 Accordingly, the interplay between arm‘s length

principle and other standards that provide bases for transfer pricing provide

potentials for transfer pricing manipulation.

5.3.2 Allocation of Taxing Rights

The DTAs that EAC countries have concluded specify standards for allocation of

taxing rights for MNCs‘ income operating in contracting countries. 657 The standards

require that source country to tax active income only if they are attributable to

655
For more details on methods to arrive at arm‘s length price see discussion on chapter 2.
656
In practice however, CUP is regarded as a traditional methods and associated parties ought to use
that method first before embarking to other methods.
657
Cooper J. et al., Transfer Pricing and Developing Economies: A handbook for Policy Makers and
Practitioners, Directions in Development. Washington, DC: World Bank. doi:10.1596/978-1-
46480969-9. License: Creative Commons Attribution CC BY 3.0 IGO, 2016, p.35.
 167

permanent establishment.658 This means that a permanent establishment cannot pay

corporate tax in the host country. The right to tax passive incomes such as

dividends, interest and royalties is completely removed from source country unless

there is permanent establishment with a specified rate that the source country can

impose tax.659 Such standards also set limits upon which a source country can tax

passive income. For example, both DTAs between Canada and Tanzania and UK and

Kenya require source country to tax passive income amount, which does not exceed

15 percent of gross amount of such income.660 The requirement that business profit

in context of transfer pricing be taxed on resident basis and limited right to tax

passive income by source country entails that MNCs are entitled more taxing rights

than source country. This implies that EAC as source countries are denied their right

share of tax, which could be obtained from MNCs‘ transactions. Arguably, this is

the effect of OECD based DTAs because such standards were set to reflect

developed countries, in particular, OECD members‘ interests in reducing source

based taxation of capital exporting enterprises.661

In context of transfer pricing, allocation of taxing rights is done by using arm‘s

length principle. Such principle requires business profit of associated enterprises to

be taxed separately at a market price as if they are independent parties.662 Such

allocation is made by adjusting business profits believed not to be taxed under arm‘s

658
Article 7(1) of DTA between Canada and Tanzania; see also Article 8(1) of the DTA between UK
and Kenya.
659
Ibid, Articles 10 (1), 11(1) and 12(1), see also, Articles 11 (1), 12 (1) and 13 (1) of DTA between
UK and Kenya.
660
Ibid, Article 10 (2) (a), 11 (2) and 12 (2), see also Article 11 (1) (b), 12 (2) and 13(2) of DTA
between UK and Kenya.
661
McGauran, K., note 30 p.14.
662
Article 9 of DTA between of Canada and Tanzania and Article 10 of DTA between UK and
Kenya. For more details on arm‘s length principle see chapter 3.
 168

length principle. Thus, a source country will potentially be expected to align its

transfer pricing law in a manner that is in line with DTAs. To import such principle

may mean to protect profits of MNCs. The right to tax passive income on resident

basis as enshrined in EAC countries‘ DTAs gives room for MNCs to manipulate

transfer prices that may arise out of passive income such as interest. For example, for

MNCs to establish and manage their activities, they require equity or debt capital.

When a new subsidiary company is established, the parent company may finance

working capital in short-term until it starts making profit. Such capital may be

equity, which increases the credit base of the company or loan and shows in the debt

column of the company‘s account such that it will have to be paid with interest.663 In

context of transfer pricing, when determining arm‘s length interest, the rate of

interest on loan, capital amount of the loan, the currency and the credit worthiness of

the borrower must be considered.664 When a company is having higher level of debt

capital than equity, it is said to be thin capitalized.

The result is that profits from the new subsidiary may be repatriated to repay debt at

an interest rate higher than arm‘s length price. Consequently, the EAC countries may

lose their share of tax because such an income may be shifted from one entity to

another in form of interest payable on loan amount.665

663
Cobham, A., et al, note 37. p. 5.
664
Ibid,
665
Although substantive laws of countries provide for thin capitalization ratios, the interpretation of
treaty prevails over countries law and therefore there is little host country could do.
 169

The DTAs also require that any other income not dealt with in other articles of such

DTA be taxed only by resident country.666 Basically, the principle extends more

taxing rights to resident than source country. Arguably, such principle would work

well if both contracting countries have more or less some level of economic

development with reciprocal investments. In this context, both contracting countries

stand to benefit from such income that may arise and not deal with other provisions

of the particular DTA.667 To the contrary, EAC countries are having low level of

economic development and therefore, they have no capacity to invest in developed

countries that they signed DTAs. It means that EAC countries stand to lose more tax

than developed countries. Implementation of such principle would mean that

associated MNCs, in context of transfer pricing, may allow permanent establishment

to take advantage to generate incomes not covered by particular DTA such that they

would be taxed on resident basis only. It implies that tax rights as allocated in DTAs

potentially play a role of shifting taxing rights from source country to resident

country of an investor or to tax haven countries.668

5.3.3 Qualification for DTA Benefits

Normally, DTAs provide persons entitled to benefit from such agreements with a

view of ensuring that taxing rights are allocated accordingly. EAC countries‘ DTAs

have concluded and adopted meaning of legal persons for purpose of enjoying treaty

benefits. DTAs grant benefits to residents of both contracting countries who are
666
Article 22(1) of DTA between Canada and Tanzania; see also Article 24 of DTA between UK and
Kenya.
667
This requirement may work well within EAC because the level of economic and investment is
more or less equal.
668
Busse M., et al The relationship between double taxation treaties and foreign direct
investment.2010, p.5 available at http://www.researchgate.net/publication/210417692 assessed30th
June 2015.
 170

liable for tax therein by reason of domicile, residence, place of effective

management, place of incorporation or any other criterion of similar nature.669

Accordingly, domestic laws have also adopted the same meaning. 670 In context of

such definition, a corporation is a resident of that state if it is incorporated or where

the place of effective management is situated.671 Furthermore, the definition of

residence includes any other ―criterion of similar nature‖ in determining residence of

a corporation for treaty benefits and allocation of tax rights. This definition is open-

ended because it has potential to cover other legal entities, depending on MNCs‘

activities. The broad definition of residence is influenced by the character of MNCs‘

operations operating across countries. It is argued that qualification of corporation as

a residence by way of ‗effective management‘ and any other ‗criterion of similar

nature‘ may create room for taking a variety of legal entities that evolve in response

to creativity of MNCs‘ activities in profit maximization. It may include special

purpose entities672 or companies, which have no physical activities in a particular

669
Article 4 of the DTA between Tanzania and Canada.
670
Section 66 4 (a) and (b) ITA RE 2008.
671
See article 3 (a) and (b) of DTA between Tanzania and Canada. For meaning of effective
management See discussion chapter 3.
672
The OECD definition of SPEs is as follows: ―Multinational enterprises (MNEs) often diversify
their investments geographically through various organizational structures. These may include
certain types of Special Purpose Entities. Examples are financing subsidiaries, conduits, holding
companies, shell companies, shelf companies and brass-plate companies. Although there is no
universal definition of SPEs, they do share a number of features. They are all legal entities that have
little or no employment, or operations, or physical presence in the jurisdiction in which they are
created by their parent enterprises which are typically located in other jurisdictions (economies).
They are often used as devices to raise capital or to hold assets and liabilities and usually do not
undertake significant production. An enterprise is usually considered as an SPE if it meets the
following criteria: (i) The enterprise is a legal entity, a. Formally registered with a national
authority; and b. subject to fiscal and other legal obligations of the economy in which it is resident.
(ii) The enterprise is ultimately controlled by a non-resident parent, directly or indirectly. (iii) The
enterprise has no or few employees, little or no production in the host economy and little or no
physical presence. (iv)Almost all the assets and liabilities of the enterprise represent investments in
or from other countries. (v) The core business of the enterprise consists of group financing or
holding activities, that is – viewed from the perspective of the compiler in a given country – the
channeling of funds from non-residents to other non-residents. However, in its daily activities,
 171

country, but may qualify for benefits under DTAs.673Accordingly, such DTAs do not

provide any test to qualify a corporation or any other legal entity to treaty benefits.

For example, requirement that the corporation must itself carry on business in a

whole or part in the country of residence or the corporation must not be merely an

investment holding company not carrying business at all.674 The implication of this is

that it not only broadens the scope within which resident corporations may be created

but also it widens obligation of the source (host) country in dealing with transfer

pricing issues between associated MNCs.

The importance of such criterion is that the EAC becomes vulnerable to transfer

pricing issues in the following scenarios: Firstly, there is potential for the host

country to lose right share of tax because more taxing rights are on residence basis of

MNCs. Accordingly, EAC countries have no reciprocal investments with developed

countries that they signed DTA and hence, they do not have corporation, which can

be taxed on residence basis to benefit them. Secondly, MNCs have capacity to

establish special purpose entities that may be used to shift profit obtained from

transfer pricing manipulation. Accordingly, MNCs have large networks of DTAs that

they may use treaty shopping675 advantage and make difficult for host country to

managing and directing plays only a minor role.‖ See the 4 th Edition of the OECD Benchmark
Definition of Foreign Direct Investment.
673
Although interpretation of DTA require adherence of Vienna Convention that in case of conflict,
provisions of treaty need to be interpreted in good faith, and that provision of treaty prevails in case
of conflict. Conduit entities may fall within DTA because of any other criterion notion embodied in
DTAs. This is so because in interpreting provision of treaty, definition of particular treaty prevails
over other methods of interpretation. Again, notion of ‗good faith‘ as enshrined in DTAs is vague
and not measurable. See Vogel, K., note 262.
674
Ward D.A., Access to Tax Treaty Benefits, Advisory Panel on Canada, Research Report prepared
for Advisory Panel on Canada‘s System of International Taxation, 2008, p. 4.
675
Treaty shopping is a ―graphic expression used to describe act of resident of a third country taking
advantage of a fiscal treaty between two contracting states‖ see Union of India and Azadi Bachao
Andolan (2003) SC 56ITR INDIA P. 113.
 172

implement anti-treaty measures. Thirdly, in case of transfer pricing dispute, it may be

difficult for EAC to conduct audit and obtain comparables for functional analysis

purposes. Generally, the broad definition of residence of a corporation provides

potential for manipulation of transfer prices between associated MNCs. Such

potentials are exacerbated by the fact that EAC tax authorities have low

administrative capacity to handle transfer pricing issues.676 Hence, MNCs stand to

benefit more on residence principle than the source country.

5.3.4 Exchange of Information and Administrative Cooperation

Exchange of information is another principal enshrined in EAC countries‘ DTAs.677

The essence of this principle is that tax revenue of contracting countries should be

able to obtain information on financial and economic activities of their residents,

either corporations or individuals operating across countries for purpose of enforcing

tax compliance. This principle offers foundation for assistance, cooperation and

coordination in resolving enforceability of international tax problems between

contracting countries. However, exchange of information for tax purposes is not

automatic and it can only be obtained upon request. Yet, the country, which

information is requested from is not treated to be under obligation to do so.678 From

EAC countries‘ perspective, tax transparency prays an important role because

manipulation of transfer prices by MNCs is an obstacle in obtaining their right share

of tax. Thus, use of this principle could be useful for EAC countries. The gist of the

matter is that arm‘s length principle requires analysis of various data used by a

676
Absence of transfer pricing cases in some of EAC countries may be taken as evidence.
677
Article 30 of DTA between Canada and Tanzania.
678
Article 30 of DTA between Tanzania and Canada.
 173

taxpayer to establish whether or not the principle was followed. To the contrary,

inclusion of exchange information does not ensure detection of manipulation of

prices. A mere request of information cannot detect such offences. From legal point

of view, strong evidence needs to exist so as to request information from another

country. This is because the DTAs do not make exchange of information between

contracting countries as mandatory and such situation poses serious difficulties for

effective information exchange. Since manipulation of prices is within parameters of

tax planning associated with lack of transparency, it means that even initial

suspicions are hard to prove in absence of reliable information.679

5.3.5 Elimination of Double Taxation

Another important feature of DTAs, which EAC countries have concluded thus far

enshrines requirement for elimination of double taxation.680 It was the original role

of double tax treaties.681 The methods are credit and exemptions. Significance of

these provisions is that an investor is entitled to be relieved from paying tax on

income, which he has paid in a home country. Arguably, this would require

reciprocity of investment from both contracting countries. Since EAC countries are

unlikely to have investment in developed countries, they stand not to benefit from

such relief. However, most double tax relief has been solved partly through domestic

legislation provided through credit and exemption.682 As the resident country is given

679
McGauran, K . note 30 p.19.
680
Article 24 of the DTA between Canada and Tanzania, see also article 26 of DTA UK and Kenya.
681
League of Nations, Double Taxation and Tax Evasion: Report and Resolutions Submitted by the
Technical Experts to the Financial Committee of the League of Nations, League of Nations
document no. F.212, Geneva: League of Nations, February 7, 1925.
682
Article 24 of EAC DTA. See also McIntyre M.J., legal Structure of Tax Treaties, 2003 revised
edition 2010 p.2 available atwww.iatj.net/.../LegalStructureofTaxTreaties.-M.McI, Accessed
 174

more taxing right, it is also obliged to avoid double taxation. The credit method

entails the resident remaining liable in the country of residence on his or her

worldwide income. Any lowering of tax rates in the source state is calculated against

the resident state‘s tax rate, leading to one tax rate for the investor. In context of

transfer pricing, however, significant problems of double taxation still exist. It

happens when revenue authorities make adjustment in arriving at arm‘s length price

on the income, which might be already paid tax in another country. Accordingly,

given the complexities involved in arriving at arm‘s length price, there is a danger of

MNCs not to pay tax on either country.

Thus, it is submitted that arm‘s length and other transfer pricing standards as

enshrined in EAC countries‘ DTAs and in tax convention models are vulnerable to

transfer pricing manipulation between associated MNCs. Yet, EAC countries are still

embracing such standards. The embracement may be inferred due to fear from

discouraging investments, which have been seen as important means to develop their

economies.683 Recall, such standards as enshrined in EAC countries‘ DTAs are based

on OECD model.684 Accordingly, investors from OECD countries prefer OECD

model to be applicable because it favours residence principle. Given lack of

reciprocal investment from EAC countries, there is no equal bargaining power when

negotiating with such countries.685 The effect of OECD model lock in provides

potentials for EAC countries to incorporate international norms of transfer pricing,

1.May 2015, stating that, ―tax treaty to day seems reaffirming the operation of the credit or
exemption system that most countries have unilaterally adopted to prevent double tax‖.
683
See discussion chapter 4.
684
See article 9 of DTA between Tanzania and Canada, Kenya and UK, Uganda and Netherland, EAC
double tax agreement.
685
In this context EAC countries are likely to face pressure from their investors‘ home countries to
embrace OECD transfer pricing standards.
 175

which, to a great extent, remains unenforceable.686 This is evidenced by either few or

absence of transfer pricing cases in EAC. For example, to date there is no transfer

pricing case that has been decided in Tanzania, but only in Kenya few cases

including one land mark case of Unilever.687 Thus, policy makers and legislators fall

in dilemma of interaction of competing considerations of the need for raising tax

revenue and the need for attracting foreign investments. The UN model, which is

made for developing countries provides for, to a lager extent, but not exclusive right

for countries to tax on source basis. As indicated before, one purpose of the UN

model is to help developing countries in their tax treaty negotiations with developed

countries.688 However, more that 80 percent of its provisions are adopted from

OECD model, save for few provisions, which are either new or are highly brood. For

example, the definition of permanent establishment under the UN model is broader

than the OECD model.689 The UN model also provides limited force of attraction

rule that aims to deter manipulation of permanent establishment attribution rules.

Likewise, the UN definition of royalties is broader than the OECD model.690

Although the UN model is made for developing countries, it failed to solve the

existing dilemma. The failure of UN model to solve such dilemma is caused by the

following reasons: Firstly, evolution and changes of UN Model have always been

686
―Many developing countries have included in their tax legislation some of the measures requested
by the OECD Report on Harmful Tax Competition, e.g. transfer-pricing regulations based on
OECD guideline‖ See also, OECD note 22.
687
An interview with TRA officials in Tanzania and KRA Kenya.
688
Resolution 1273 (XLIII) of the Economic and Social Council of the United Nations.
689
See art. 5 of UN model, on 12 months period.
690
Article 12(3) of UN model.
 176

towards increasingly similarity with the OECD model.691 Consequently, the OECD

model has capacity to induce or destroy other models like the UN model. Secondly,

there is lack of global international tax instrument, which is above all other

convention models capable to regulate both developed and developing countries.

Thirdly, EAC countries may be lacking political power and influence on treaty

negotiation(s) with developed countries.

5.4 International Tax Planning and its Linkage to Transfer Pricing

Manipulation

Apart from tax treaties in playing a significant role in transfer pricing manipulation,

activities of tax advisers under auspices of tax planning significantly contribute to

manipulation of transfer prices by MNCs. It is common knowledge that before

starting business, normally, MNCs seek advice from tax advisers on how best they

can position their investments to minimize tax payment in a certain country. 692 The

main preoccupation is to see that MNCs minimize tax liability in their world wide

incomes. This is sought to be achieved by evaluating tax implications of various

investments and their strategies.693 Such responsibility is attained through contracts

between MNCs and tax advisers in regard to tax arrangements of their businesses

across countries. Since tax arrangements are done within auspices of tax avoidance,

they have a direct impact on transfer pricing manipulations. This part focuses on how

691
Kosters B., The United Nations Model Tax Convention and its Recent Developments, 4 Asia-
Pacific Tax Bulletin 7, 2004 arguing that ‗‗The 2001 UN model made some changes to the 1980
version of the UN model and with regards to the text, the bulk of the changes were made with a
view to bring the UN model more in line with the OECD Model‘‘) See also Baistrocchi E., The
use and interpretation of tax treaties in the emerging world: Theory and implications, in British
Tax Review, 2008 Issue 4,p.374.
692
This is in line with the transaction cost theory for establishment of MNCs. It should be noted that
the common tax advisers are KPMG, Ernest and Young, PWC and Delloite among others.
693
Interview with KPMG Tanzania office and Paulclaim accounting firmDar es Salaam.
 177

tax avoidance provisions are used by associated MNCs to manipulate prices by

avoiding tax beyond legal requirements. This may be useful for EAC legislators in

developing appropriate responses to transfer pricing manipulation problem.

It is common knowledge that every person, whether an individual or legal person,

has duty to pay tax on taxable income according to laws of the particular country.

The taxpayer ought to interpret provisions of tax legislation with the view of

complying with law requirements. Unlike other laws, tax legislation are notoriously

susceptible to different interpretations. Consequently, doubt may arise about the

exact tax results from a transaction as well as freedom of contract that enables a

choice in the legal form of a transaction or an entity.694 To create certainty in such

situation, the law allows tax payers to take advantage of the law if such law does not

create liability to pay tax or to arrange its affairs to pay less tax, which is commonly

known as tax avoidance. Generally, tax avoidance is lawful and allowed for three

related reasons: Firstly, tax payers are entitled to follow onerous interpretation of

ambiguous tax legislation. Secondly, taxpayers may exercise freedom of contract and

commerce to opt for legally permissible arrangement(s) of affairs and can take in

account options, which are cost-effective including the least onerous tax burden.

Thirdly, government designs tax laws that offer a lower tax burden to taxpayers in

defined circumstances.695 It is within this ambit that tax planning comes in to play to

allow taxpayer exercise freedom of contract and commerce in arranging tax affairs

with a view of minimizing tax burden. In essence, tax avoidance places an obligation

694
Hattingh J., Anti Avoidance Rules, a paper presented at first African tax symposium, Victoria falls
Zambia, 18-19 May 2015.
695
Ibid.
 178

to taxpayers to plan their tax affairs while taking incentive of the law without

infringing the spirit of the law and legislators‘ intention.

Tax planning ―is a process of taking into consideration all relevant factors in light of

the material non-tax matters for the purpose of determining whether or not and if so,

when, how and with whom to enter into and conduct transactions, operations

including relationships with the object of keeping the tax burden falling on taxable

events and persons as low as possible while attaining the desired business plus other

objectives.‖696 Tax planning is lawful and is allowed under the law of different

countries under tax avoidance rules.697 Both tax avoidance and tax planning are

arrangements, which aim at lawful reduction of tax liability of the tax payer.

However, the former entails securing loopholes in tax laws and minimize its tax

liability within parameters of the law,698 while the latter not only secures loopholes

but also ensures compliance with tax obligation to avoid penal provisions.699

However, ―tax planning may reach a point beyond which it cannot be tolerated

within a legal system intended to conform to principles of justice‖, 700 commonly

known as aggressive tax planning or aggressive tax avoidance.701

696
Duhia N.M.F., Advance Tax Practice 1, A Paper Presented at Tanganyika law Society Tax Law
Practice Training 22nd -25th July 2014 Beach Comber Dar es salaam. The objectives of tax planning
are minimization of tax liability or realization of tax savings or the elimination of tax liability
altogether but within the legal requirements. Accordingly it ensures availability funds to meet any
tax obligations and to minimize litigation thereby saving time, hardships and costs.
697
See for example section 23 of ITA Cap 470 R.E 2014; see also CA: Canada Revenue Agency, Tax
Avoidance, available at http://www.cra-arc.gc.ca/gncy/lrt/vvw-eng.html, Accessed 20 August 2015.
698
See OECD, Glossary of Tax Terms, available at:
http://www.oecd.org/ctp/glossaryoftaxterms.htm#E Accessed 2015 which defines tax avoidance as
arrangement of a taxpayer‘s affairs that is intended to reduce his tax liability. Although the
arrangement could be legal (i.e. in line with ―the letter of the law‖), it is usually in contradiction
with the intent of the law it purports to follow (i.e. against ―the spirit of the law‖).
699
Ibid.
700
Vogel K., note 262, p 117.
701
For the purpose of this work aggressive tax planning is used.
 179

Generally, there is no clear demarcation between aggressive tax planning and tax

avoidance. However, MNCs usually use schemes that fall between tax evasion and

tax avoidance and take advantage of variation of laws between countries.702

Sometimes the distinction between aggressive tax planning and tax avoidance can be

made by courts.703 It is submitted that tax avoidance is the one that results in

benefits that are intended by the legislatures. To the contrary, aggressive tax planning

is one that results in benefits that are not intended by the law and infringes the spirit

of the law together with purpose of the legislator.704 However, it can be argued that

the difference between lawful avoidance and aggressive tax planning can be inferred

from the taxpayers‘ intentions. If there is malice aforethought, it may amount to

unlawful avoidance. If there is no intention then, it amounts to lawful avoidance. The

link between aggressive tax planning and MNCs is that the former arranges

associated MNCs‘ affairs such that profits are earned where they are taxed at the

lowest possible rates and expenses are incurred where their deductions yield the

greatest tax relief.705

702
Hattingh J., note 694. Tax evasion is an illegal act of not paying taxes intentionally. This is done
either by under reporting business income, deliberately underpaying taxes owed. In most countries
tax evasion is a criminal offence.
703
In IRC v Willoughby [1997] STC 995, 2004, The House of Lords described aggressive tax
avoidance ―as a course of action designed to conflict or defeat the evident intention of parliament‖.
Merks P., Tax Evasion, Tax Avoidance and Tax Planning, 34 Intertax 5 2006, p. 281.
704
Ogazón Juárez L.G., and Hamzaoui R., ‗Common strategies Against Tax Avoidance: A Global
Overview,‘ in Madalina Cotrut, International Tax Structures in the BEPS Era: An Analysis of Anti
– Abuse Measures, ed. IBFD e book, 2015 p.4 describes aggressive tax planning as arrangements
that ―push the limits‖ of acceptable tax planning and would fall into the realm of tax avoidance.
Similarly, tax avoidance exists where a taxpayer seeks to obtain a tax advantage by means of sham
or artificial transactions, considering that the law could not have intended to grant a tax advantage
in such way.
705
Arnold B.J. and Wilson J.R., Aggressive International Tax Planning by Multinational
Corporations: The Canadian Context and Possible Responses, School of Public Policy, University
of Calgary, SSP Research Papers, Vol.7 Issue 29, September 2014. p.17.
 180

5.4.1 Transfer Pricing Manipulation Schemes

As stated before, aggressive international tax planning is done by tax advisers. The

obligation of such advisers is to ensure that MNCs exploit difference in gaps in the

relevant countries‘ tax laws as well as create opportunity to reduce, defer or

eliminate MNCs‘ overall tax liability. The implication is that tax advisers always

look out for new schemes and new ways to exploit weaknesses of the law. They

promote tax avoidance schemes to their clients that are sometimes not legally

available. The said advisers may advise MNCs in complex strategies and contrived

structures that may not reflect the substance of their business and instead, they would

be designed to avoid tax.706 Such avoidance schemes are often informal

arrangements created to obtain tax benefits of the client by reducing their tax

liability, while they contravene intention of legislators that give benefits to tax

advisers.707 The interplay between associated MNCs, tax haven, tax arbitrage,

qualified and experienced lawyers and accountants and less aggressive transfer

pricing laws is a key to obtaining such objective. However, not all tax planning

amounts to transfer pricing manipulation. One of the objectives of aggressive tax

planning is minimization of taxation in a foreign operating or source country to high

tax jurisdiction either by shifting gross profit via trading structures or reducing net

profit by maximizing deductions at the taxpayer level.708 Aggressive tax planning

provides for a direct link with international transfer pricing in that tax avoidance

schemes, which do not reflect substance of associated MNCs‘ businesses involve

706
House of Commons Committee of Public Accounts, Tax avoidance: the Role of Large
Accountancy Firms (follow-up), Thirty- Eighth Report of Session 2014 -15, January 2015 p.4.
707
Australia Taxation Office, Tax Planning, available at https://www.ato.gov.au/General/Tax-
planning. Accessed 20th December 2015.
708
OECD note 246.
 181

transactions between associated MNCs uses transfer pricing. To achieve this

objective, various avoidance schemes are used by associated MNCs to manipulate

transfer prices. The schemes depend on the transaction used. The common

transaction involves tangible goods, intangibles, services and intra-group

financing.709

5.4.1.1 Under or over- Pricing of Prices and Invoices

This scheme involves over- or under- pricing of prices or invoice of goods

transferred between associated companies with a view of shifting profit. For

example, in 2012, it was discovered that Resolute Goldmine Tanzania Limited was

selling gold at US$530 per ounce to an associated company outside Tanzania. At that

time, market price of the gold was US$1,200 per ounce.710 The tax lost from such

scheme was substantial amount of royalties for the use of the mine. Over-invoicing

entails that invoices for goods transferred between associated parties do not reflect

the actual amount of transferred goods. For example, in 2011, it was established that

India reported to import 120,000 tons of cashew nuts from Tanzania. However, an

export company from Tanzania reported to have exported 80,000 tons. 711 Through

such scheme, export tax and corporate tax for 40,000 tons that were not charged were

lost. Such over-invoicing was also noted on fuel transactions imported in Tanzania,

which had import duty exception for mining in companies. 712 Notably, such miss

709
Price Waterhouse Coopers, International Transfer Pricing, 2008.
710
Bomani Mining Review Report of 2008 and Masha Mining review report of 2006.
711
Kataraihya L., Tanzania Transfer Pricing Regulations 2014, A Global perspective, A Changing
Role of Professional Accountants and related Tax policies, A paper presented at NBAA
Accountants Annual Conference 2014, AICC, Arusha, Tanzania.
712
Muganyizi T. K., Research Report 1: Mining Sector Taxation in Tanzania,‖ International Centre
for Tax and Development (Brighton, UK: Institute of Development Studies, August 2012), 20,
http://www.ictd.ac/sites/default/files/ICTD%20Research%20 Report%201_0.pdf p.26 accessed
July 2015
 182

invoicing was from tax haven countries, namely, Switzerland and Singapore.

Tanzania, for example, lost more than 19.69 Pound Sterling between 2005 and 2007

as a result of bilateral trade mispricing with the EU and USA.713 A study by Global

Financial integrity reveals that African countries such as Tanzania, Ghana, Kenya,

Uganda and Mozambique collectively lost US$ 14.39 billion between 2002 and

2011.714

5.4.1.2 Thin Capitalization

This scheme entails use of interest rate obtained from intra-financing between

associated MNCs. Generally, interest on debt is deductable by the debtor for tax

purposes but dividend on shares is not. This distinction creates strong preference for

MNCs to use debt financing so as to reduce tax in source countries where their

subsidiaries carry on business, while dividends received by resident company from

subsidiaries are often exempted from resident country‘s tax.715 The manipulation can

be done by using three ways: first, MNCs from tax haven may finance a related

company in a high tax country. The amount of interest deductable in the high tax

country is overpriced and repatriated to pay loan in a low tax country. In that way,

MNCs benefit further. Second, there is potential for overpricing of interest due to

exchange rate risks claimed in strong currency. Third, the company may thin its

capital by having a large amount of debt to equity ratio. For example, in 2007, Geita

713
Christian Aid, the Missing Millions; the Cost of Tax Dodging to Developing Countries Supported
by Scottish Government, Christian aid report 2009, p.3.
714
Clough C. et al., Hiding in Plain Sight: Trade Misinvoicing and the Impact of Revenue Loss in
Ghana, Kenya, Mozambique, Tanzania, and Uganda: 2002-2011, Global Financial Integrity Report
2014, p.
715
Wilson J.R, Aggressive International Tax planning by Multinational corporations p. 18, see also,
Cobham A. et al., note 37.
 183

Gold Mine had 125,970:1 of debt to equity ratio. Consequently, Tanzania lost

US$830 from 2001 to 2007.716

5.4.1.3 Use of Intellectual Property Rights

This scheme involves the right to use intellectual property rights such as trade mark,

technological knowhow and marketing intangibles. From practical point of view,

most MNCs operating in EAC hold intellectual property rights, which are licensed

associated companies for annual royalty payment. For example, Tanzania Breweries

Company limited (TBL) is a subsidiary of SABMiller, the largest breweries

company, which uses intellectual rights of parent company SABmiller Plc. However,

the trademark owned by the parent company for African brands are registered in the

Netherland where there no or minimal royalty taxes are paid. 717 For TBL to use trade

mark, it must pay the parent company. The TBL may treat royalty charges as

expenses that qualify for tax relief in Tanzania while the income in the hand of the

parent company attracts no or low tax rate in the Netherlands.

5.4.1.4 Use of Special Conduit Entities

The scheme entails establishment of entities, which may be incorporated in tax haven

countries where corporate tax rates are very low, for example, Mauritius corporate

tax rate is 15 percent.718In this context, MNCs may take advantage by registering

their corporations in countries where corporate tax is low. For example, MultiChoice

716
Boman Report note.
717
Hearson M. and Brook, note10. See also, Sikka P. and Willmott, H., The Tax Avoidance Industry:
Accountancy Firms on the Make, Critical Perspectives on International Business, Vol. 9 Iss: 4,
pp.415 – 443 available at www.tax.mpg.de/.../Paper_Prem_Sikka p. 30, Accessed 30th December
2015; See also, Arnold B.J., and Wilson J.R, note 705 pp18 and.26.
718
Section 44 and schedule 1 of the first schedule of Mauritius Income Tax, consolidated 2016.
 184

Tanzania is a permanent establishment of MultiChoice Africa which is wholly-

owned by Naspers Group registered in Mauritius. MNCs may take advantage on the

way various tax avoidance rules interact and develop a scheme that may reduce their

tax liability. This may be achieved by developing special transfer pricing

programmes to suit certain MNCs transactions either by increasing or reducing the

transfer prices for such particular circumstances. In World Com, a USA giant

telecommunication company increased its profit by adopting intangible creating asset

transfer pricing programme called the asset ‗management foresight‘ and registered in

low tax country, which, in turn, licensed to other associates for annual royalty

payment.719

5.4.1.5 Use of Management Fee

This scheme entails use of management fee and other costs to avoid tax. In this

context, MNCs may register management in a country where management fee is low

compared to where operations of the company are taking place. For example,

SABmiller Plc registered Bevman service Management Company in Switzerland

where the tax in Management Company is charged at a lower rate than elsewhere.

Assuming that the company is responsible in managing its subsidiary in Tanzania,

for that reason, the TBL has to pay Bevman fee for the services received. Arguably,

MNCs potentially have opportunities to escape tax with respect to international

investment rather than domestic investment.720

719
OECD, Base Erosion and Profit shifting, 2013, p. 9. See also Tullow Oil v Uganda Revenue
Authority , TAT App no.40 of 2011 Uganda Tax Appeal Tribunal 1(16 June 2014);where Tullow
oil used disposal of mineral licensing rights to avoid tax. In Zain International BV v Commisioner
General and URA, HCT 2011 where Zain used disposal of telecommunication shares to avoid tax.
720
Rego S.O., Tax Avoidance Activities of U.S. Multinational Corporations (July 11, 2002) p. 2
available at http://ssrn.com/abstract=320343, Accessed 26th december2015; See also Leblang S.,
International Double No taxation. Tax Notes International 7/20/1998, 181-183., p.81.
 185

Accordingly, MNCs with more extensive international operations have lower

worldwide effective tax rates.721 Aggressive tax planning reduces the present value

of tax payments and generally, it increases after tax rate of return to investors‘

corporation.722 Such planning affects effective tax rate of MNCs in two ways: First,

it creates temporary or permanent book tax differences between a corporation‘s

pretax income and taxable incomes. In order to obtain an effective tax rate, pretax

income is divided to taxable income. In this context, the effective tax rate is reduced

because of various deductions on taxable income while pre-tax remains the same.723

Because of aggressive tax planning by MNCs, it is estimated that US$365 shifted

from developing to developed countries due to transfer pricing manipulations.724 As

already noted, aggressive tax planning by MNCs is done by tax advisers. In running

their activities, normally, tax advisers have their code of conduct in which they refer

while doing their businesses. Such codes of conduct does little more than shroud the

way tax advisers exploit flaws in international tax law avoidance schemes for their

clients.725 Tax advisers are also responsible for preparation of MNCs‘ group transfer

pricing policy. Group transfer pricing policy records transfer pricing practices that

yield arm‘s length results in specific circumstances. Accordingly, such policy may

721
Ibid.
722
Ibid.
723
Ibid.p.7. Effective tax rate is the average rate at which an individual or corporation is taxed. The
effective tax rate for a corporation is the average rate at which its pre-tax profits are taxed. For
corporations, the effective tax rate is computed by dividing total tax expenses of the corporation's
earnings before taxes. The effective tax rate is the net rate a taxpayer pays if all forms of taxes are
included and divided by taxable income. See investopedia dictionary online. It should be noted
that, tax system of each country sets out different rate of tax at different level of income. For
example, see first schedule of ITA Cap332 RE2008 of Tanzania. Secondly MNCs frequently use
foreign operation to avoid income taxation and ETR capture this type of tax avoidance. In this
context the company is said to have effective planning because it has reduced ETR on taxable
income while maintaining their financial accounting income. This is in line with theories for
existence of MNC and accounting transfer pricing theory.
724
Action note10Action Aid.,p.6
725
For example research done by House of Commons reveals that PWC code of conduct has that
problem. See House of Commons Report p. 3 note 89.
 186

also provide room for transfer pricing manipulation by not crafting their policy

according to arm‘s length principle as required by the law.726

The problem with tax advisers is that they are also government advisers and receive

government contracts. Accordingly, normally, governments seek assistance in

auditing their accounts.727 The effect of this is that it may be difficult to challenge

and discipline their activities. On top of that, some countries like Tanzania do not

have regulatory authorities for regulating Accounting firms. Scholars argue that big

tax advisers have established international structures and they are present in OECD

meetings. They may become potential in frustrating development of accounting

standards that can expose corporate tax avoidance schemes. 728 Accordingly, the big

firms control formulation of audit standards at international federation of

standards.729 Generally, it can be argued aggressive tax planning has given MNCs

power to exploit opportunities for avoiding tax through transfer pricing on profits

arising from MNCs activities.

Arguably, existing international transfer pricing standards potentially provide room

for MNCs to manipulate transfer prices. The interplay between aggressive tax

planning and complexities surrounding arriving at arm‘s length price exacerbate the

problem. Manipulation of prices has caused enormous profit shifts from countries

where economic activities of MNCs take place and consequently, they affect tax base

726
For example, in Unilever case The KRA provided evidence that Unilever group transfer pricing
policy is offending the provision of sect. 18 of Kenyan income tax Act. See Unilever case p.12.
727
Interview with officials Ministry of Finance Dar es Salaam and KPMG officials Dar es salaam
Tanzania.
728
Sikka P. and WillmottH., note 741, p.34.
729
Ibid.
 187

of host countries. Arm‘s length principle, which is a corner stone in regulating

transfer prices between associated MNCs, ought to provide a concrete solution to

existing problem. However, such principle is not providing a complete solution. The

problem has irked both developed and developing countries. It is in this context that

the OECD and G20 countries came up with another plan to complement the existing

arm‘s length principle and other transfer pricing standards that seem to fail. As a

result, the Base Erosion and Profit Shifting Action Plan (BEPS Action Plan) was

established. The next part examines BEPS Action Plan in curbing transfer pricing

manipulation by MNCs.

5.5 Transfer Pricing in Context of Base Erosion and Profit Shifting Action

Plan 2013

5.5.1 Background to BEPS Action Plan

The incentive provided by international transfer pricing standards to MNCs and the

role played by aggressive tax planning using both international treaties and domestic

tax laws, significantly have brought challenges in curbing manipulation of transfer

prices. Accordingly, the existing arm‘s length principle, which seems not effective

enough to catch all spheres of transfer pricing manipulations, has caused serious

profit shifting and base erosion in host countries.730 The problem has irked both

developing and developed countries. However, concerns on tax base erosion between

developed and developing countries are different. In developed countries, there is a

symmetric level of investments and therefore, the impact of base erosion may be

730
Base erosion and profit shifting is defined as ―tax planning strategies that exploit gaps and
mismatches in tax rules to make profits ―disappear‖ for tax purposes or to shift profits to locations
where there is little or no real activity but the taxes are low, resulting in little or no overall
corporate tax being paid.‖ See Ogazón Juárez L.G., and Hamzaoui R., note 704 p. 3.
 188

more or less the same. Accordingly, the tax revenue authorities of such countries are

more sophisticated to counter aggressive planning. To the contrary, developing

countries such as EAC, for a long time, have been capital importers and thus, the

impact of base erosion goes one way only. The BEPS was adopted by OECD and

G20 countries in response to the growing volume of base erosion and profit shifting

by MNCs. The BEPS Action Plan came as a measure to ensure that profit by MNCs

are taxed where economic activities generating that profit are performed or where the

value of intangible is created. The objective of BEPS action plan is,

―To complement existing standards that are designed to

prevent double taxation with instruments that prevent
double non-taxation in areas previously not covered by
international standards and that address cases of no or
low taxation associated with practices that artificially
segregate taxable income from the activities that
generate it.”731

The motive for aggressive tax planning has been caused by both domestic law and

tax treaties, which provide room to be manipulated by taxpayers. Consequently, such

planning has changed the way MNCs have been carrying on their businesses. In due

regard, MNCs have been keen to follow aggressive tax planning to keep pace with

the theory of their establishment.732 The situation has been exacerbated by

globalization, development of technology as well as communication and raise of

digital economy, which affected the physical elements‘ presence of PE for tax

purposes.733 The digital economy, in particular, has caused a large amount of money

731
OECD, BEPS Action plan 3.
732
Taking advantage of favourable conditions and cost minimization.
733
See discussion on chapter 3.
 189

to be extracted without paying any tax in either country they operate. 734 Hence,

various host countries‘ tax bases have been eroded through transfer pricing enabled

by digital economy. Although various countries have anti-avoidance tax rules,

unfortunately, the existing anti avoidance rules, in particular, arm‘s length principle

seems not sufficient enough to curb base erosion and profit shifting to keep pace with

changes caused by aggressive tax planning.735 To address those challenges, the

OECD and G20 countries adopted BEPS Action Plan as a viable solution.736 These

efforts are reaffirmation by both OECD and G20 countries that existing arm‘s length

principle on which the current rules are based present significant problems in curbing

transfer pricing manipulation.

5.5.2 An Overview of BEPS Action Plan

The BEPS Action Plan contains 15 Actions that need to be implemented as follows:

Action 1, addresses tax challenges of the digital economy, Action 2 deals with

neutralization of effects of hybrid mismatch arrangements. Action 3 requires

strengthen CFC rules and Action 4 requires limitation of base erosion via interest

deductions and other financial payments. Action 5 requires counter harmful tax

practices more effectively by taking into account transparency and substance. Action

6, requires prevention of treaty abuse; Action 7 requires prevention of artificial

avoidance of PE status and Action 8, 9 as well as 10 require assurance of transfer

734
Ogazón Juárez L.G. and Hamzaoui R. note 704.
735
A s rightly pointed out by OECD BEPS 2013 that, ―taxation is at core of countries‘ sovereign,
when countries design their tax rules , may not take in to account other countries rules and when
such domestic rules are applied may lead to gaps or friction. Accordingly, international rules that
are developed to such friction and gaps seems failed to filling such gaps and fictions. Moreover,
the existing international and domestic tax rules revealed weaknesses that create room for base
erosion and profit shifting. See background of Action Plan on Base Erosion and Profit Shifting,
OECD Publishing, 2013.
736
Individual countries and economic blocks such as EC and US have taken such initiatives.
 190

pricing outcomes in line with value creation in relation to intangibles, risks and

capital including other high-risk transactions. Action 11 requires establishment of

methodologies to collect and analyze data on BEPS address it. Action 12 requires

taxpayers to disclose their aggressive tax planning arrangements. Action 13 requires

re-examination of transfer pricing documentation. Action 14 requires countries to

make dispute resolution mechanisms more effective and Action 15 requires

development of a multilateral instrument.737

The BEPS Action Plan holistically touches associated MNCs‘ operations, in one way

or another, and where issues transfer pricing may feature indirectly. However, the

most direct provisions in context of transfer pricing are Actions 8, 9, 10, and 13. For

purpose of this work, Actions 4, 6, and 7 were considered.738 Implementation of

BEPS Action Plan measures is not uniform such that some require an immediate

action, for example, revise guidance on transfer pricing. Other measures require

changes to bilateral tax treaties and other measures require domestic law

implementation.739 In transfer pricing context, implementation requires countries to

comply with existing transfer pricing standards as administered by OECD and UN

models. It is important to note that the BEPS Action Plan is a soft law and therefore,

it is not binding to non-members like EAC.

737
OECD., Action Plan on Base Erosion and Profit Shifting, OECD Publishing, 2013. The BEPS plan
15 actions were developed by OECD for both developed and developing countries. However,
concerns of tax base erosion between developed and developing countries is different. In developed
countries there is symmetric level of investments and therefore the impact of base erosion may be
more or less the same. Accordingly, the tax revenue authorities of such countries are more
sophisticated to counter aggressive tax planning. To the contrary, developing countries for a long
time have been capital importers and thus the impact of base erosion goes one way only.
738
Action 4, 6 and 7 presents important aspects that form bases of determination of transfer price.
739
OECD question and facts.
 191

5.5.3 Guideline in Applying arm’s Length Principle in the Context of BEPS

Action Plan

The desire to align transfer pricing outcomes with value creation to counter

manipulation of transfer prices manipulation has necessitated the need to improve

application of arm‘s length principle. The fact that arm‘s length principle is a corner

stone for setting transfer pricing between associated MNCs, the principle is

strengthened to ensure that outcomes of transfer pricing are in line with value

creation. To keep pace with rules, measures and principles as enshrined in BEPS

Action Plan, specific guideline were developed by OECD in applying arm‘s length

pricing in context of BEPS. The guideline covers eight areas and is examined in

detail because they are corner stone of any transfer pricing analysis for both revenue

authorities and associated MNCs. It worth noting that arm‘s length guideline in

BEPS context is replacing Chapter I Section D of the OECD guideline for transfer

pricing 2010.740

5.5.3.1 Identifying Commercial or Financial Relations

As stated before, comparability analysis is the corner stone for arm‘s length principle

to apply. To run comparability analysis, the guide requires two important aspects to

be taken in to account. First, identification of commercial or financial relations and

conditions including economically relevant circumstances attached to those relations

so as to delineate transaction of associated MNCs. Second, an undertaking to

compare conditions and economically relevant circumstances of accurately

740
OECD/ G20 Base Erosion and profit Shifting Project, Final Report, 2015 p.15. It should be noted
that at the time when this work was written the document was not on published and therefore
reference is made to OECD/G20 G20 Base Erosion and profit Shifting Project, Final Report, 2015.
 192

delineated transactions of associated MNCs with conditions together with

economically relevant circumstances of comparable transactions between

independent corporations.741 Identification of commercial or financial relations and

conditions together with economically relevant circumstances requires the following

be done: First, to understand broadly, the industry or sector in which the MNE group

operates742 and factors affecting business performance.743 The understanding may be

derived from particulars of group of MNCs under analysis, which normally contains

information on factors affecting their performance.744 For revenue authority, such

information may be found in the master file submitted to them in accordance with

requirement of Action 13.745 Second, identification of operations of each MNC

within that group followed by analyses of activities of each MNC and then

identification of their commercial or financial relations between associates as

expressed in their transactions.746 This is done so as to delineate actual transactions

between associates.

In delineating accurate transaction, the guide requires economically relevant

circumstances in which transactions taking place should be considered.747 They

include the following: first, contractual terms of the transaction. Second, functions

performed by each of the parties to the transaction, taking into account assets used

and risks assumed, including how those functions relate to the wider generation of

741
Ibid, para 1.33.
742
The business may be mining, pharmaceutical, luxury goods, manufacturing industry,
telecommunication to mention few.
743
OECD/ G20 note 765 para 134.
744
Ibid.
745
BEPS action plan for more details on Action 6 measures see discussion below.
746
OECD/ G20 Base Erosion and profit Shifting Project, Final Report, 2015. p.15 para 1.35.
747
Ibid.
 193

value by the MNC group to which the parties belong, the circumstance surrounding

the transactions and industry practices; third, characteristics of property transferred

or services provided; fourth, economic circumstances of parties and the market in

which the parties operate; and fifth, business strategies pursued by the parties.748

5.5.3.2 The Contractual Terms of the Transaction

These are terms of contract concluded between associates of group of MNC. They

provide terms upon which goods and services between them are transferred. Such

terms may include responsibilities of each division, obligations and rights,

assumption of identified risks, and pricing arrangements. Such information is useful

because it provides for starting point of delineating transaction between them and

their intention at the time of concluding their contract. 749 Where the terms of contract

do not provide sufficient information for transfer pricing analysis, the guide requires

that resort should be made to actual conduct of the associates of the particular

MNC.750 In terms of the guide, the actual conduct of the parties should be established

by analyzing other categories of economic relevance of commercial or financial

relations.751 However, it is unclear about methods to be employed in analyzing

conduct of the parties by using other relevant economic patterns.

When it is established that characteristics of the transaction that are economically

relevant are inconsistent with the written contract between the associates, the

transaction reflected in the actual conduct of the parties should prevail in delineating

748
Ibid p. 16 para 1.36.
749
Ibid,p.18, para 1.42.
750
Ibid, para 1.43.
751
For details of other economic relevance category see note 772 above.
 194

the actual transaction of associates.752 Where there are material differences between

contractual terms and the conduct of the associated MNCs in their relations,

functions they actually performed, the assets actually used and risks actually

assumed in the context of the contractual terms should be used to determine the

factual substance as well as accurately delineate the actual transaction.753 Where

there has been a change in terms of a transaction, the guide requires examination of

circumstances surrounding the change. That should be done in order to establish

whether or not original transaction has been replaced through a new transaction with

effect from the date of change or whether or not the change reflects into intentions of

parties in the original transaction.754

5.5.3.3 Function Analysis

In determining arm‘s length price functional analysis is important in establishing

economically significant activities including responsibilities, asset used and risk

assumed by parties to the transaction. Accordingly, risk analysis is corner stone of

functional analysis for arm‘s length price purposes. Therefore, functional analysis is

useful in delineating transaction between associates for the purpose of comparing

with transaction of an independent corporation. The analysis focuses on aspects

parties actually do and capability they provide in generating value of a group as a

whole together with the contribution of each associate.755 The capability of each

associate is important in identifying economically relevant commercial or financial

relations and as such, capability affects options that are realistically available.

752
OECD/ G20 Base Erosion and profit Shifting Project, Final Report, 2015 p.18 para.1.45
753
Ibid, para 1.46.
754
Ibid, para 1.47.
755
Ibid, p. 20 para 149.
 195

Accordingly, such capability is used in comparing a similar situation in arm‘s length

arrangements.756

In analyzing risk assumed in commercial or financial relations, the guide provides

the following six steps that need to be followed: Step one involves identification of

economic risks with specificity.757 This entails definition and categories of transfer

pricing. The guide defines risk in a transfer pricing context as an effect of uncertainty

on the objectives of the business.758 Transfer pricing risks are categorized according

to source, which gives rise to such risks. They include strategic risks or marketplace

risks, infrastructure or operational risks, financial risks, transactional risks and

hazard risks.759

Step two entails determination on how specific, economically significant risks are

contractually assumed by the associated enterprises under terms of the transaction.

Contractual assumption of risk embodies risk clearly identified in the contract

between associated parties and the party assuming such risk. It provides clear

evidence of a commitment to assume risk prior to materialization of risk outcomes.

Such evidence forms an important part for revenue authorities‘ transfer pricing

analysis of risk analysis in commercial and financial relations, which may occur

years after conclusion of such contract.760 However, not every contractual exchange

of potentially higher but riskier income for lower but less risky income between

756
Ibid, p.21 para 1.53.
757
Ibid, p. 22 para 1.60.
758
Ibid, p.25 para 1.71
759
Ibid, p.27 para 1.71
760
Ibid, p.28 para 1.77 to 1.78.
 196

associated enterprises is automatically arm‘s length.761 Accordingly, the pricing

adopted in the contractual arrangements alone does not determine which party

assumes risk.762

Step three entails function analysis in relation to identification of associate(s), which

control,763 manage764 and perform risk mitigation function and have financial

capacity to assume the risk, and the associate encountered outcomes of such risks.765

Step four entails interpreting information obtained in steps 2 and 3 as well as

determine whether or not contractual assumption of risk is consistent with the

conduct of the associated enterprises and other facts of the case by analyzing whether

the associated parties follow the contractual terms; and whether the party assuming

risk, as analyzed exercises control over the risk and has the financial capacity766 to

assume the risk.767 This is sought to be achieved by analyzing whether or not the

associate follows contractual terms and whether or not the associate actually has

financial capacity to manage as well as control the risk. 768 Where or not it is

established that conduct of both parties is consistent with contractual obligations, the

761
ibid p. 29 para 1.80.
762
Ibid p.29 para para 1.81.
763
Control over risk is defined as "(i) the capability to make decisions to take on, lay off, or decline a
risk-bearing opportunity, together with the actual performance of that decision-making function
and (ii) the capability to make decisions on whether and how to respond to the risks associated
with the opportunity, together with the actual performance of that decision-making function‖. See
Ibid, p.23 para 1.65.
764
The guidance defines risk management as ―(i) the capability to make decisions to take on, lay off,
or decline a risk-bearing opportunity, together with the actual performance of that decision-making
function, (ii) the capability to make decisions on whether and how to respond to the risks
associated with the opportunity, together with the actual performance of that decision-making
function, and the capability to mitigate risk, that is the capability to take measures that affect risk
outcomes, together with the actual performance of such risk mitigation.‖ see ibid, p.22 para 1.61
765
Ibid p. 29 para 1.82
766
Is access to funding to take on the risk or to lay off the risk, to pay for the risk mitigation functions
and to bear the consequences of the risk if the risk materializes. see p. 23 para 1.64 .
767
Ibid, p. 23 para 1.64.
768
ibid p.31 para 1.86 to para 1.87.
 197

analysis is said to be complete.769 Where it is established that the conduct of the

associated parties is inconsistent with contractual terms in relation to risks, which are

economically significant, such terms may be used by third party for pricing purposes

between them. The assumption of risk should be determined according to the actual

conduct of the associates.770 Where the associate party assuming risk is not

controlling the risk, further risk analysis should be taken by using step five.771 In

establishing whether or not the party assuming risk controls that risk, the guide

requires the identified risk between associated MNCs be compared with risk of

independent parties‘ transaction as a control test.772

Step five entails allocation of risk between associates to MNCs. Under this step,

where analyses one to four establish that the party assuming risk is not controlling

that risk, then the risk should be allocated to the associate, which actually controls

and manages the risk.773 Where more than one associate controls the risk and have

finance capacity to assume the risk, the risk should be allocated to associates who

have the most control of risk.774 In circumstances where no associate parties are

identified as controls and have capacity to assume the risk, rigorous analysis of the

facts and circumstances of the independent parties‘ case will be performed for the

purpose of identifying reasons for such situation. Based on that assessment, the

revenue authorities will determine what adjustments to the transaction needed for the

769
Ibid p.31 para 1.87 Here step 5 may be skipped and step six may be considered.
770
Ibid p.31 para 1.88.
771
ibid p.32 para1.90.
772
Ibid, p.32 para 1.97.
773
Ibid, p.33 para 1.98.
774
Ibid.
 198

transaction to result in an arm‘s length price.775 Step six entails pricing of the

transaction by taking into account consequences of risk allocation. This step,

essentially, entails the relationship between performed functions and corresponding

allocation of returns of the associates in an MNC. The guide sets a general rule that

an assumed risk should be compensated with an appropriate anticipated return, and

risk mitigation should be appropriately remunerated.776 Thus, a taxpayer who

assumes and mitigates a risk will be entitled to greater anticipated remuneration than

the taxpayer that only assumes a risk or only mitigates, but does not do both. 777 The

guidance provides that associates, which have financial capacity to assume risk but

do not perform any relevant economic activities and do not exercise control over the

financial risk will not be allocated any excess profits as well as will not be entitled to

any more than a risk-free return.778

The guidance sets another general rule that, ―a functional analysis is incomplete

unless the material risks assumed by each party have been identified and considered

since the actual assumption of risks would influence the prices and other conditions

of transactions between the associated enterprises.‖779 Thus, the associate party

assuming the risk for transfer pricing purposes needs to control risk and has financial

capacity to assume the risk. However, for enterprises to have control over risk, an

enterprise is not required to perform the risk mitigation activities itself, but it is

required to be actively involved in the decision process when outsourcing these

775
Ibid, p.35 para 1.99.
776
Ibid p.34 para 1.100.
777
Ibid.
778
Ibid p.34 para 103.
779
Ibid, p.21 para 1.56.
 199

activities.780 Nevertheless, the guidance does not provide any guideline on how

taxpayers and revenue authorities will allocate risks in practical stances. Such

situation may render application of arm‘s length principle difficult to implement.

5.5.3.4 Characteristics of Property or Services

The guidance requires characteristics of property and services to be considered in

delineating controlled transaction for comparison purposes.

―In the case of transfers of tangible property, the physical features

of the property, its quality and reliability, and the availability and
volume of supply; in the case of the provision of services, the
nature and extent of the services; and in the case of intangible
property, the form of transaction (e.g. licensing or sale), the type
of property (e.g. patent, trademark, or know-how), the duration
and degree of protection, and the anticipated benefits from the use
of the property.”781

However, characteristics of service and property may be given more or less weight,

depending on the method used to arrive at arm‘s length. Expressly, more weight is

given to CUP method than other methods.782 This factor is subjective because it

depends on the method applied in transfer pricing analysis. Accordingly, lack of an

hierarchal requirement in applying arm‘s length methods contradicts with this

guidance.783 This situation may provide room to MNCs to select a method that would

not necessarily consider characteristics of the property or services. Furthermore, the

guide clearly acknowledges that practically, comparability for methods based on

gross or net profit indicators often put more emphasis on functional similarities than

780
ibid p.23 para 1.65.
781
Ibid, p.35 para 1.107.
782
ibid, p. 35 para 108.
783
According to tax models the taxpayer is at liberty to choose any methods deemed to fit in
determining arms length price.
 200

on product similarities.784 Arguably, the guide acknowledges difficulties involved in

comparing characteristics of property and services and thus, there is a danger of

setting rules, which are not implementable.

5.5.3.5 Economic Circumstances

Economic circumstances are compared for purpose of determining whether or not

differences in economic circumstances have a material effect on price and whether

reasonably accurate adjustments can be made to eliminate effects of such differences.

In terms of the guide, relevant economic circumstances for transfer pricing purposes

include, but they are not limited to, the following,

“Geographical location, the size of the market, the extent of

competition in the markets and the relative competitive positions of
the buyers and sellers, the availability of substitute goods and
services, the levels of supply and demand in the market as a whole
and in particular regions, if relevant, consumer purchasing power,
the nature and extent of government regulation of the market, costs
of production, including the costs of land, labour, and capital,
transport costs, the level of the market (e.g. retail or wholesale),
and the date and time of transactions.”785

Where economic circumstances between associated MNCs and independent

corporations are more or less the same, such situations are comparable.786 Where

economic circumstances are found to be significantly different, the guide is silent on

recourse to be taken by the MNCs or revenue authorities. Such situation may provide

advantage to MNCs to manipulate prices because they are not bound to make

comparison in absence of comparability situation.

784
Ibid, p.35 para 108.
785
Ibid, p.36 para 1.110.
786
Ibid, p. 37 para 113.
 201

5.5.3.6 Business Strategies

Business strategies are also considered when determining comparability of controlled

and uncontrolled transactions. Business strategies in context of transfer pricing

include, but they are not limited to, innovation and new product development, degree

of diversification, risk aversion, assessment of political changes and input of existing

and planned labour laws together with duration of arrangements787 and market

penetration schemes.788 Generally, a taxpayer is required to follow business strategy

that distinguishes it from potential comparables. To establish whether taxpayer

actually followed business strategy, the conduct of the parties and the cost of

business strategy should be taken in to account. The taxpayer is deemed to follow

business strategy if he produces a return sufficient to justify its costs within a period

of time that would be acceptable in an arm‘s length arrangement. 789 This is possible

only if the taxpayer is in a position to foresee such expectations.790 However, if such

an expected outcome was not foreseeable at the time of the transaction or if the

business strategy is unsuccessful but nonetheless is continued beyond what an

independent corporation would accept, the arm‘s length nature of the business

strategy may be doubtful and may warrant a transfer pricing adjustment. Certainty of

the law is very important for its implementation. Arguably, examination of economic

strategies for transfer pricing purposes is based on possibilities and expectation.

From practical point of view, it may be difficult for revenue authorities to establish

whether a taxpayer was in a position to foresee results of such strategy because a

foreseeable element is not measurable. Accordingly, the guide is silent under

787
Ibid p. 37 para 114.
788
Ibid para 1.115.
789
Ibid para 1.118.
790
Ibid.
 202

circumstances the taxpayer was in a position to see what was coming. Such

uncertainties may provide chances to associated MNCs to manipulate prices.

5.5.4 Recognition of the Accurately Delineated Transaction

Delineated transaction between associated parties for transfer pricing purposes is

recognized once substance of the commercial or financial relations has been

identified by analyzing economically relevant factors. The actual transaction as

delineated is used to determine transfer price under the arm‘s length principle.791

The general rule is that where the same transaction can be seen between independent

parties in comparable circumstances, such transaction should be recognized for

transfer pricing purposes.792 However, there is an exception to this rule. The

accurately delineated transaction can be disregarded for transfer pricing purposes if

such transaction viewed in its entirety lacks commercial rationality of arrangements

between unrelated parties in comparable circumstances. The guide does not clearly

set out under what circumstances can accurately delineate transaction can be

disregarded but this is inferred from examples provided in the guide.793

5.5.5 Losses

The guide also requires losses to be examined for transfer pricing purposes if the

associate of MNC continuously makes losses while continuing to carry on with

business.794 The assumption is that an associate cannot continue to make business if

it always makes losses. Therefore, there is a way in which associate MNCs benefit

791
Ibid p. 39 para 1.121.
792
Ibid, p.39 para 1.122.
793
Ibid para 1.125 and 1.126.
794
Para 1.130.
 203

from that business. Hence, only justifiable losses may not be taken in to account for

transfer pricing analysis purposes. Thus, both taxpayer and revenue authorities have

to analyze justifiable losses that may not be taken in to account for transfer pricing

purposes.795 In terms of guide, the losses are justifiable if they are recurring for a

reasonable period and they are made for specific objectives of the business

strategy.796Accordingly, same types of losses that an independent corporation would

have incurred under the arm‘s length principle. The losses are not justified if in

context of business strategy they continue beyond a reasonable period, particularly

where comparable data over several years show that the losses have been incurred

for a period longer than that affecting comparable independent corporation.

However, the guide does not provide guideline on period deemed to be reasonable.

Again, the term reasonable as used is vague and not measurable such that it provides

uncertainty of the law.

5.5.6 Effect of Government Policies

The effect of government policies must be taken into account in evaluating transfer

price between associate MNCs as a condition affecting market in a particular

country. Sometimes the government makes intervention in the market for policy

reasons and actually affects transactions.797 The affected transaction of associate

MNCs should be compared with transaction of independent parties affected by the

795
Ibid, p. 41 para 1.131 .
796
Ibid
797
Ibid, p.41 para 1.132 Such intervention may include ―price controls (even price cuts), interest rate
controls, and controls over payments for services or management fees, controls over the payment of
royalties, subsidies to particular sectors, exchange control, anti-dumping duties, or exchange rate‖.
 204

same intervention.798 In determining arm‘s length price, the revenue authorities are

required to adjust arm‘s length price to account for government intervention. Where

the government intervention applies only to transactions between associated MNCs,

the guide clearly states that,

―There is no simple solution to the problem. Perhaps one way to

deal with the issue is to apply the arm‟s length principle viewing
the intervention as a condition affecting the terms of the
transaction. Treaties may specifically address the approaches
available to the treaty partners where such circumstances exist.‖799

In essence, the guide acknowledges difficulties involved in applying arm‘s length

principle. Use of words like ‗perhaps‘ suggests probability and failure to provide

concrete solution(s) to application of arm‘s length principle. In addition, the guide is

silent on a situation where there is no DTA between countries. It means that the

guide provides incomplete solutions in applying arm‘s length principle. Although

both taxpayer and revenue authorities are likely to be affected, the revenue authority

stands to lose more than the taxpayer.

5.5.7 Use of Customs Valuations

The guide recognizes that arm‘s length principle is used by customs administration

as comparison of value of imported goods between related seller and buyer. Just like

in transfer pricing, special relations that exist between related seller and buyer may

affect the value of imported goods for customs evaluation purposes. Thus, customs

evaluation may be used by revenue authorities in evaluating the arm‘s length

798
Ibid,
799
Ibid p.42 para 1.134.
 205

character of a controlled transaction transfer price and vice versa. 800 This is possible

because customs officials may have contemporaneous information regarding the

transaction that could be relevant for transfer pricing purposes, especially if prepared

by the taxpayer, while tax authorities may have transfer pricing documentation,

which provide detailed information on circumstances of the transaction.801 However,

it requires cooperation between income tax and customs administration in evaluating

transfer prices within the country.

5.5.8 Location Savings and Other Local Market Features

Location savings refer to a situation whereby associated MNCs relocate some of

their activities to a place where costs are lower than in location where activities were

initially performed. The location savings and other local market features may affect

comparability including arm‘s length prices. With regard to location savings for

transfer pricing purposes, it is necessary to determine whether location servings

shared between associated MNCs.802 Where the functional analysis shows that

location savings exist that are not passed on to customers or suppliers, and where

comparable in the local market are present, such comparables will be sufficient to

provide basis upon net location savings should be allocated among associated

MNCs.803 In absence of comparables, allocation should base on analysis of function

performed, risks assumed and assets used of the relevant associated MNC. With

800
Ibid, p.43 para 1.137.
801
Ibid.
802
Ibid, p.44 para 1.141, this is sought to be achieved by examining whether location savings exist;
(ii) the amount of any location savings; (iii) the extent to which location savings are either retained
by a member or members of the MNE group or are passed on to independent customers or
suppliers; and (iv) where location savings are not fully passed on to independent customers or
suppliers, the manner in which independent enterprises operating under similar circumstances
would allocate any retained net location savings.
803
Ibid p.44 para 1.142.
 206

regard to other local market features,804 it is necessary to examine data on

comparable uncontrolled transactions in that geographic market to establish whether

or not a comparability adjustment is required. Where the examined data show that

comparable local market features are present then the need for making specific

adjustments for local market features would not arise.805 In absence of reasonable

local market comparables, determination of appropriate comparability specific

adjustments for features of the local market should be based on underlying facts and

circumstances.806

The guide requires that in conducting a transfer pricing analysis, intangibles such as

contractual rights, government licenses or know-how necessary to exploit that

market should be distinguished from tangible local market features.807 The

contractual rights and government licenses may limit access of competitors to a

particular market and may affect the manner in which economic consequences of

local market features are shared between parties to a particular transaction. In these

circumstances, it is necessary to determine each affiliated party‘s contribution to

804
other local market features that may affect comparability include the relevant features that affect
Relevant characteristics of the geographic market in which products are sold, purchasing power
and product preferences of local households in that market, whether the market is expanding or
contracting, degree of competition in the market, relative availability of infrastructure in the
market, relative availability of trained and educated workforce, proximity to profitable markets and
similar features in a geographic market that create market advantages or disadvantages. See p. 44
para 1.144.
805
Ibid para 1.145.
806
―(i) whether a market advantage or disadvantage exists, (ii) the amount of any increase or decrease
in revenues, costs or profits, vis-à-vis those of identified comparables from other markets, that are
attributable to the local market advantage or disadvantage, (iii) the degree to which benefits or
burdens of local market features are passed on to independent customers or suppliers, and (iv)
where benefits or burdens attributable to local market features exist and are not fully passed on to
independent customers or suppliers, the manner in which independent enterprises operating under
similar circumstances would allocate such net benefits or burdens between them.‖ See p.44
para1.146.
807
Ibid p.45 para 1.149.
 207

obtain the license to determine allocation of profit attributable to the license of

intangible. In assessing the impact of the government license, contribution by the

local member of local market intangibles and other group members of intangibles

such as skills, experience, and knowledge should be considered.808

5.5.9 Assembled Workforce

Workforce 809 is another factor also affects transfer pricing and is taken into account

in a transfer pricing comparability analysis. The guide indicates the need to

determine benefits or detriments of the unique assembled workforce with that of

independent parties. However, the guide is silent on modalities on how the

determination can be done. The guide states that,

―where it is possible to determine the benefits or detriments of a

unique assembled workforce vis-à-vis the workforce of enterprises
engaging in potentially comparable transactions, comparability
adjustments may be made to reflect the impact of the assembled
workforce on arm‟s length prices for goods or services.”810

In absence of such possibilities, the associated may take advantage of the situation

and affect the arm‘s length price. Where an assembled workforce is transferred from

one associate to another as part of the transaction, time and cost savings should be

reflected in the arm‘s length price charged for the transferred assets. 811 If the transfer

of a workforce or a secondee results in the transfer of valuable know-how, then the

transfer of that valuable know-how should be valued in accordance with rules on

808
Ibid p.45 para 1.150.
809
Is a situation where by a corporation assembles a uniquely qualified or experienced cadre of
employees producing or providing services capable of affecting arms length price
810
Ibid, p. 46 para 1.152.
811
Ibid, p.46 para 1.153.
 208

intangibles and an appropriate price should be paid for the right to use the

intangibles.812

5.5.10 MNC Group Synergies

Associated MNCs may benefit from interactions or synergies amongst group

members that would not generally be available to similarly situate independent

enterprises. Such synergies may stem from economies of scale, combined or

integrated computer and communication systems, integrated management, and

elimination of duplicative expenses.813 Such synergies may be unfavorable if they

impose bureaucratic impediments that smaller, nimbler enterprises do not face or as a

result of additional burdens and requirements placed on units because they are part of

a large organization. Consequently, that smaller unit of associated parties receives

incidental benefits.814 Under such circumstances, no compensation should be paid for

incidental benefits received by an MNC group member solely because it is a member

of the larger MNC group.815 Where synergistic benefits and burdens of group

membership may arise because of deliberate concert the nature of the advantage or

disadvantage, the amount of the benefit or detriment and the manner the benefit or

detriment should be allocated among group members must be determined through

functional and comparability analysis.816 If important group synergies exist and can

be attributed to deliberate concerted group actions, the benefits of such synergies

should generally be shared by group members in proportion to their contribution to

812
Ibid p.46 para 1.154.
813
Ibid, p. 47 para 1.157
814
These are benefits arising solely by virtue of group affiliation and in the absence of deliberate
concerted actions or transactions leading to that benefit.
815
Ibid,p.47 para 1.158.
816
Ibid,p.47 para 1.161.
 209

creation of the synergy.817 In this context, arguably, revenue authorities must depend

on information from the taxpayer and in absence of such information, the said

processes cannot be implemented.

The review and analysis of guidance to apply arm‘s length principle in context of

BEPS Action Plan reveal that to arrive at arm‘s length price, it requires long and

complex procedure to follow. That may require sufficient well equipped human

resources and other resources to manage such analysis. However, the guidance does

not provide conclusive solution in certain areas, which seem to materially affect

transfer price between associated MNCs. The principle is subjective because it

depends on nature of transaction and available comparables. In some instances, it

does not provide practical solution(s) to relevant issues. In other circumstances, the

application depends on reasonableness and foresee-ability of certain issues, patterns,

which bring uncertainty of the law. Such uncertainty is undesired in law. Therefore,

the principle is uncertain and cannot assure countries‘ right share of taxes arising

from associated MNCs. In addition, the guidance admits difficulties involved in

arriving at arm‘s length principle. Although such guidance could be seen as

providing room for EAC countries to shape their policies and law in a manner that

would take into account international standards and principles, the way they are

formulated including complications involved in arriving at arm‘s length price, in

practice, it tends to restrict realization of objective of curbing transfer pricing

manipulation.

817
ibid p.48 para 1.162.
 210

5.6 BEPS Action Plan Measures in Curbing Transfer Pricing Manipulation

The BEPS Action Plan sets a timeframe upon, which measures in form of rules or

principles will be developed and used by countries in tackling base erosion as well as

profit shifting problems.818 Thus, OECD and G20 came up with package of measures

believed to represent the first substantial renovation of the international tax rules in

almost a century.819 Such measures are expected to render ineffective aggressive tax
820
planning as discussed below. Action four requires countries to design rules to

prevent base erosion through use of interest expense. In context of transfer pricing,

use of interest techniques is normally practiced by associated MNCs through intra-

group financing. In due regard, the OECD developed a fixed ratio rule as a measure

to prevent such concern. The rule requires associated MNCs to deduct net interest

expense economically equivalent to interest to a percentage of its earnings before

interest, taxes, depreciation and amortization (EBITDA ratio). 821 Given different

situations of countries in tackling BEPS, the OECD sets a range of 10 percent to 30

percent to ensure that countries apply a fixed ratio that would be low enough to

tackle BEPS.822 However, currently, the EBITDA is not dealing with banking and

insurance sectors because of their specific features and they require specific rules to

deal with.

818
Annex A of OECD BEPS 2013.
819
OECD/ G20 Base Erosion and profit Shifting Project, Final Report, 2015 p.2. It should be noted
that these measures were a result of the work performed on equal footing between all G20 and
OECD countries. Accordingly, European Commission substantially contributed its view
throughout the project. In addition other international organization such IMF, WB and UN also
contributed to the work. In Africa, Africa Tax Administration Forum also contributed to the
project direct through participation on committee of fiscal affairs.
820
Action 4, of the OECD Action Plan on Base Erosion and Profit Shifting, OECD Publishing, 2013
821
OECD/G20 Report p.15.
822
Ibid.
 211

Action Plan six requires countries to develop rules to prevent arrangements through

which a party who is not a resident of one of the two contracting countries of a tax

treaty to obtain benefits that the treaty grants to residents of the countries.823 These

arrangements are often implemented by establishing conduit companies for purpose

of shifting profit from host countries. In due regard, the three measures have been

taken by OECD as follows: first, countries are required to include, in their tax treaty,

a clear statement that countries to a tax treaty intend to avoid creating opportunities

for non-taxation through avoidance by using treaty shopping arrangements. Second,

there has to be inclusion of limitation on benefits rule (LOB) in DTA as specific anti-

avoidance rule.

The LOB entails to limit treaty benefits to entities that have sufficient link with its

country of residents. Third, there has to be inclusion of principle purpose of test rule

(PPT) in DTA as a general ant-avoidance rule based on principal purposes of

transaction or arrangements.824Where it is established that one of the principal

purpose of arrangements or transactions is to obtain treaty benefits, such benefits

would be denied, unless such benefits would be in accordance with the object and

purpose of provisions of the DTA.825 The PPT rule is applicable where such

transaction or arrangement is not covered by LOB.826 Action eight requires countries

to assure that transfer pricing outcomes are in line with value creation of

intangibles.827 This Action requires countries to develop rules to prevent BEPS by

823
Action 6 of the OECD Action Plan on Base Erosion and Profit Shifting, OECD Publishing, 2013.
824
OECD/G20 Report note 848, p.21-22.
825
Ibid.
826
Ibid.
827
Action 8 of the OECD Action Plan on Base Erosion and Profit Shifting, OECD Publishing, 2013
 212

moving intangibles among group members. It involves:- (i) adopting a broad and

clearly delineated definition of intangibles; (ii) ensuring that profits associated with

the transfer as well as use of intangibles are appropriately allocated in accordance

with (rather than divorced from) value creation; (iii) developing transfer pricing rules

or special measures for transfers of hard-to-value intangibles; and (iv) updating the

guidance on cost contribution arrangements.828

Measures taken in regard to definition of intangible, the word is expanded and thus,

―intangible‖ is intended to address something, which is not a physical asset or a

financial asset, capable of being owned or controlled for use in commercial activities,

whose use or transfer would be compensated had it occurred in a transaction between

independent parties in comparable circumstances.829 The guidance clearly

distinguishes intangible from market conditions or local market circumstances that

are incapable of being owned or controlled. The guidance also provides definition of

marketing intangibles as,

―An intangible that relates to marketing activities, aids in the

commercial exploitation of a product or service, and or has an important
promotional value for the product concerned. Depending on the context,
marketing intangibles may include, for example, “trademarks, trade
names, customer lists, customer relationships, and proprietary market
and customer data that is used or aids in marketing and selling goods or
services to customers.”830

With regard to allocation of profit by associated MNCs on use or transfer of

intangibles, the guidance sets a principle that legal ownership alone of intangibles by

associated MNCs does not necessarily generate a right to returns from exploitation of

828
Ibid.
829
OECD/G20 Report para 6.6.
830
Ibid, P.69.
 213

the intangible.831 In determining the arm‘s length condition for transactions that

involve use or transfer of intangibles and parts dealing with ownership, the guidance

requires six steps to be followed. First, it encompasses identifying the intangibles

used or transferred in the transaction with specificity and specific economically

significant risks associated with the development, enhancement, maintenance,

protection, and exploitation of the intangibles. Second, identifying full contractual

arrangements with special emphasis on determining legal ownership of intangibles

based on terms and conditions of legal arrangements.

Third, identifying parties performing functions, using assets, and assuming risks

related to developing, enhancing, maintaining, protecting, and exploiting the

intangibles by means of the functional analysis, and, in particular, which parties

control any outsourced functions, and control specific, economically significant

risks. Fourth, confirming consistency between terms of contractual arrangements and

conduct of the parties. Fifth, delineate actual controlled transactions in light of legal

ownership, other relevant contractual relations and the conduct of the parties; and

sixth, where possible, determine arm‘s length prices for transactions consistent with

each party‘s contributions of functions performed, assets used, and risks assumed.832

In regard to hard-to- value to intangible,833 the guideline sets the rule that the tax

administration can consider ex post outcomes as presumptive evidence about

831
Ibid, p. 65.
832
Ibid, pp.74 -75.
833
―The term hard-to-value intangibles (HTVI) covers intangibles or rights in intangibles for which, at
the time of their transfer between associated enterprises, (i) no reliable comparables exist, and (ii)
at the time the transactions was entered into, the projections of future cash flows or income
expected to be derived from the transferred intangible, or the assumptions used in valuing the
 214

appropriateness of ex ante pricing arrangements, based on reliability of information

on kind of ex ante pricing that has been based.834 The purpose of this guide is to

ensure that transfer pricing analysis is not weakened by information asymmetry

between the taxpayer and tax authorities. However, it does not take extra measures to

compel MNCs to provide information on time, particularly to developing countries.

This is important because developing countries like EAC are vulnerable to

manipulation of transfer prices. Accordingly, this approach is very cumbersome and

seems not to be realistic for EAC. It is common knowledge that most if not all

intangibles, in particular, techno know how used by MNCs in developing countries

are developed by them and it may come to countries where the MNC associates

operate after a certain couple of years. For a country like Tanzania, it may be

difficult to obtain such information. Although this approach may seem to be viable to

solve existing intangible transfer pricing, there is danger for EAC legislators to adopt

BEPS measures that are not implementable and unrealistic in the economy. Action

nine deals with risks and capital.

This Action requires countries to develop rules to prevent BEPS by transferring risks

among, or allocating excessive capital to associated MNCs. The guide focuses more

on accurately delineating transactions between associated enterprises by examining

contractual relations against the actual conduct of the parties through a transfer

pricing comparability analysis. The guide sets a principle that allocation of risk

should be considered under arm‘s length principle and that legal ownership of

finance risks alone does not create an entitlement to profits. To assume a risk for

intangible are highly uncertain, making it difficult to predict the level of ultimate success of the
intangible at the time of the transfer. See OECD/G20 Report p.110.
834
Ibid.
 215

transfer pricing purposes, the associated MNCs need to control the risk and have the

financial capacity to assume the risk.835 The guide defines control over risk as:

"(i) The capability to make decisions to take on, lay off, or decline a
risk-bearing opportunity, together with the actual performance of
that decision-making function and (ii) the capability to make
decisions on whether and how to respond to the risks associated
with the opportunity, together with the actual performance of that
decision-making function."836

Financial capacity refers to an enterprise's capability to access funding when

managing risk as well as absorbing consequences of risk in the event of an

unfavourable outcome.837

Action ten requires countries to develop rules to prevent BEPS by engaging in

transactions, which would not or would only very rarely occur between third parties.

This will involve adopting transfer pricing rules or special measures to: (i) clarify

circumstances in which transactions can be re-characterized; (ii) clarify application

of transfer pricing methods, in particular profit splits, in the context of global value

chains; and (iii) provide protection against common types of base eroding payments,

such as management fees and head office expenses.838 With regard to re

characterizing of transaction, the guide provides a principle to re-categorize

contractual terms to reflect commercial or financial patterns that actually exist

between associated MNCs based on their conduct and economically relevant

characteristics of the transaction including options realistically available to the

parties.839

835
OECD/G20 20 P.22.
836
Ibid.
837
Ibid.
838
Action10 of the OECD Action Plan on Base Erosion and Profit Shifting, OECD Publishing, 2013.
839
OECD/G20 Base Erosion and Profit Shifting Final Report 2015.pp.17 -18.
 216

In comparing situation with independent parties, the guide suggests to look at

contractual terms and actual legal ownership in light of commercial or financial

relationship between associated MNCs. Where it is established that the conduct and

characteristics, which are economically relevant are inconsistent with a written

contract between associated MNCs, the actual transaction should be delineated for

transfer pricing purposes in accordance with characteristics of the transaction

reflected in the conduct of the parties.840 Thus, the actual conduct of associated

MNCs is a key factor in delineating a transaction and aligning transfer pricing

outcome.

With regard to clarifying application of transfer pricing methods, selection of the

most appropriate transfer pricing method should be based on a functional analysis

that provides a clear understanding of the MNC‘s global business processes and the

manner intangibles interact with other functions, assets, and risks that comprise the

global business.841 In other words, it is especially important to ground comparability

and functional analysis on an understanding of the MNCs‘ global business by

identifying all factors that contribute to value creation, which may include borne

risks, specific market characteristics, location, business strategies and MNE group

synergies.842 On transfer of intangibles, the selected transfer pricing method selected

take into account all relevant factors materially contributing to creation of value, not

just intangibles and routine functions.843

840
Ibid,p.18.
841
Ibid p. 26.
842
Ibid, pp.58 -59.
843
Ibid, p.98 para 6.133.
 217

The revised guidance makes clear that any of the five OECD transfer pricing

methods as well as ‗alternative methods‘844 might constitute an appropriate transfer

pricing method for transactions involving transfers of one or more intangibles.845 In

this respect, the OECD explicitly states that a rule of thumb cannot be used as

evidence that a price or apportionment of income is arm‘s length including an

apportionment of income between a licensor and a licensee of intangibles.846

Whereas it recognizes use of thumb rule, under limited circumstances, transfer

pricing methods based on costs may be utilized, particularly where the intangibles

are not unique and valuable, for example, development of intangibles used for

internal business operations, such as internal software.847 This implies that transfer

pricing methods most likely to prove useful in matters involving intangibles is CUP

and transactional profit split method.848 In clarifying the split profit method in the

context of global value chains, the OECD is still working on it. Action thirteen deals

with re-examination of transfer pricing documentation. The Action requires countries

to develop rules regarding transfer pricing documentation to enhance transparency

for tax administration by taking into consideration compliance costs for business.849

The rules developed include a requirement that MNCs should provide all relevant

governments with needed information on their global allocation of income, economic

activity and taxes paid among countries according to a common template. Measures

844
The guideline (report) is silence as to what constitute alternative methods.
845
OECD/ G20 Base Erosion and profit Shifting Project, Final Report, 2015 p.98 para 6.136. This
implies that the transfer pricing methods most likely to prove useful in matters involving
intangibles is the transactional profit split method.
846
OECD/ G20 Base Erosion and profit Shifting Project, Final Report, 2015 p.100 para 6.144.
847
Ibid, p.100 para 6.143.
848
Ibid, p. 100 para 6.145.
849
OECD Action Plan on Base Erosion and Profit Shifting, OECD Publishing, 2013.
 218

taken by the OECD are a three-tiered standardized approach to transfer pricing

documentation to be followed.

First, MNCs are required to provide to tax authorities with high-level information

regarding their global business operations and transfer pricing policies in a ‗master

file‘ to be available to all relevant tax authorities in countries they operate.850

Second, detailed transactional transfer pricing documentation should be provided in a

‗local file‘ specific to each country, identifying material related party transactions,

the amounts involved in those transactions, and the company‘s analysis of the

transfer pricing determinations they have made with regard to those transactions.851

Third, large MNCs are required to prepare Country-by-Country files containing

information on pre-paid tax and paid tax in each country they operate. Such report

should also contain their number of employees, stated capital, retained earnings and

tangible assets in each tax jurisdiction.852

In enhancing compliance, the guide requires local files and country-by-country to be

finalized before due dates for filing tax returns for a relevant fiscal year. However,

due to some circumstances, the country-by-country submission time may be

extended up to one year.853 Tax authorities are required to maintain confidentiality of

documents availed to them by MNCs.854 Most important innovation in the guide is

that it provides templates for all three kinds of reports.855 However, the guide

850
Ibid.14.
851
Ibid, p.16.
852
Ibid, p. 1.
853
Ibid p.17.
854
Ibid p.18.
855
Ibid, Annex 1-iv.
 219

excludes associated MNCs with less than 750 million EURs to provide country-by-

country reports.856 Arguably, the enhanced three tier approach might be beneficial

for EAC countries but this is subject to improved tax revenue capacity. Accordingly,

the threshold of 750 million EURs requirement to report country-by-country pattern

is very high and creates potentials to leave out a significant number of associated

MNCs to take advantage.

Action seven requires countries to develop changes to the definition of permanent

establishment to prevent artificial avoidance of permanent establishment status in

relation to BEPS, including through use of commissionaire arrangements and the

specific activity exemptions including related profit attribution issues.857 The

measure taken by the OECD is developing a rule that a person is deemed to have PE

in the contracting state if he is acting on behalf of enterprises and habitually

concludes contract or plays a principal role leading to a conclusion of contracts in the

name of the enterprises for transfer of ownership, granting of the right to use or

provision of service without material modification by the enterprise.858 The guide

also has clarified on activities that are not deemed to be PE. They include

maintenance of a fixed place of business solely for the purpose of carrying on for the

enterprise, any other activity, provided that such activity or overall activity is of

preparatory or auxiliary nature.859 Accordingly, it developed anti-fragmentation rule

to limit associated MNCs to establish and maintain several fixed places of business

separated locally and organizations to be viewed as places of preparatory nature for

856
Ibid p.10.
857
Action 7 of the of the OECD Action Plan on Base Erosion and Profit Shifting, OECD Publishing,
2013
858
OECD/G20 Action 7, p.16.
859
Ibid.p 29.
 220

purpose of establishing existence of PE for tax purposes. 860 However, Action 7 does

not make any changes to existing international standards on allocation of taxing

rights on international income. From the foregoing, measures and principle under

BEPS Action Plan in aligning transfer pricing outcomes with value creation are still

based on arm‘s length principle.

5.7 An Alternative to Arms’ Length Principle

Use of arm‘s length principle as the corner stone for regulating transfer pricing

between associated MNCs has been, to a great extent, of benefits to MNCs more than

host countries. Both developed and developing countries have been irked by this

problem and therefore, thought has been brought to completely depart from such

principle. Scholars have suggested that formulary apportionment methods should be

applied as alternatives to arm‘s length principle.861 OECD member states also

advocate for use of formulary apportioned within European Union.862 African

countries also have called upon to adopt formulary apportionment method given

weakness of arm‘s length and lack of comparables prevailing in Africa.863 The

860
Ibid, p.39.
861
Avi –Yohah R.S. and Clausing K., Reforming Corporate Taxation, in a Global Economy: A
Proposal to Adopt Formularly Apportionment, The Brookings Institution, 2007; Picciotto. S.,
Towards Unitary Taxation of Transnational Corporations, Tax Justice Network 2012, p.1.; Cauzin
R., Policy Forum: The End of Transfer Pricing? Canadian Tax Journal 2013, 61:1 159 – 78;
Meager L., Transfer Pricing Alternatives Needed, Business and Management, 2014; Rectenwald
G., A Proposed Framework for Resolving Transfer Pricing Problem: Allocating the Tax Base of
Multinational Entities based on Real Economic Indicators of Benefit and Burden, Duke Journal of
Comparative and International Law, Vol.23:425; Altshuler R. and Geubert H., Formulary
Apportionment: It is Better than the Current System and Are there Better Alternatives? National
Tax Journal, December 2010, 63 (4 part 2), 1145 -1184.
862
Weiner J.M., Formulary Apportionment and Group Taxation in the European Union: Insights from
the United States and Canada (PDF), Working Papers No. 8, Taxation and Customs Union,
European Commission, ISSN 1725-7557, 2005. P.247. See also, EU, Towards an internal Market
without tax obstacles: A strategy for providing companies with consolidated corporate tax base for
their EU worldwide activities, Communication 0582, Brussels 2001 p.15.
863
Oguttu A.W., A Critical Analysis of what Africa‘s Response should be to the OECD BEPS Action
Plan? A paper presented at 1st Africa Tax Symposium – Zambia, 2015.
 221

argument in fovour of formulary apportionment method is that the arm‘s length

principle is unfit for global economy because it is based on artificial distinct legal

entities; it creates artificial tax incentives; very complex; and it does not ensure

countries their right share of tax.864 Notably, to date, formulary apportioned method

as an alternative to Arm‘s length principle has not been adopted as an international

standard. However, the method has been widely used in USA MNCs operating with

USA and Canada. Formulary apportionment is a method of allocating profit earned

by associated MNCs to countries, which the company has tax presence.865 In this

method, associated MNCs are considered to as one unit despite being operating in

different countries. In ascertaining the income for tax purposes, the method requires

deduction in their worldwide expenses based on global accounting system.

The net income is then distributed among countries in which the MNC has tax

presence based on agreed factors and formula. Thereafter, each country applies its

864
Avi –Yohah R.S. and Clausing K., note 861, p 10.
865
The existing formulary apportionment originates from USA. This happens when USA congress
concerned about double taxation between USA corporations and it PE operating across the USA
border. In this context, the USA congress presumed that, PE outside USA was established to milk
the income of USA parent corporations. In this context, the USA congress established the first
legislation in 1921 requiring multinationals to provide consolidated accounting reports ―to make an
accurate distribution or apportionment of gains, profits, income, deductions, and capital between or
among related business. See, Durst, M. C., and Culbertson, R.E., Clearing Away the Sand:
Retrospective Methods and Prospective Documentation in Transfer Pricing Today, 57 Tax Law
Review, 2003, p. 37 and 43.As the time went on, the issue of apportionment of income became
serious. In 1928, the USA congress reformulated the 1921 legislation by empowering
commissioner to apportion, allocate or distribute gross income or deduction for the purpose of
prevention of tax evasion. The provision provides that, ―In any case of two or more trades or
businesses (whether or not incorporated, whether or not organised in the United States, and
whether or not affiliated) owned or controlled directly or indirectly by the same interests, the
Commissioner is authorised to distribute, apportion, or allocate gross income or deductions
between or among such trades or businesses, if he determines that such distribution,
apportionment, or allocation is necessary in order to prevent evasion of taxes or clearly to reflect
the income of any such trades or businesses.‖ see Revenue Act of 1928, Pub. L. No. 70-562, ch
.852, §45, 45 Stat. 791, 806
 222

tax rate to the income apportioned to it and tax accordingly. 866 The common factors,

which ought to be taken into account for establishing a formula is proportion of

sales, assets and payroll.867 However, sales-based formula is preferred because it

takes into account complicated issues like intangible. The information ought to be

obtained from MNCs‘ country-by-country report. Advantages of formulary

apportionment method include the following: first, the method can align countries‘

tax systems with global economy. Second, it eliminates tax incentive and possibility

of shifting income to tax haven countries. Third, it is simple and easy to apply.

Fourth, it provides potential for increase in revenue or enables a tax rate reduction.868

Critic of formulary apportionment argues that it is vulnerable to double taxation in

absence of a common formula. Secondly, it may lead to high compliance cost in

absence of common tax accounting rules. Third, differences in currency exchange

rates and rules of countries may distort the apportioned income. Fourth, the method

does not reflect profit or loss of each entity.869

From the foregoing, it is submitted that the approach suggested in applying

formulary apportionment is too simple to deal with and basically it does not take into

account difference of tax laws of countries. Accordingly, there is no clear guideline

in applying formulary apportionment, which ought to be regulated by law.

866
Ibid, see a Picciotto. S note 486 p.1.
867
Avi –Yohah R.S. and Clausing K., note 864, p.12. see also, Mclntyre M.J., Theory and Practice of
Combined Report with formulary apportionment, A paper presented at Multistate Tax
Commission, December 2009.
868
Ibid, p.13 -16. See also Rectenwald G., A Proposed Framework for Resolving Transfer Pricing
Problem: Allocating the Tax Base of Multinational Entities based on Real Economic Indicators of
Benefit and Burden, Duke Journal of Comparative and International Law, Vol.23:425, p.435.
869
OECD., Review of Comparability and of Profit Methods: Revision of Chapters I-III of the
Transfer Pricing Guidelines Centre for Tax Policy and Administration, Organisation for Economic
Co-operation and Development, July 2010, p. 8- 10.
 223

Additionally, disadvantages of the method outweigh advantages. This might be

reasons formulary apportionment has not been adopted widely by countries as an

international standard. Consequently, there is no global instrument that regulates the

same. The fact that formulary apportionment is based on profit split, it is argued that

profit split method can be used to obtain such objective.870 Likewise, other countries

have also modified their transfer rules to suit their interest while based on arm‘s

length principle. For example, Brazil modified its transfer pricing by doing away

with comparability factors by using a fixed margin based on mathematical theory.871

Despite weakness of arms length principle, if other factors remain constant, and

available arm‘s length principle may remain a viable option for regulating transfer

pricing across countries. World Bank study has shown that countries have increased

their income by using transfer pricing law based on arms‘ length principle.872

5.8 Conclusion

The foregoing examination and analysis suggest that application of international

transfer pricing standards as enshrined in various tax treaties and conventions are

susceptible to manipulation of transfer prices by MNCs. The weakness of such

standards, in particular, arm‘s length principle has given room for MNCs to take

advantage and practice aggressive tax planning. The interplay between transfer

pricing standards and aggressive tax planning has caused enormous base erosion in

countries where economic activities are taking place. Results are that both developed

870
Kroppen H. et al., Profit split, the Future for Transfer Pricing? Arms ‗Length Principle and
Formulary Apportioned Revisited From a theoretical and Practical Perspective, Fundamentals of
International Transfer Pricing in law and Economics, in (W Schon and K.A.Konrad) editors, MPI
Studies in Tax law and public Finance 1, DOI 10.1007/978-3642-25980-7_13, 2012 p. 268.
871
See law 9430/96 of Brazil. See also Falcao T., Brazil‘s Approach to Transfer Pricing: A Viable
Alternative to Status Quo? Tax Management Transfer Pricing Report, Vol. 20 no. 20 2/23/ 2012.
872
Cooper et al., note 657 p.11.
 224

and developing countries faced base erosion and profit shifting impact. International

initiatives have been taken to rescue countries from base erosion and profit shifting

through transfer pricing by supplementing existing standards. The intention is to

ensure that profits are taxed where economic activities generating such profits are

performed and where value is created.

However, the BEPS Action plan to a great extent is not taking in to account issues of

concern for EAC countries. Notably, measures, rules and principles are still based on

arm‘s length principle, which previously, seemed to fail in such areas. Furthermore,

to a great extent, the whole process of arriving at arm‘s length price is still based on

comparability and analysis of various issues. Although tax authorities have been

availed with the tool for auditing, the whole procedure is very cumbersome.

Accordingly, application of arm‘s length solutions provided in the guide sometimes,

is inconclusive and contains probabilities, which to lead to uncertainty of the law. A

plea for use of formulary apportionment has not been well addressed. Countries,

which have been embracing such method in their application is limited with

countries because the law applicable to such transaction is the same. Absence of a

thorough study in handling formulary apportionment as a viable solution to existing

problem renders decision to opt for it difficult. Notwithstanding, the weakness of

arm‘s length principle advantage of using it outweigh the disadvantage.

 225

CHAPTER SIX

TRANSFER PRICING LEGISLATION IN TANZANIA

6.1 Introduction

Abolition of socialist ideology in Tanzania and adoption of a free market economy in

which trade liberalization is enhanced, increased regional trade and economic links

with other countries throughout the world. The result is an increase in MNCs‘

operations in the country whereby transfer pricing is practiced. However, like other

countries of the world, Tanzania faces the problem in relation to the law regulating

international transfer pricing in particular. Manipulation of prices by MNCs through

transfer pricing causes income tax base erosion and profit shifting problems that have

necessitated changes in tax laws governing transfer pricing in many countries.

Arm‘s length principle as a corner stone for transfer pricing between MNCs, and

other principles have been enshrined in various domestic tax legislation and DTAs in

Tanzania.873 However, the application of arm‘s length principle remains largely

untested or implemented. This chapter analyses an adequacy of transfer pricing

legislation in curbing transfer pricing manipulation in Tanzania.

6.2 An Overview of Social, Economic and Political Context

Tanganyika, now Mainland Tanzania, attained its independence on 9th December,

1961. Economically, it inherited the colonial economy and remained an appendage

of the metropolitan economy. The actual situation of the economy of Tanzania

immediate after independence is well explained by Rweyemamu that,

873
Income Tax Act, Cap 332 RE 2008 (ITA), Income Tax transfer pricing Rule 2014,(TP rules)
Tanzania Revenue Authority Guidelines, (TRA Guideline)
 226

“When Mainland Tanzania became independent on 9th December

1961, it inherited its basic position within the international
community from the colonial relationship. In economic terms,
this means that a client „independent‟ state on the periphery of
western capitalism was created. Political independence did not
necessarily mean economic independence namely control over
economic decision making and the national economy, the
establishment of a firm industrial structure leading to self
generating and self sustain grown,…on the contrary the
institution framework diligently erected by Britain during
colonial period ensured Tanzania economic dependence on
international capitalism in general and in Britain in particular…
Investments, both public and private, were assumed to flow easily
from Britain.”874

Essentially, the economy of Tanganyika was export economy directly or indirectly

integrated in the world of capitalist system via export sector. 875As a consequence, the

government of Tanganyika continued to depend on foreign source of income for

development of the country. To solve the problem, the government of Tanzania spelt

various laws aimed at attracting both local and foreign investors to participate fully

in industrial development sector in the country.876 They included the Tanganyika

Development Act,877 which established National Development Corporation (NDC).

The function of the NDC encompassed to provide loans to African small scale

business enterprises, to provide incentive to high risk investment in areas important

for the country‘s development and to enter into joint ventures with foreign private

investors.878 Foreign Investment Protection Act879 was also established. The

874
Rweyemamu J., Underdevelopment and industrialization in Tanzania, 1976, PP 38 -39.
875
Shivji I.G., Classes struggle in Tanzania, Dar es Salaam, TPH, 1976, P.36.
876
Maina C.P., Foreign investment in Tanzania, the Mainland and Zanzibar, University of Dar es
Salaam, 1994, p. 5.
877
1962. The intention of the parliament was to use private sector for industrial and commercial
development. However, most industrial opportunities in the country were neither so readily
identifiable nor so clearly feasible and attractive to ensure their accomplishment without
encouragement. See Kiunsi, note 80 p. 10.
878
Ghai Y.P., Law in the Political Economy of Public Enterprises, African Perspective, Uppsala
Offset Centre AB, 1977, p. 209.
 227

objective of the Act was to encourage foreign investors by providing statutory

guarantee on their investments.880 To enable implementation of the Act, Foreign

Investment (Protection) Regulation of 1964 was established.881 Consequently,

dominant sectors were given to private investors as was reflected in the five years

development plan.882 The plan also outlined various incentives for private sector like

repatriation of capital and profits, provision of industrial estates, tariff protection for

infant industries and investment allowances.883

To supplement general guarantees provided in the legislation, the government also

concluded bilateral agreements with foreign countries in its efforts to encourage and

protect foreign investment. They included, for example, agreement between United

States of America and Tanganyika on investment guarantee,884 the Agreement

between Tanzania and Germany on encouragement and reciprocal protection of

investment,885 and the agreement between Tanzania and Swiss Confederation

concerning encouragement and reciprocal investment encouragement. 886 From the

foregoing, it is submitted that from the beginning of independence, political leaders

believed that foreign investment and aid were important catalysts for development.887

879
Act No 40 of 1963.
880
Special supplement to the Tanganyika Gazette, Vol XLIV No. 32 of 14 th June, 1963 p.8.
881
Government Notice No. 523 of 1964.
882
Government of Tanganyika, Development Plan for Tanganyika, 1961 -1962 and 1963 -1964, Dar
es salaam Government Printer, 1962, pp 7 -8.
883
Ibid.
884
Of 14th November 1963.
885
Of 30th January, 1965.
886
Of 3rd May, 1965.
887
Mapunda B.T., Compensation for Expropriation of Foreign Investments: The Problem of
Standards, The LL.M Dissertation, University of Dar es Salaam 1993, p.153.
 228

It was clearly pointed out by the then president Nyerere that, ―the government wishes

to work with private investors for the development of the Tanganyika.‖888

Notwithstanding, efforts to encourage foreign investors, in 1967, there was dramatic

change of laws of investment in Tanzania. In the same year, the country adopted

socialism ideology whereby all major means of economy were placed under public

ownership and control.889 Consequently, the law operated to restrict development of

private sector while ensuring public sector investment.890 However, socialism

ideology failed due to poor performance and inefficiency of public enterprises,

among other things. In 1986, Tanzania embarked on economic recovery programme

and liberalized its economy. Implementation of economic reform was part of

conditions for financial aid administered by World Bank and other donor community

members. That was evidenced by expanded donor support, ranging from public

infrastructure building to civil services and governance reforms. For example, there

was support of $200 million World Bank credit for Songo Songo natural gas field

development project.891

The most remarkable development was pronouncement of Zanzibar Resolution,

which officially abandoned socialism ideology in Tanzania.892 The resolution

necessitated formation of a new policy and law with a view of attracting foreign

investments. That was followed by establishment of Investment and Protection Act

888
Nyerere J.K., Freedom and Unity, Oxford University Press, 1966, p.209.
889
This was done following the proclamation of Arusha declaration of 1967.
890
Kiunsi H.B, note 80 p. 13.
891
United Nations, An investment Guide to Tanzania, UNCTAD/ITE/IIA/2005/3, 2005, p.13.
892
United Republic of Tanzania, Investment Promotion policy, Dar es Salaam, Government Printer,
1990.
 229

of 1995, which was repealed and replaced by Tanzania Investment Act. 893 The Act

establishes Tanzania Investment Centre (TIC) as agency to coordinate, promote,

encourage and facilitate investments in the country,894 among other things. In

enhancing industrial activities, Tanzania also established Export Processing Zone895

(EPZ) and special economic zone,896 which also attracted MNCs. Results were an

increase in foreign MNCs in the country whereby transfer pricing is practiced. Such
897
MNCs‘ operations are ranging from mining, manufacturing,898

telecommunications,899 and finance undertakings.900 Others are shipping,901 tourism

and promotion services. Accordingly, the recent discovery of huge gas reserves

increased attraction of foreign MNCs in the country.902 In due regard, it is clear that

most MNC investors are subsidiary companies from developed and tax haven

countries. 903 In fact, Tanzania leads EAC region in investment inflow.904

893
1997.
894
Section 4 of Tanzania Investment Act, 1997.
895
Established under Export Processing Act, 2002.
896
Established under Special Economic Zone Act, 2006.
897
for example Geita Gold mine (GGM)a part of Anglo Gold Ashanti from South Africa, Songas gas
Tanzania limited from party of CDC Group plc from UK, Williamson Diamond Mines part of De
Beers Group of South Africa.
898
for example Carnauld Metal Box Ltd UK, Coca Cola Kwanza Tanzania Ltd from USA, Mbeya
Cement Co. Ltd from France, SBC Tanzania Ltd as part of (Pepsi co Inc of USA, Tanzania
Cigarette Company, Tanzania Breweries company Ltd and recently Dangote Cement
899
Such as Vodacom Tanzania Limited, MIC Tanzania Ltd, Airtel Tanzania Limited, Hallow tel and
Zantel.
900
such as KPMG from Switzerland, Standard chartered bank UK, Citi Bank from USA, Barclays
Bank from UK, FNB from South Africa.
901
See for example Maersk Tanzania Ltd from France.
902
UNACTAD, note 914, p. 34.
903
The presence of various investment opportunities such as natural resources, cheap labour and
market has been important catalyst for MNCs operations in Tanzania. Accordingly, favourable tax
laws and political stability have contributed substantially in attracting MNCs operations in the
country. See Burhan., A.M., Analysis of Multinational Corporations (MNCs) in Tanzania,
Scholarly Journal of Business Administration, Vol. 3(1) pp.1-6 January, 2013, p. 1. Available
online http:// www.scholarly-journals.com/SJBA ISSN 2276-7126 ©2013 Scholarly-Journals.
904
UNACTAD, World Investment Report 2015, p. 34. See also BOT, Tanzania Investment Report:
Foreign Private Investment, 2013, p.15.The report shows investment inflow trend in Tanzania from
2008 -2012. United States of America, Tanzania Investment Climate Statement 2015, p.7.
 230

The increase of MNCs‘ operations whereby transfer pricing is enhanced has brought

about enormous challenges in curbing transfer pricing manipulations in the country.

The problem has been caused by use of tax avoidance schemes by associated

MNCs.905 As a result; profits arising from international transactions have been

shifted outside the country where parent companies operate or to tax haven countries.

For example, between 2001 and 2007, Tanzania lost US$830 million because of thin

capitalization by Geita Gold Mine.906 This is from one company only. Between 2001

and 2010, Tanzania also lost US$ 333 million due to manipulation of prices. 907

Furthermore, other reports indicate that Tanzania is losing US$ 150 million each

year due to trade mispricing.908 For example, recall, in 2008, Resolute Tanzania

Limited was selling gold to sister a company USD 530 per ounce, the amount that

was less than half of the market price by then.909 Such amount of money was

eventually shifted outside Tanzania.

904
for example Geita Gold mine (GGM)a part of AngloGold Ashanti from South Africa, Songas Gas
Tanzania limited from party of CDC Group plc from UK, Williamson Diamond Mines part of De
Beers Group of South Africa.
905
See discussion chapter five above. See also Bajungu C., Transfer pricing ―Fairness in
Multinationals Extractive Industries, a paper presented in seminar hosted by The Tax Justice
Network; Agenda Participation 2000 (Tanzania), Norwegian Church Aid and KEPA, 2013. Oguttu
A.W., A Critical Analysis of what Africa‘s Response should be to the OECD BEPS Action Plan? A
paper presented at 1st Africa Tax Symposium – Zambia, 2015.
906
Kabwe, Z.Z., Transfer pricing in Tanzania, My Experience in Tackling Tax avoidance/ Evasion
through parliament, A paper presented at Tax Justice Network, Agenda Participation 2000, KEPA
and Norwegian Church Aid-NCA Transfer Pricing Seminar Dar es salaam, 3 rd October 2013, p. 2.
See also Bomani Mining Review Report of 2006 and Masha Mining review report of 2006.
907
Kar, D and Spanjers, J., Global Financial Integrity, Illicit Financial Flows from Developing
countries: 2003 to 2012, 2014.
908
Curtis M., et al, The One Billion Dollar Question: How Can Tanzania Stop losing So Much Tax
Revenue, a Report by Tanzania Episcopal Conference, National Muslim Council of Tanzania and
Christian Council of Tanzania, First Ed. June 2012 p. 17. See also Msafiri A.G., Sustainable Use
of Natural Resources – Gold Mine in the Lake Zone, A paper presented at St. Augustine
University of Tanzania (SAUT) main Campus Mwanza 24th October 2014, p.8.
909
Kabwe, Z. Z., note 923, p.1.
 231

6.3 Transfer Pricing Laws in Tanzania

The legal and regulatory framework of transfer pricing comprises the following

major sources: the Constitution of United Republic of Tanzania, Tax legislation as

well as their rules and tax treaties.

6.3.1 Constitution of United Republic of Tanzania (CURT) 1977

Any government requires finance to provide for public services and run the

government. For that reason, governments depend on various taxes collected in their

countries. Such taxes collected by government are governed by tax law by using

special procedures. The fact that tax is the backbone of the country taxation becomes

of quasi-constitution nature.910 Thus, the basic principles in exercising taxing powers

must be clearly established in the constitution of the country. 911 The Constitution of

the United Republic of Tanzania (CURT) recognizes tax as the main source of

finance for government and it provides a principle upon which tax is imposed. The

provision provides that, ―no tax of any kind shall be imposed save in accordance

with a law enacted by parliament or pursuant to a procedure lawfully prescribed and

having the force of law by virtue of a law enacted by Parliament.‖ 912 If plainly

construed, the CURT requires no person to be taxed except in accordance with the

910
Brennan G. and J. Buchanan, The Power to Tax: Analytical Foundations of a Fiscal Constitution,
London, Cambridge University Press, 1980 as quoted from Luoga, F., Taxation in the Advent of
Democratization and Transition to Free Market Economy in Tanzania and concerns on the Rule of
Law and Human Rights, Law, Social Justice & Global Development Journal (LGD),2002, para
4.1.1 available at www.gepc.or.tz/wp.../IncomeTax-Law-in-Tanzania-Source-Book-Prof.-
Luoga.pdf.
911
Ibid.
912
Article 138(1) of the CURT, 1977 as amended from time to time. In the case of Commissioner
General TRA v Airtel Tanzania Ltd, The court of Appeal held that, ―it is good practice in tax
matters that the taxpayer be made aware as much as possible, by full citation of the enabling taxing
provision, the legal basis upon which an assessment and /or a tax demand has been made…. if the
relevant legal provision does exist and whether tax liability exists, then the tax should be paid‖
emphasis is mine.
 232

law.913 Therefore, the CURT confers right to taxpayers to arrange their tax affairs

and pay what is required by the law. Consequently, MNCs as part of large taxpayers

who substantially contribute to finance of the country are obliged to pay according to

the requirement of the law. The fact that tax is the main source of finance of the

country, the Constitution empowers the government only to present bills related to

financial matters.914 The bills include matters related to levy a tax or to alter taxation

otherwise than by reduction.915 Although the CURT does not clearly provide for

transfer pricing laws, the principle enshrines under the CURT are also applicable to

taxation of MNCs.

6.3.2 Income Tax Act, 2004

Transfer pricing legislation regulating transfer pricing was introduced in Tanzania in

2004. Prior to that, transfer pricing was largely untested and regulated through

limited scattered provisions contained in anti-avoidance provisions of Income Tax

Act.916 The arms‘ length concept was used as a test to measure situations where

related parties to a transaction by visual of their relations arrange their affairs and

pay less amount of tax. The application of arms‘ length principle by then is well

stated by Luoga that,

“It is an underlying assumption of income tax law that profits or

gains made by a taxpayer are achieved through the interplay of
market forces which are independent of the taxpayer‟s control.
This assumption often break down where parties to a transaction
do not have opposing economic interests, but have, by virtue of
the particular relationship between them, a common economic
interest which enables them to arrange the terms of the

913
Ongwamuhana K., Tax Compliance in Tanzania: Analysis of Law & Policy Affecting Voluntary
Tax Compliance, Mkuki na Nyota, Dar es Salaam, 2011 p. 79.
914
Article 99(1) of the CURT, 1977 as amended from time to time.
915
Ibid, Article 99(2) (i).
916
1973.
 233

transaction to produce the least amount of tax. Persons in such

circumstances are said not to deal with each other “at arm‘s
length‖ and transactions between them are referred to as
―transactions not at arm‘s length.‖917

To this extent, the Commissioner General of Tanzania Revenue Authority (TRA)

was empowered to appropriately adjust any amount of transactions liable for tax if it

was established that there was tax avoidance scheme.918 The arm‘s length concept

was also used to ascertain profit of business carried out between related non-

residents.919 However, there was no clear indication whether or not the arm‘s length

principle was used to comply requirement of DTA which existed by then.920

The Income tax Act of 2004 (ITA), which came into force on 1st July 2004 repealed

and replaced the Income tax Act of 1973. The main objective of ITA is to provide

provisions ―for the charge, assessment and collection of income tax for the

ascertainment of the income to be charged and for matters incidental thereto‖.921 The

ITA has XI Parts: Part I provides for title, scope of application and interpretation.

Part II provides for imposition of income tax. Part III income tax base in essence

comprises calculation of the income base, rules governing calculation and assets and

liability. Part IV provides for rules applicable to particular type of persons such as

partnership, trust and cooperation. Party V deals with special industries such as

insurance business, retirement savings and charitable organizations. Part VI deals

with international taxation upon which source and resident principles are set, taxation

917
Luoga, F., note 910.
918
Section 27, of Income Tax Act, 1973.
919
Section 19(2) of Income Tax Act, 1973.
920
See for example Article 9(2) of the convention between the government of Italian Republic and the
Government of the United Republic of Tanzania for the avoidance of double taxation and the
prevention of fiscal evasion with respect to taxes on income.
921
Preamble of the ITA, Cap 332 RE 2008.
 234

of PE, controlled foreign company and trusts including foreign tax relief. Part VII

provides for special procedures, which include the taxpayers‘ obligation, withholding

tax payment procedures, installment payment procedure and income payable on

assessment. Part VIII deals with non-compliance upon which offences, penalties and

interest are prescribed, recovery of tax, third party liability and proceedings. Part IX

is about remission, refunds and set-off. Part X provides for administration of tax by

commissioner and other officers, audits together with information collection. Part XI

provides for transitional provisions.

Part III is of particular interest because it provides for income tax base upon which

taxes are imposed.922 The ITA imposes tax on resident and nonresident on incomes

from employment, business or investment having source in Tanzania while residents

are taxed on their worldwide incomes.923 For purpose of this work, a corporation is

resident of Tanzania for tax purposes if it is incorporated or formed under laws of the

United Republic or at any time during the year of income the management and

control of the affairs of the corporation are exercised in the United Republic.924 Two

issues can be observed, firstly, the ITA does not provide clear difference between

‗incorporation‘ or ‗formed.‘ Lack of clarity on these two words may provide

potentials for MNCs to declare non-residents for tax purposes. In African Barrick

Gold Plc v Commissioner General TRA,925 the appellant claimed that the Tax board

erred in law and the fact in holding that appellant company is not resident for tax

purposes because the words ‗incorporation and formed‘ meant the same thing and

922
Ibid, Section 5.
923
Ibid, section 6 (a) and (b). For purpose of this work, income from employment is not dealt with.
924
Ibid, section 66 (4) (a) and (b).
925
Tax Appeal No 16, 2015.
 235

therefore, activities done by the company did not amount to being resident. The

Appeal Board stated that the said words are different because the word ‗formed‘ is a

safe habour aim to accommodate all situations for which a company may be

established under the law of Tanzania and acquire residence status for tax purposes.

Secondly, there is no clear guideline under circumstances management and control of

the affairs are said to be exercised in Tanzania for transfer pricing purposes, the

situation that may bring difficulties in determination of residence of a

taxpayer.926Apart from residence issue, the law is silent under what circumstances an

income is said to have source in Tanzania for transfer pricing purposes. 927 However,

the law clearly state under which circumstances payments are regarded to have

source in Tanzania.928 Thus, the amount to be charged is profit or gains from

conducting business or investment for the year of income.929

6.3.2.1 Application of Arms’ Length Principle in Tanzania

Section 33(1) of Income Tax Act930 provides for the arms‘ length principle as basis

for regulating transfer prices between associated parties. The provision provides that,

“In any arrangement between persons who are associates, the

persons shall quantify, apportion and allocate amounts to be included
or deducted in calculating income between the persons as is
necessary to reflect the total income or tax payable that would have

926
Barrick Gold Plc v Commissioner General TRA, Tax Appeal No 16, 2015. In this case the
appellant claim that at the time control and management of company of affairs was not exercised in
Tanzania.
927
Kenya for example clearly provides circumstances showing business is carried out in Kenya for
transfer pricing purposes. See chapter 7 para 7.3.2.1.
928
Ibid, section 69 (a) to (i).
929
Ibid, sections, 3, 8, 9, and 20 respectively. See also Para 4.1 of TRA Practice Note 5 on Income
from Business and Practice Note 6 on Income from Investment.
930
RE 2008.
 236

arisen for them if the arrangement had been conducted at arm‟s

length.”931

The ITA is silent on meaning of arm‘s length, however, the TP Rules defines as a

principle whereby commercial or financial transactions between associates is taking

place on the same terms as if such transactions had taken place between independent

persons under comparable conditions and circumstances.932 In context of this

definition, the independent transaction is used as a test upon which transaction

between associated parties is measured or tested. The policy underlies section 33 is

to address tax avoidance schemes involving manipulation of prices of goods and

services under international and domestic transactions between associated parties.

Thus, the function of arm‘s length principle is to adjust prices of goods and services

to reflect arm‘s length price that would have been charged had the transaction

conducted on normal business grounds between unrelated parties. It is in this context

that ITA gives the Commissioner General (Commissioner) power to adjust prices

that are not at arm‘s length.933 However, adjustment in this context is only possible

once the anomaly is noted as a result of transfer pricing audits.

For arm‘s length to apply transactions between associated parties must be arranged

because of their special relations existing between them. Notably, the transaction

between associated parties does not necessarily mean that the price charged for such

transaction is not at arm‘s length. The price must be affected by arrangement

931
Ibid, section 33 (1). The introduction of such principle was modeled on OECD and UN models See
Article 9 OECD and UN Models. In essence this was part of implementation of multilateral
institutions policies. See chapter 4 for more details.
932
Rule 3 of TP Rules 2014.
933
Section 33 (2) of ITA R.E, 2008.
 237

between parties because of their relationship. However, neither the ITA nor Transfer

Pricing Rules explain under what circumstances the transaction between associated

parties is said to be arranged. In context of tax, arrangement is defined to mean

action, agreement, arrangement course of conduct, dealing, promise, transaction,

understanding or undertaking involving more than one person and it includes a part

of arrangement.934 Arguably, the meaning of arrangement as provided does not

directly correspond to context of transfer pricing because it does not show

circumstances or elements that actually indicate presence of arrangement that affects

the actual taxable amount. The words used are mere another meaning of

arrangement935 thereby missing connection to transfer pricing. The notion

‗arrangement‘ is the corner stone of dispute between associated MNCs and the tax

authority. While the associated parties are alleged not to arrange their affairs because

of special relation existing between them, the revenue authorities are required to

prove such arrangement, which practically becomes difficult like it was in Unilever

case.936

6.3.2.2 Associated Parties

In context of transfer pricing, there must be transactions between associated parties

for arms‘ length principle to apply. Generally, the ITA does not provide specific

definition of associated parties for transfer pricing purposes. However, in context of

ITA, parties are regarded associated in relation to corporation if are direct or indirect

controls or benefits fifty percent or more of the rights to income or capital or voting

934
Section 3 of Tax Administration Act, Cap 399, 2015.
935
See for example in thesaurus dictionary the word arrangement mean agreement.
936
Income tax appeal no. 753 of 2003 KE: HC September 2005, see also chapter 4.para 4.6. See
discussion chapter seven para 7.3.3. 1.
 238

power through one or more corporation.937 Arguably, the threshold control of fifty

percent of the shareholding or voting power in the entity is very high. To this extent,

it leaves important elements of connected shareholders having considerable

percentage of rights to income, capital or voting power of the company.

The problem with this is that associated parties may use such loophole to escape

from arm‘s length.938 Although the law clearly states that in case the situation of

associated parties is not covered by the ITA, one may reasonably be expected to act,

other than as an employee, in accordance with the intentions of the other.939

However, the requirement is subjective and does not give conclusive answers. Given

intricacies of transfer pricing, it is not easy to measure the extent or reasonableness

and intention of the parties to a transaction. Accordingly, the law does not provide

any guideline in establishing the intention of the parties.940

Permanent establishment and its head office or other related branches are also

associates for transfer pricing purposes941 Likewise, the ITA is silent on meaning of

branch, but Transfer Pricing Rules describe branch as permanent establishment (PE)

as defined by Tax treaty if the transfer pricing issue is originating from tax treaty.942

937
Ibid, Section 3 (i) (bb). It should be noted that the ITA provides broad meaning of associated
parties to include individual, trust, and partnership. However, for the purpose of this study only of
corporation is taken in to account. In context of ITA, corporation is defined as any company or
body of corporate established, incorporated under any law in force in the united republic of
Tanzania or elsewhere excluding partnership. See section 3 of ITA as amended by Finance Act,
2014.
938
For example, in African Barrick Gold Plc v Commissioner General TRA, Tax Appeal No 16,
2015, the company developed avoidance scheme by declared loss while distributed dividends to its
shareholders.
939
Section 3.
940
See TRA Transfer Pricing Guideline, 2015.
941
Section 71(6) of ITA Cap 332 R.E 2008.
942
Rule 3 of TP Rules 2014. See also para 3 of the TRA, Transfer Pricing Guidelines, 2015.
 239

If the issue is originating from ITA, then the meaning of PE as defined in the ITA

will prevail.943 In context of ITA, PE means,

“a place where a person carries on business through an agent,

other than a independent acting in the ordinary course of business,
a place where a person has used or installed, or is using or
installing substantial equipment or substantial machinery; and a
place where a person is engaged in a construction, assembly or
installation project for six months or more, including a place where
a person is conducting supervisory activities in relation to such a
project.”944

In context of the tax treaty, permanent establishment means a fixed place of business

through which the business of an enterprise is wholly or partly carried on and it

includes, especially a place of management a branch, an office, a factory, a

workshop, a mine, an oil or gas well, a quarry or any other place of extraction of

natural resources. It also encompasses a building site, a construction, an assembly or

installation project or supervisory activities in connection therewith, but only where

such site, project or activities continue for a period of six months or more,

furnishing of services including consultancy services by an enterprise through

employees or other personnel engaged by the enterprise for such purpose, but only

where activities of that nature continue (for the same or connected project) within the

country for a period or periods aggregating to six or more months within any twelve

month period.945 The tax treaty also clearly provides for activities that cannot

constitute a permanent establishment. The problem with this definition is that the

meaning of PE in the treaty is wider than that of ITA. Yet, in applying arm‘s length

943
Ibid.
944
Ibid, Section 3.
945
Article 5 (1), (2) and (3) of the DTA between Tanzania and Canada for avoidance of double
Taxation and prevention of Fiscal evasion with respect to taxes on Income and on the Capital
1995.
 240

principle, the law requires transfer pricing regulations to be construed in consistency

with OECD and UN models and their Guidelines.946 In case of inconstancy between

domestic law and international instruments, the domestic law shall prevail.947 This

requirement is perfect if ITA, as substantive law, is addressing the matter

extensively. In such situation, if the ITA will prevail, the MNCs stand to benefit

more because the Act does not sufficiently cover the matter. For example, a mine is

not clearly stated to constitute permanent establishment under the ITA despite being

leading in MNCs operations in Tanzania. Accordingly, the ITA is silent on whether

or not the existing definition of PE can be applicable on electronic commerce

between associated parties.

6.3.2.3 Ascertainment of Transfer Pricing Income

Generally, associated MNCs are taxed on profit from business or investment derived

from Tanzania. Yet, the law is silence under what circumstances the business is said

to be conducted in Tanzania for transfer pricing purposes.948 However, ITA defines

business to mean trade concerned in nature of trade, manufacture, professional or

isolated arrangement with a business character.949 It includes past, present and

prospective businesses. Accordingly, a mining and petroleum operations are treated

as business activities for purpose of calculating taxable income.950 However, absence

of a clear distinction may render MNCs to take advantage as recipients of business

946
Rule 9 (1) of the TP Rule 2014.
947
Ibid, Rule 9(2).
948
Other countries clearly state under what circumstances the business is said to be carried, see for
example section 18 (1) of cap 470 of the laws of Kenya. In the case of the Trustee of AD Charitable
Business Trust v CIT 3 EACTC 89, it was stated that ―Dividing line between what it does not
amount to the carrying on business is not always easy to ascertain‖.
949
Section 3 ITA RE 2008. See also Para 4.1 of TRA Practice Note No 5 on Income from Business.
950
Ibid, section 65B (4) and 65K (4) respectively as amended by section 28 of Finance Act, 2016.
 241

income because of large scope of deductions for expenses in respect of incomes from

businesses.951 In calculating taxable amount, the law requires any expenditure

incurred by the person wholly and exclusively in production of income from the

business or investment be deducted.952 In addition, in calculating the interest amount,

the law requires debt obligation incurred by the person wholly and exclusively in

production of income from business or investment to be deducted. 953 Arguably, for

deductions to be effected, they presuppose presence of actual cost spent on a

particular aspect allowable for deductions. However, it is unclear if a taxpayer fails

to produce actual cost on such expenditure. That may provide potentials for MNCs to

claim deductions that are not actually spent as was in Bulyanhulu Gold Mine Ltd v

Commissioner General TRA.954 In this case, the tribunal disallowed deduction for

expenditure of capital nature because the taxpayer failed to produce evidence. On

appeal, the Court of Appeal ordered the TRA to re-assess the value of the aircraft on

basis of market value and deduct expenses according to accounting principles.

Despite huge deductions available, the law clearly prohibits deductions from

expenditure of capital nature.955 Accordingly, no deduction in interest is allowed in

excess of 7.3 debts to equity ratio.956 In calculating taxable amount from mineral

operations, annual charges and royalties incurred under Mining Act and mining

development agreement, legally depreciated allowances, acquisition and

951
Ibid, see deductions under sections 11, 12, 13, 14, 15, 16, 17, 18, and 19 respectively of ITA as
amended by Finance Act, 2016, See also, Luoga F.M, note 10, p. 102 – 103.
952
Ibid, section 11(2).
953
Ibid, section 12 (1).
954
Consolidated Civil Appeal No. 89& 90, 2015, p. 18.
955
Section 11 (3) of ITA Cap 332 RE 2008 as amended by Finance Act, 2012.
956
Ibid, section 12 (2) (a) as amended by section 22 of Finance Act, 2012.
 242

rehabilitation expenses are deductable.957 This is in addition to other deductions.

Likewise, in petroleum operations, royalties and annual fees incurred depreciation

allowance and decommission funds are deductable.958 However, no deduction is

allowed in agricultural development and environment, gifts, depreciation allowance

for depreciable assets and long-term contracts in both mining and petroleum

operations.959 In addition, unrelieved loss, bonus payment and excess expenses

incurred are not deductable.960

In calculating the taxable amount of permanent establishment, the law requires to be

taxed separately from its owner and on amount attributable to it.961 For example,

MultiChoice Tanzania Limited is a permanent establishment of MultiChoice Africa a

South African company. MultiChoice Tanzania Limited conducts business on behalf

of MultiChoice Africa. For being a permanent establishment, MultiChoice Tanzania

is taxed on amounts attributable to it, including amounts derived and payment

received, liability owed, expenditure incurred and payment made.962

In addition the following arrangements between permanent establishment and its

owner are recognized for calculation of income: transfer of an asset or liability of

tangible, intangible, and debt obligation arising out of borrowing money used

exclusively in the business of PE.963 Moreover, sales of trading stock by the owner of

the same permanent establishment and other business activities of the owner

957
Section 65E (1) of ITA as amended by section 28 of Finance Act, 2016.
958
Ibid, section 65N (1).
959
Ibid, section 65E (2)(a).
960
Ibid, section 65E (2) and 65N (2).
961
Section 71(1) of ITA Cap 332 RE 2008.
962
Ibid, section 71 (2).
963
Ibid, section 71 (3) and (4).
 243

conducted with residents of the country of the permanent establishment of the same

or a similar kind as those effected through the PE are regarded as activities carried on

by permanent establishment.964 Ascertainment of income under ITA reveals that

there is no specific approach in ascertaining business profit for transfer pricing

purposes and therefore, calculations are made just like any other income under ITA.

Unlike Tanzania, Kenya Income Tax clearly provides ascertainment of taxable

amount for transfer pricing purpose.965The problem with this is that a transaction

between associated parties contains features that might not exist in independent

transactions, which may substantially affect business profit for tax purposes.

Nevertheless, in context of transfer pricing where associated parties‘ profit is not

made just like an independent part could have been made, the Commissioner is

empowered to make adjustment.

6.3.2.4 Transfer Pricing Adjustment

Transfer pricing adjustment is adjustment made by commissioner where it is

established that price or interests of transactions between associated parties were not

made at arm‘s length price.966 Accordingly, any adjustment in respect of assessment

made on one of associated parties may be reflected by an offsetting adjustment on

assessment of the other person up on request by the other part. 967 This is achieved by

re-characterizing the source and type of income, loss, amount of payment or

apportionment and allocation of expenditure including income from a domestic or

964
Ibid, section 71 (5).
965
See discussion chapter seven.
966
Section 33(2) of ITA Cap 332 RE 2008 and Rule 14 (1) of TP Rules 2014. See also TRA, Transfer
Pricing Guideline para 11 (2) (f).
967
Ibid, Rule 14(2).
 244

foreign permanent adjustment968 Prima facie, the re-characterized transaction will be

taken by the TRA and compared with transactions between unrelated parties or

between associated and third party. However, the re-characterized (hypothetical)

transaction is not actual transaction of the associated parties, which faced

commercial transactions that could not have been faced by unrelated parties in a

similar situation. Under such circumstances, the Commissioner imputes a

hypothetical transaction into actual transaction of the associated parties and may

come out with an amount that was not actually incurred. It is unclear on the extent

which the re-characterized transaction actually takes into account special

circumstances that associated MNCs face when transacting with each other, a

pattern, which cannot be found to unrelated parties.969 For example, associated

MNCs, which distribute their activities in production, distribution and manufacturing

centres have advantage in reduced transaction costs, increased information sharing,

reduced risks and increased bargaining power. Such circumstances may potentially

affect analysis of arm‘s length price. In context of ITA, special circumstances

existing between associated parties are considered as basis for adjustment only.970

Given the wide discretion of the Commissioner, there is a danger of the taxpayer

being affected by such requirement.

Accordingly, it is unclear whether or not adjustment for comparability purposes is

based on actual transaction of associates or on the re-characterized transaction. The

adjustment for comparability purposes and (adjusted) re-characterized transactions

968
Ibid, section 33 (2) (a) and (b) as amended by section 23 of Finance Act, 2016; Rule 4 (2)
969
See TRA , Transfer Pricing Guidelines 2015 paras 8, 9 and 11respectively.
970
Ibid, para 11 (1) (e).
 245

serves different purposes.971 Generally, transfer pricing adjustment may result in

double taxation in international transactions. Consequently, the law also allows

corresponding adjustment for purpose of avoiding double tax under the following

conditions: First, if transfer pricing adjustment has been made in another country in

which Tanzania has DTA and such transactions are subject to tax in Tanzania.972

Secondly, if the adjustment results in taxation in another country of income or profit

that is also taxable in Tanzania.973

6.3.3 Income Tax (Transfer Pricing) Rules 2014

Income Tax (Transfer Pricing) Rules (TP Rules) was established in 2014 and came

in force on 2nd February 2014,974 ten years after introduction of arm‘s length

principle. The objective of the TP Rules is to give effect to transfer pricing principle

in determination of transfer pricing methods. The TP Rules applies to transaction

between associated MNCs operating within and outside Tanzania. 975 The TP Rules

maintain meaning of associated parties as provided in the ITA. Accordingly, both

ITA and TP Rules do not state clearly on transactions subject to arm‘s length

principle for transfer pricing purposes.976

However, if read between lines, transactions subject to arm‘s length principle include

the following: first, income splitting arrangement.977 Under this category, the

971
See discussion below on comparability factors.
972
However, Tanzania is having very limited number of DTAs.
973
Rule 13 (a) and (b) of TP Rules 2014.
974
Government Notice No. 27 of 2014. The decision in the case of Mbeya Cement company ltd v
Commissioner General TRA, Civil Appeal No. 19 played an important role in establishment of TP
Rules.
975
Rule 2.
976
In Kenya, the law clearly provides transactions subject to arm‘s length principle for transfer pricing
purposes. See chapter seven para 7.3.3.2.
977
Section 34(1) and (4) respectively.
 246

Commissioner is empowered to consider market value of any payment made. 978

Second, intercompany loan between associates by restricting interest on the debt to

an equity ratio of 7:3.979 Third, services rendered between associates,980 financing,981

sale and licensing of intangibles.982 However, services, intangibles and financing are

not stated in ITA.983 The problem with this is that the TP Rules are subsidiary

legislation and therefore, they may not override substantive statutory provisions.

Fourth, transactions related to minerals and petroleum.984 Fifth, arrangement made

between permanent establishment and the owner.985 However, ITA is silent on

transaction related to sell or lease of tangible goods to residents because it only refers

to PE and the owner. In addition, the ITA does not have any safe habour provision

that may cover any other transactions between associated parties where it is not

clearly stated in the statutes. Kenya clearly provides for safe habour provision to

cover transactions that may be subject to transfer pricing.986 Clarification for type of

transaction subject to arm‘s length principle is very important to cater for any profit

or loss of particular associated parties involved for transfer pricing purposes.

6.3.3.1 Determination of Arm’s Length Price

The TP Rules prescribe methods to arrive at arm‘s length price. The methods are

comparable uncontrolled price, resale price method and cost plus method commonly

978
Ibid, section 34 (4).
979
Ibid, section 12. This rule is commonly known as thin capitalization.
980
Rule 10 (a) and (b) of TP Rules.
981
Ibid, Rule 10(3).
982
Ibid, Rule 11.
983
Section 33 of ITA Cap 332 RE 2008.
984
Ibid, Section 65B (5) and (6), section 65K (5), (6) and (7) respectively as amended by section 28 of
the Finance Act, 2016.
985
Ibid, section 71 (6) (a) and (b).
986
See chapter seven para 7.3.3.2.
 247

known as traditional methods.987 Other methods include profit split method and

transactional net margin method.988 The TP Rules essentially adopt transfer pricing

methods as enshrined in OECD and UN models.989 Apart from these methods, the TP

Rules empowers the Commissioner to prescribe for other methods provided that the

results would be consistent with arms‘ length principle.990 However, neither ITA nor

the TP Rules or the TRA Transfer pricing Guidelines provide any guideline on what

constituted other methods. In determining arm‘s length price, the rules require a

taxpayer to apply first, the traditional methods, where such methods do not give

appropriate answers; and then resort can be made to the rest of methods.991

Notwithstanding, this requirement a tax payer is required to apply the most

appropriate methods depending on the nature of transactions and comparable

circumstances. The method is said appropriate if it takes into account strength and

weakness of the method, function performed by each party to a transaction,

availability of information and degree of comparability with independent parties.992

Accordingly, when transaction involves sale or licensing intangibles, CUP method

should be employed and where the intangible is unique, profit split method may be

987
Rule 3.
988
Ibid, Rule 5 (1). For definition of each method see Rule 3. See also Para 10 of TRA Transfer
pricing Guideline 2015. To arrive at arm‘s length price special procedure need to be followed as
set in TRA guideline. First, understanding associated parties‘ transaction in the context of their
business. This is sought to be achieved by analyzing functions performed, risk assumed and asset
used. This is followed by characterization of business based on the nature of activity and
complexity of transaction. Identification of comparable transaction is performed with a view of
setting level upon which transactions are compared. The determination of a controlled
transactions leads to the determination of the tested party. As a general rule, the tested party is the
one to which a transfer pricing method can be applied in the most reliable manner and for which
the most reliable comparables can be found‖ This is then followed by selecting transfer pricing
method by taking in to account profit level indicator which measures the relationship between
profits and sales, costs incurred or assets employed. See Para 7 of TRA transfer Pricing Guideline
2015.
989
See discussion chapter 3.
990
Rule 5(4) of TP Rules, 2014; See also TRA, Transfer Pricing Guidelines 2015 para 10(1).
991
Ibid, Rules 5 (2), (3) and (4) respectively.
992
Ibid, Rule 4(3).
 248

used.993Additionally, the TP Rules prohibit a person to apply any other method,

which is not listed or prescribed by the Commissioner.994 In verifying whether the

transaction was consistent with arm‘s length principle, the rules require the

Commissioner to base on the appropriate method used by the taxpayer. In practice,

associated MNCs in Tanzania prefer transactional net margin method, which is

comparatively more complicated than CUP. The method is preferred because it uses

the net profit as a profit level indicator which makes it easier to obtain

comparables.995Arguably, the law contradicts by imposing hierarchal application of

methods, on one hand and on the other, requiring the most appropriate method to be

employed. Yet, it clearly states CUP and split profit methods to be applied in certain

transactions. This situation may bring problem(s) in practical terms like it was in

Unilever case whereby the taxpayer claimed to use methods as enshrined in OECD

regardless of their appropriateness996

6.3.3.2 Transfer Pricing Comparability Factors

Comparability of transactions between associated and independent part is corner

stone in obtaining arm‘s length price of associates. In due regard, the TP Rules

require characteristics of property or services transferred, function performed, risk

assumed, asset used, contractual terms of the transaction, economic circumstances

and business strategies pursued by associated parties to be compared. 997 Transaction

between independent parties is comparable if comparability factors are similar to that

993
Ibid, Rule 11(2).
994
Ibid, Rule 5 (5).
995
KPMG Dar es salaam.
996
See discussion in chapter seven para 7.3.3.
997
Rule 6 (1) (a) to (e) of TP Rules 2014.
 249

of associated parties, or no differences between comparability factors or persons

entering it to transaction are likely to materially affect the price, cost charged, paid,

or profit.998 In addition, where adjustment can be made to any difference, which

affects the price, then such transaction is comparable.999 The result of transactions

between associates is then compared to results obtained in uncontrolled

transactions.1000 If the price falls within the range of arm‘s length then, the price is

said to be an arm‘s length.

From comparability factors, a few issues may be raised. First, the TP rules limit

comparables to sufficiently available information only. However, comparability

factors presuppose to be obtained from various corporation documents. In context of

transfer pricing, associated MNCs are required to furnish such documents based on

their transfer pricing policy.1001 Such requirement does not exist to unrelated

corporations. The only available information for such companies is related to

performance of the corporations and not details on modalities of their operations.

Such information is normally available in form of published or filed financial

statements, with practical observance being highly consistently followed by public

companies and financial institutions.1002 Consequently, use of Tanzanian

comparable pattern may be a very limited possibility and may lead to absence of

Tanzania comparables. For example, transfer pricing audit done by an extractive

team of TRA found that one a company was selling a rare gemstone available in

998
Ibid, Rule 6 (2) (a) and (b).
999
Ibid Rule 6 2(c). See also TRA, Transfer pricing Guideline 2014 para 8.3.
1000
Rule 6(3).
1001
Ibid, Rule 7.
1002
See for example section 32(3) of the Banking and Financial Institutions Act, 2006.
 250

Tanzania only to a sister company at very low prices since 2004. However, price

adjustment was done in 2011 such that it affected transactions from 2009 due to lack

of comparables.1003 In due regard, a considerable amount of profit was shifted

outside the country. In practice, the resort is made to foreign databases used

elsewhere in the world, for example, in ascertaining the arm‘s length interest rate,

appropriate indices such as London Inter Bank Offered Rate (LIBOR) or specific

rates quoted by banks for comparable loans can be used as a reference point.1004 Yet,

such data may be very expensive to obtain, for example, to subscribe Orbis data base

it costs TRA Euro 45,000/= per year.1005

Second, although the law requires a contractual term to be considered in

comparability, the TP Rules are silent on situations where the contractual terms do

not provide sufficient information for transfer pricing analysis.1006 For example, the

agreement may not include logistic services in their procurement agreement. Such

added services may form substantial component of procurement processes and may

have tax implication. Such discrepancies may be used to affect required transfer

price between associates. Third, while comparability is regarded as corner stone for

arms‘ length principle to apply, the law does not provide clear guideline on what

should be done in absence of comparables.1007

1003
Readhead, A., Transfer Pricing in Extractive sector Tanzania, 2015 p. 17.
1004
Para 15.4 of TRA Transfer Pricing Guideline, 2015.
1005
An interview with TRA ITU unit officials.
1006
See also TRA, Transfer Pricing Guidelines 2015 para 9.3.
1007
Ibid, paras 8 and 9 respectively.
 251

6.3.3.3 Application of Arms’ Length Principle to Intangibles

Literally, intangibles are valuable assets that cannot be touched. Intangible assets for

transfer prices purposes include a patent, an invention, secret formula or processes,

design, a model, plan, trademark, know how or marketing intangibles. 1008 From this

definition, three categories of intangibles may be ascribed. First, manufacture of

intangibles such as patent, design, processes or procedures, secret formula and

invention. These intangibles are normally done within the corporation. Second,

human competence, which entails knowledge held by various persons in the

organization and their knowledge is valuable commonly known as knowhow. The

third is marketing intangible, which includes marketing activities that aid in

commercial exploitation of property or have an important promotional value for the

property concerned.1009 These entail external activities that may include brands,

trademarks, licenses, franchise, contractual rights as well as customer and supplier

relationship.

Where intangible is sold or licensed between associated parties, the owner of the

intangible is required to charge the other associate at arm‘s length price at the value

of which such intangible is expected to generate.1010 In context of transfer pricing,

the person is regarded as owner of intangible if expenses and risks associated with

1008
Rule 3 of TP Rules 2014.
1009
Ibid.
1010
Rule 11(1) (a) and (b). Section 3 of ITA defines payment made by the lessee under a lease of an
intangible asset as royalty. Thus royalty is paid for use or right to use any copyright, patent, design
or model, plan, secret formula or process, trademark, or the supply or acquisition of scientific,
technical, industrial or commercial knowledge or information. is interesting to note that royalties
cover more aspects of intangibles than definition provided in Transfer Pricing guideline such as the
use of, or right to use, a cinematography film, videotape, sound recording or any other like medium;
the use of, or right to use, industrial, commercial or scientific equipment; the supply of assistance
ancillary to intangibles or a total or partial forbearance with intangibles. It is not clear whether such
right and use of the said intangibles are property or goods for transfer pricing purposes.
 252

development of such intangible property are borne by that person.1011 However, if the

owner of the intangible is not vested with the legal ownership then, the owner may

receive arms‘ length consideration for the development of such intangible.1012 With

regard to marketing intangibles, where an associate who is not owner of marketing

intangible and incurs cost for marketing such intangibles, and such cost are in excess

to those comparable independent persons, the owner will pay such associate arm‘s

length price for undertaking such activities.1013 In arriving at arm‘s length price for

intangibles, the law requires the taxpayer to use comparable uncontrolled price

(CUP)1014 method in absence of highly valuable or unique intangible, where such

peculiarly exists; the profit split method is employed.1015

In addition, any other methods may be used as prescribed by the Commissioner

provided that it has high degree of comparability between transactions.1016 Arguably,

the CUP method entails presence of a direct comparison of prices charged between

associates and independent parties in a comparable situation.1017 The apparent

question is relevance of CUP method in arriving at arm‘s length price for intangibles.

For example, PE is charged by its owner for use of patent for manufacturing a

product. It is common knowledge that development of patent for a certain product

normally is unique and may be developed solely for use of company.

1011
Rule 11 (6) of TP Rules 2014.
1012
Ibid, Rule 11 (4).
1013
Ibid, Rule 11 (5).
1014
CUP means a method where the price charged in transaction between associated parties is
compared with the price charged between independent parties in comparable situation. Rule 3 of TP
rules 2014. For more details on CUP method see chapter 3.
1015
Rule 11 (2) of TP Rules 2014.
1016
Ibid, Rule 11 (3).
1017
Ibid, Rule 3.
 253

Accordingly, the company may need to keep its secrets for their own benefits. Under

these circumstances, the independent corporation may not be ready to provide such

information. Such situation may lead to absence of comparables and consequently,

render CUP method less reliable than expected. Even where comparables are

available, re-characterization of intangible transaction for transfer pricing adjustment

may pose serious challenges. Notably, TRA guideline is silent on this matter, instead

is making reference to OECD Guidelines.1018

Notwithstanding, requirement of using CUP method for intangibles, the TP Rules

also require a taxpayer to apply first, the traditional methods and where these

methods do not give an appropriate answer, then resort can be made to the rest of

methods.1019 At the same time, the law obliges the tax taxpayer to select the most

appropriate method, depending on nature of transaction and function performed. The

problem with this requirement is that some traditional methods may not be

appropriate for intangible transactions. For example, the resale price method relies

on margins obtained from purchase and resale. It is unlikely that intangibles like

patent and trademarks can be purchased as well as resold on a regular basis.

Likewise, the cost plus method entails comparison of costs with added margins for

production of the good. Royalties paid for the right to use of intangibles have little

relations with cost. Royalties charged on use of rights of intangibles are not based on

direct cost of production of such intangible but rather, on the right to use such

intangible.1020

1018
TRA, Transfer Pricing Guidelines 2015, para 13 (2).
1019
Rules 5 (2), (3) and (4) respectively of TP Rules 2014.
1020
Canada v GlaxoSmithKline Inc., 2012 SCC 52.
 254

6.3.3.4 Application of Arm’s Length Principle to Intra Group Services

The TP Rules also require transfer of services and finances between associates to be

made at arm‘s length price.1021 The ITA does not provide aspects that constitute

services for transfer pricing purposes. However, TP Rules define intra-group services

to mean ―services rendered between companies in the same group.‖1022 Such

meaning is general and it does not give a clear indicator on scope of intra group

services for transfer pricing purposes. To the contrary, TRA guideline provides a

range of services that may be taken into account for transfer pricing purposes, for

example, management and technical or commercial services.1023 From legal point of

view, the guideline is not a law per see and therefore, the guideline and rules cannot

prevail over substantive law.1024 Such discrepancy may provide potential to MNCs

to manipulate transfer prices.

For example, in Tanzania, one of the methods used by MNCs in manipulating prices

is management fee.1025 The problem with intra-group services is that other charges

may be paid directly to the other associate without implicating transfer prices in

absence of proper agreement on payment of such services. Such amount or rates

may be substantial to the extent of affecting transfer prices between associated

MNCs. This is possible because in calculating taxable profit of permanent

establishment, such charges may be deducted.1026 In applying arms‘ length methods,

the law requires associated parties to demonstrate that intra-group services was

1021
Rule 10 (1) and (5) of TP Rules 2014.
1022
Ibid, Rule 3.
1023
TRA, Transfer Pricing Guidelines 2015 Para 14.
1024
ITC 1675 62 SATC 219.
1025
See for example Mbeya Company Ltd v Commissioner General TRA, Civil Appeal no 19, 2008.
1026
Section 71 of ITA Cap 332 RE 2008.
 255

actually rendered and had substantial economic value to the business.1027 In

ascertaining the amount for service rendered, the law excludes any charges made for

shareholders or custodial activities, duplicative, incidental or on call services.1028

Additionally, the TP Rules empower the Commissioner to declare certain service not

sufficient for transfer pricing purposes.1029 There is a danger for abuse of such

powers1030 because there is no clear guideline about services to be disregarded for

transfer pricing purposes.1031

6.3.3.5 Arms’ Length Aspect of Intra-Group Financing

The law requires interest obtained out of intra-group financing to be charged at arm‘s

length rate. The TP Rules recognize intra-group financing to include loan, security

and guarantee, advance or debt and interest bearing trade credit.1032 To the contrary,

the ITA clearly excludes debt obligation owed to residential financial institution and

non-resident bank or financial institution, whose interest tax is withheld in

Tanzania.1033 In financing transactions, the arms‘ length applies to the rate of interest

paid on intra-group loan.1034 Generally, interest is deductible for income tax purposes

before tax.1035 Hence, the only tax possibility is withholding amount of interest

levied on the nonresident creditor by the source country. In due regard, it is likely for

1027
Rule 10 (1) (a) TP Rules 2014.
1028
Ibid, Rule 10 (2)( a) and (b).
1029
Ibid, Rule 10 2(c).
1030
Ibid, Rule 10 (2) (c). The purpose of MNCs is to make profit, any loop hole in law gives chance to
maximize profit. Given the financial capacity of MNCs, and given the prevalence of corruption in
developing countries like Tanzania, the chances of abuse of power is high.
1031
See TRA, Transfer Pricing Guidelines 2015, para 14.
1032
Rule 3.
1033
see note 87.
1034
Rule 10 (3) of TP Rules. Although it is not clearly stated, in Tanzania all types of intra group
financing fall within definition of services.
1035
section 11 and 12, 7.
 256

associated MNCs to fund their associates by way of debt instead of equity.1036 To

avoid such practices, the law provides thin capitalization rules to limit the amount of

debt funding in relation to equity. The law requires 7.3 as ratio of the debt to

equity.1037 Where there is change of amount of debt or equity, the amount of either of

them shall be the average of balances of amount of debt or equity at the end of the

month or part of the month.1038

In context of ITA and for the purpose of calculating taxable interest, ―debt means

any debt obligation excluding a non interest bearing debt obligation, debt obligation

owed to residential financial institution, debt obligation owed to a non-resident bank

or financial institution whose interest tax is withheld in Tanzania.‖1039 Arguably

these provisions may not work well in calculating taxable income or interest between

associated parties. In addition, financial institutions, banks and free loans may play a

significant role in manipulating transfer prices.

As noted before, most MNCs operating in EAC countries are essentially associates

of large companies from developed and emerging economies. Such associates have

been running their economic activities by using debt capital from parent MNCs.

Accordingly, multinational transactions between associated MNCs are made in

different currencies other than EAC currencies.1040 Most parent MNCs are from

1036
See Chevron Australia Holding PTY Ltd (CAHPL) v Commissioner of Taxation [2015] FCA 1092.
In this case the Court held that CAHPL had not shown that the interest paid under the Credit
Facility Agreement was equal to or less than arm‘s length.
1037
Section 12 of ITA Cap 332 RE 2008 as amended by Finance Act, 2012.
1038
Ibid, section 12(4) as amended by Finance Act, 2012.
1039
Ibid, section 5.
1040
It should be noted that to date, EAC member state still using different currencies. However, there
are discussions going on in establishing single currency in EAC.
 257

developed and emerging economies, where they have strong currencies. 1041 Thus,

there is potential for an intercompany loan, which is regarded as service to use

differences on rules of conversion and interest payable on loan to shift profit from

one country to another. Notably, MNCs normally earn a fixed rate of income and are

protected by contractual obligations with respect to their investments. The interest

received by a foreign company granting the loan would normally be subject to an

exemption in the country where the receiving company is situated. 1042 However, the

existing thin capitalization rules do not sufficiently address such concerns,

particularly in natural resources.1043 Accordingly, the existing contractual obligation

offered to investors does not necessarily make reference to transfer pricing.

6.3.3.6 Advance Pricing Agreement

The ITA does not provide for Advance pricing agreement (APA), but the TP Rules

provide for APA.1044 The objective Advance Pricing Agreement is to ascertain, in

advance, transfer prices of specified related parties‘ transactions over a specified

period of time.1045 There are three types of APA in Tanzania, namely, unilateral,

bilateral and multilateral APA.1046 Generally, the taxpayer is not obliged to enter

into APA. However, when the taxpayer chooses to enter into APA, both the TRA

and the taxpayer are bound by such agreement.1047 The power to reject or accept the

1041
See Mnali J.M., Note 1, p. 11; TIC, Report on the study of Growth and Impact of investment in
Tanzania,2008 p.21.
1042
See for example section 10 2nd schedules of the Income Tax Act, 2004 where investment is
exempted. The interest amount is then allowed as a deduction in the hands of the company paying
the interest as required section 12 as amended by Finance Act, 2012.
1043
EAC countries are now witnessing the good number of MNCs investing in such areas mostly
likely transfer pricing practices will be enhanced Such areas are critical in generating income for
country‘s socio and economic development and need aggressive transfer pricing laws..
1044
Rule 12 of TP Rules 2014.
1045
TRA, Transfer Pricing Guidelines 2015, Para 17(1).
1046
Rule 12(3) of TP Rules 2014
1047
TRA, Transfer Pricing Guidelines 2015, Para 17(2) .
 258

APA is vested to the Commissioner alone.1048 However, according to TRA officials,

to date, no APA has been concluded in Tanzania. The duration of APA once

concluded is five years.1049 The law requires that once the APA is entered, Tanzania

Revenue Authority (TRA) has to suspend transfer pricing adjustment for covered

transaction where the transaction is consistent with the terms of agreement.1050 Such

requirement presupposes terms of agreement are implemented as required and no

substantial changes of economic or comparables or characteristics of the goods

transacted are capable to affect effected transaction.

Arguably, there is possibility of changes to economic circumstances that may affect

concluded APA. Accordingly, sometimes, there may be inconsistence between the

actual transaction and results of applying confirmed transfer pricing methods after

the closing date of the return. The TP Rules do not impose requirements for the

taxpayer to make necessary adjustment(s) to reflect changes of economic

circumstances or actual conduct of the taxpayer in final return for the year. The TP

Rules allow only adjustment made by a competent revenue authority of another

country, which is consistent with arm‘s length principle and correspondence

adjustment is made.1051

Although the law allows the Commissioner to cancel the APA in material breach of

fundamental terms of the contract,1052 the Commissioner does not cancel APA where

1048
Rule 12(4) of TP Rules 2014
1049
Ibid, Rule 12(9).
1050
Ibid, Rule 12 (7).
1051
Ibid, Rule13.
1052
It is not clear whether the cancellation of APA will be based on ordinary terms of contract or on
discretional power of TRA. This is important as it may bring contradictions as to which law should
apply and may lead to shift burden of proof to TRA to show breach of the taxpayer as was stated
in Eaton Corporation v. Commissioner, T.C. No. 5576-12, 2012. See also Spencer K., and
 259

there are substantial changes for economic circumstances. Notwithstanding

exemption for audits and adjustment offered to confirm APA, the rules empowers the

Commissioner to adjust any price or interest where he has the reason to believe such

prices or interests are not at arm‘s length price. This requirement contradicts Rule

12(7). The law gives, on one hand, and takes, on the other hand, and therefore, it may

affect the taxpayer. Additionally, the law is silent on enforcement mechanisms of

APA. Arguably, APAs are not well regulated this situation may render variation in

its application.

6.3.3.7 Transfer Pricing Documentation Requirement

The ITA does not provide for mandatory transfer pricing documentation

requirement. Yet, it is mandatory for any taxpayer to prepare and maintain hard or

electronic documents necessary to explain tax returns at least for a period of five

years.1053 To the contrary, the TP Rules make mandatory requirement for

contemporaneous transfer pricing documents submitted prior to due date of filing

income tax return.1054 The required information includes organizational structure,

nature of business, transfer pricing analysis including function(s) performed, asset

used, risk assumed, transfer pricing methods and application of such method

including any other document considered relevant by the Commissioner.1055 Such

document may be submitted to the Commissioner upon request within 30 days.1056

Kelleher M., An Advance Pricing Agreements Binding Commitments? International Transfer

Pricing Journal, March/April 2013, p. 117-119.
1053
Section 35(2) and 34 of the Tax Administration Act, Cap 147, 2015. The official language of
document is Kiswahili or English.
1054
Rule 7 (1) and (3) TP Rules 2014.
1055
Ibid, Rule 7(2).
1056
Ibid, Rule 7 (4). This means the taxpayer is not obliged to produce transfer pricing to
commissioner unless is requested to do so.
 260

Where an associated party fails to maintain documents, the TP Rules impose penalty

of fine not less than fifty million Tanzanian shillings or convicted to a prison for not

less than six months or both.1057 To the contrary, the Tax Administration Act

imposes penalty of 10 currency points for each month for which failure continues to

maintain document.1058 To the contrary, ITA imposes penalty of difference between

the income tax payable for each month and part of month for which failure continues

as the higher 2.5 percent or fine of one hundred thousand shillings.1059 Apparently,

there is conflicting transfer pricing documentation penalty and it is unclear about a

provision that will prevail in case of conflict with the taxpayer.

6.4 Administration and Enforcement of Transfer Pricing Rules

6.4.1 Institutional Framework for Transfer Pricing

In Tanzania, all matters related to assessment and collections of revenue are vested to

Tanzania Revenue Authority (TRA).1060 The TRA was established in 1995 as a body

corporate with a perpetual common seal.1061 The TRA is vested with the following

responsibilities:- administration and enforcement of laws related to revenues,

1057
Ibid, Rule 7(5).
1058
Section 77 (1) and (2) of the Tax Administration Act, 2015.
1059
Section 98(1) (a) (d) and (e) R.E 2008. It should be noted that section 80 referred in section 98(1)
has been repealed by section 35 of Tax Administration Act, 2015. However, section (98 1) is not
amended to reflect such changes.
1060
See preamble of the Tanzania Revenue Authority Act, Cap 399 Revised edition 2006. It is
important to note that the TRA is operating under the Ministry of Finance. Tanzania has a three-
tier tax administration structure, namely; Central Government tax administration, Tax
administration in Zanzibar, and Local Governments tax administration. The Tanzania Revenue
Authority (TRA) administers the Central Government taxes, Zanzibar Revenue Board administers
domestic consumption taxes in Zanzibar, and Local Authorities administer the various local
imposed taxes. See ChatamaY. J., The impact of ICT on Taxation: the case of Large Taxpayer
Department of Tanzania Revenue Authority, Developing Country Studies, ISSN 2224-607X
(Paper) ISSN 2225-0565 (Online) Vol.3, No.2, 2013, 92. Available at www.iiste.org Accessed
2016.
1061
Section 4(1) and (2) of Tanzania Revenue Authority Act, Cap 399 RE 2006. The TRA come in to
operation on July 1996.
 261

monitor and ensure collection of various specified revenues from government and

private sector, promoting voluntary tax compliance and advising the government on

matters pertaining to fiscal policy. In curbing any loss of tax, the TRA is responsible

in determining steps to counteract fraud and any other form of tax including other

fiscal evasion.1062 In discharging its functions, the TRA has the power to identify

amendment or alteration of tax laws for purpose of improving administration and

compliance, among other things.1063 In running its activities, the TRA is financed by

the general government budget through an annual parliamentary budget. The

structure of TRA is constituted by the Governing Board and Commissioner General.

The board is responsible for formulation and implementation of TRA policy. 1064 The

Commissioner General, as Chief Executive, is responsible for executing daily

operations of TRA under general supervision and control of the Board.1065 The

responsibility of collecting tax is divided in to four departments, namely, large

taxpayer (LTD), domestic revenue, tax investigation and Customs and Excise

Department. The large taxpayer department was established in October 2001 to

provide consistent and quality service to large taxpayers, to secure revenue, to

improve audit programs, to improve collections and management of tax debts, and

also to act as models or pilots for testing new processes, procedures, structures and

systems‖1066 Most MNCs fall under large tax payer department and therefore,

1062
Ibid, section 5(1).
1063
Ibid section 5(2) as amended by section 59 of Finance Act, 2016.
1064
Section 10 (1) and (2) and section 13 of Tanzania Revenue Authority R.E 2006. See also section 5
of Tax Administration Act, 2015.
1065
Ibid, section 16(1) and (2) and section 17 respectively.
1066
Chatama Y. J., The impact of ICT on Taxation: the case of Large Taxpayer Department of
Tanzania Revenue Authority, Developing Country Studies www.iiste.org ISSN 2224-607X
(Paper) ISSN 2225-0565 (Online) Vol.3, No.2, 2013, p.92.
 262

transfer pricing issues are handled under the same department at the unit called

International Tax Unit (ITU).

The ITU was officially established in 2011 and prior to that, transfer pricing issues

were handled at large taxpayer or domestic department, depending on given

circumstances. According to TRA officials the ITU is manned by less than fifteen

officers composed of an economist, lawyers and accountants. The ITU also supports

regional offices throughout the country. In running its activities, the ITU is entitled

to its own budget of not more than three hundred million Tanzanian shillings per

year. Such amount is used for purchasing data bases and it covers administrative

issues. There are two main responsibilities of ITU, preparation of business plan for

the department and to conduct transfer pricing audit.1067 Such audit queries are

extracted from business plan prepared by the ITU. Since its establishment, the ITU

has undertaken a considerable number of transfer pricing audits in various sectors

that resulted in tax adjustment of 232 billions of Tanzanian shillings that were under

dispute by tax payers.1068 Accordingly, more transfer pricing audits are likely to

increase and more cases are likely to be taken to tribunals or courts of law. Apart

from ITU, the tax investigation department has other three separate independent

audit auditing in manufacturing, extractive industry and services. All teams have

been relatively trained on transfer pricing audits and occasionally, they have been

handling transfer pricing cases within their teams.1069

1067
Section 45 of the Tax Administration Act, Cap 147, 2015.
1068
An interview with TRA officials.
1069
an interview with TRA officials
 263

Despite considerable good performance, ITU is facing challenges in implementing

its works and renders efforts to curb transfer pricing manipulation be more

complicated. Other challenges include lack of local comparables and an unclear

approach in situations where there are insufficient comparables. However, practice

has shown that resort has made foreign databases, which are very expensive and may

not be very relevant though they form an important bench mark for analysis.

According to ITU officials, ORBIS data have never been practically used since their

subscription. Tax incentives offered to MNCs is another challenge and even when

there are sufficient indictors of transfer price manipulation, ITU may not be able to

challenge or adjust. Apart from legal issues, there is overlapping of responsibilities

between ITU and other audit teams at TRA. The problem with this is that it may

lead to inconsistency in application of transfer pricing laws. Shortage of staff and

lack of experience in handling transfer pricing in minerals have seriously affected

performance of ITU. For example, to date, no audit in mineral sector has been

completed since its establishment.1070 Lack of information is also a problem because

TRA relies on information prepared by taxpayers who are sometimes not done

professionally. Lack of transfer pricing policy by MNCs and sometimes they do not

get cooperation from MNCs are additional drawbacks to ITU functions. Moreover,

the whole process of gathering information is time consuming and expensive.

6.4.2 Transfer Pricing Dispute Resolution Mechanism

Both ITA and TP Rules are silent on enforcement of transfer pricing. To date, issues

pertaining to transfer pricing compliance, enforcement and disputes are handled just

1070
TRA interview and ibid, p. 9.
 264

like any other income tax matters.1071 Consequently, ITA provisions related to fraud,

failure to furnish returns and underpayment of tax apply to transfer price disputes. In

due regard, there are three organs responsible for solving transfer pricing disputes.

At the first instance, the Commissioner is empowered to make any tax decision in

relation to dispute arising from assessment and other decisions or omissions that

directly affect a taxpayer.1072 The most relevant aspect of transfer pricing disputes

falls within category of assessment. Generally, the Commissioner has the power to

issue an additional adjustment assessment based on the Commissioner‘s best

judgment and information available.1073 A taxpayer who is aggrieved by the

Commissioner‘s decision has the right to appeal to the

Tax Revenue Appeal Board (TRAB) in accordance with Tax Revenue Appeal Act

provisions.1074 In context of transfer pricing, where it is established that a taxpayer

did not comply with arm‘s length principle is guilty of underpayment of tax and is

liable to a penalty of one hundred percent of the underpayment of the tax.1075

TRAB1076 is the second institution responsible for handling appeals on objected

assessment decision by the Commissioner.1077 Appeals to TRAB are made pursuant

to requirement provided in The Tax Revenue Appeal Act.1078 During the hearing, the

onus of proving that the assessment or decision in respect of which an appeal is made

1071
Interview with TRA officials at KRA offices Nairobi Kenya 2014
1072
Section 50 (1) and (3) of the Tax Administration Act, Cap 147, 2015.
1073
Ibid, section 48.
1074
Ibid, Section 53.
1075
Rule 4 (5) of TP Rules, 2014.
1076
Established pursuance to section 4 of the Tax Revenue Appeal Act, RE 2006.
1077
Ibid, section 16, see also section 53 (1) of the Tax Administration Act, 2015.
1078
Ibid, section 14 and 15 respectively.
 265

lies to the appellant.1079 Any person who is aggrieved by the decision of TRAB has

the right to appeal to Revenue Appeal Tribunal (tribunal).1080 The proceedings of the

TRAB and Tribunal are of judicial nature and that their decision is enforceable and

executed just like degree or orders of the court of law.1081

Any taxpayer who is aggrieved by the decision by TRAB or Tribunal has the right to

appeal to the Court of Appeal on point of law only.1082 Accordingly, the provisions

of the Appellate Jurisdiction Act1083 and rules made there under shall apply mutatis

mutandis to appeals from the decision of the Tribunal.1084 The decision by Court of

Appeal is final. The tax dispute resolution mechanism in Tanzania reveals that there

is no special mechanism established for addressing transfer pricing disputes.

The fact that, to date, no transfer pricing cases have been decided by TRAB, the

Tribunal or Court of Appeal, it may be hard to say that transfer pricing will be

handled in a very special way. It is likely that it will be handled just like any other

tax dispute. However, at least four transfer pricing cases have been filed and are still

at the TRAB. Due to the fact that transfer pricing disputes are complex in nature

involving various disciplines, it remains to be seen the manner actors will handle

transfer pricing disputes.

1079
Ibid, section 18(2) (b).
1080
Ibid, section 8 and section 11 respectively. The procedure for appeal and onus of proof are the
same as those made under TRAB.
1081
Ibid, section 18 (1) and section 24 (3).
1082
It should be noted that the appeal from tribunal are not taken to the High court because both have
concurrent jurisdiction on tax matter.
1083
Appellate Jurisdiction Act, 1979 cap 141 of the laws of Tanzania.
1084
Section 25 of the Tax Revenue Appeal Act, RE 2006.
 266

6.5 Base Erosion and Profit Shifting Action Plan in Tanzanian Context

As noted before that the existing arm‘s length principle, to a great extent, has

encountered serious challenges in curbing transfer pricing manipulation, Base

Erosion and Profit Shifting Action Plan (BEPS Action Plan) was thought as a rescue.

The rationale behind BEPS is to ensure that profit by MNCs is taxed where

economic activities generating that profit are performed or where the value of

intangible is created. Analysis of transfer pricing law reveals that, to a certain extent,

BEPS Action Plan has been taken into account.

For example, comparability factors and analysis, requirement and payment of

ownership of intangibles and documentation requirement under TP Rules seem to be

borrowed from BEPS guidelines on application of arm‘s length principle.

Accordingly, the fact that the TP Rules are construed in manner consistency with

OECD model and Guidelines as supplemented and updated from time to time, BEPS

Action Plan is applicable in Tanzania.

6.6 Conclusion

The presented analysis and examination of transfer pricing laws in Tanzania reveal

inadequacy of law in curbing transfer pricing manipulations. The arm‘s length

principle still remains as a sole solution in curbing transfer pricing manipulation.

While the existing transfer pricing laws are premised on arm‘s length principle, they

lack clarity and in some instances, they contradict each other. Accordingly, where

clear provisions exist, they are not implementable, either because of lack of pre-

requisites, requirement such as comparables or lack of experience and knowledge of

transfer pricing by tax officers. Although the arms‘ length is applicable to extractive
 267

business there is no clear guideline on how such transactions should be handled in

transfer pricing context. The absence of decided transfer pricing cases in courts and

tribunals are indicators of such discrepancies. Although there are few cases, which

have been filed, it remains to be seen whether or not decision of such cases by

tribunal and court will reduce if not eliminate existing discrepancies. Such

discrepancies are likely to hinder Tanzania desire to obtain right share of tax from

MNCs investments for economic development.

 268

CHAPTER SEVEN

TRANSFER PRICING LEGISLATION IN KENYA

7.1 Introduction

A favourable situation created by the government of Kenya has been a catalyst in

attracting more MNCs in the country. Consequently, MNCs have been contributing

more than seventy percent to government revenue. However, such revenue has been

characterized by looming risk of losing the right share of tax from associated MNCs‘

operations in Kenya through transfer pricing. In an effort to protect its tax base,

Kenya has enacted a transfer pricing law whereby arm‘s length principle is a corner

stone. However, inadequacy of the law and complexities involved in arriving at

arm‘s length price has remained a major obstacle. While more efforts are geared

towards attracting MNCs, there is need to remove risks associated with MNCs‘

investment with a view of achieving the country‘s desire to fund its expenditure

through tax revenue. This chapter analyses adequacy of transfer pricing legislation in

curbing transfer pricing manipulation in Kenya.

7.2 Overview of Social, Economic and Political Context

Kenya gained its independence on 12th December, 1963 from British. After

independence, Kenya inherited colonial legal system and economy that reflected

colonial interests.1085 The economy of Kenya was largely centered on agriculture

with a limited range of secondary industries.1086 The history of foreign investment in

1085
Ndege P.O., Colonialism and Its Legacy in Kenya, Lecture delivered during full bright Hays
Group Project Abroad programme, Moi University Main Compus, 5 th July to 6TH August 2009. p. 4-
6.
1086
Ibid, p. 6.
 269

Kenya can be traced back prior to independence. Kenya was a settler as well as

crown colony and it was integrated by the British such that not only many British

settlers settled but also they meant to stay forever. Consequently, Kenya received

more investments.1087 British colonialists used the law as a tool for the purpose.

Using their colonial legislature, the British colonialists made some laws that

influenced the pattern of investment in East African countries. For example, the laws

made granted long land holding rights to settlers in Kenya and dispossessed Africans

off their lands and vested the same to settlers or investors. In due regard, it

discouraged Africans from competing with British investors in cash crops

production. Such laws greatly attracted foreign investors to invest in Kenya.

After independence, Kenya continued to be the most favoured destination of foreign

investment in the EAC region. That was due to relatively high level of economic

development, market size growth and openness of the foreign direct investments,

while other neighbor countries such as Tanzania and Uganda had relatively closed

regimes.1088 The large capital flow in Kenya was driven by expansion in the

agriculture sector, fiscal and monetary policies such as overvalued exchange rates,

import tariffs, quantitative restrictions including import licensing.1089 Thus,

sustainable budget deficit and import substitution industrialization strategies also

1087
Kahama C.G., et al., The Challenge for Tanzania‘s Economy. Tanzania Publish House, Dar es
Salaam, 1994, p. 17.
1088
Abala D.O., Foreign Direct Investment and Economic Growth: An Empirical Analysis of Kenyan
Data, DBA African Management Review, Vol.4 No.1 2014, PP 62-83, P.64. This is because
countries like Tanzania and Uganda opted for socialism policy while Kenya opted for market
oriented policies in the garb of socialist principle. See Nellis J., The Evolution of Enterprise
Reform in Africa: From State - owned Enterprises to Private Participation in Infrastructure – and
Back? NOTA DI LAVORO 117.2005, p 3. Available at http://ssrn.com/abstract=828764.
Accessed January 20 2016.
1089
Ibid, p. 273.
 270

contributed.1090 Whilst post-independence government of Kenya managed to attract

foreign investment for economic development, the taxation system inherited from

colonial powers remained quite substantially unaltered.1091 Such pattern informs

narrow coverage of existing tax instrument, poor tax administration and tax

collection efforts.1092 Notwithstanding, great inflow of foreign investment in Kenya

between 1980s and 1990s the economy of the country deteriorated and level of

foreign investments dropped. There are two reasons for such pattern: first, at that

time, the country experienced bad governance, high corruption level, inconsistence

in implementation of economic policies and structural reform that led to poor public

services and infrastructure.1093 Second, economic policy reforms of Tanzania and

Uganda in processes of implementing liberalization of their economy. 1094 Despite

backdrop of foreign investment in Kenya, various measures were taken by the

government of Kenya to improve foreign investment in the country. They included

establishment of Export Processing Zone (EPZ), manufacturing under bond (MUB)

and accession to the African Growth and Opportunity Act (AGOA) in 2001.1095

Other measures included establishment of investment law geared to attract foreign

investment.1096 The remarkable development made by the government of Kenya was

establishment of Kenya Vision 2008 to 2030. The objective of the 2030 vision is to
1090
Ibid.
1091
Warris A., Taxation without principles: A Historical Analysis of the Kenyan Taxation System,
Kenya Law Review, Vol 1: 272, 2007, pp 272 – 304 p. 273; See also Masoud B.S., Legal
Challenges of Cross Border Insolvencies in Sub –Saharan Africa with Reference to Tanzania and
Kenya: A Frame work for Legislation and Policies, PhD Thesis, Nottingham Trent University,
United Kingdom, 2012, p.196.
1092
Ibid.
1093
Abala, Note 1088, p. 65.
1094
Ibid, see also chapter 6 and 3.
1095
World Bank. Connecting to Compete: Trade Logistics in the Global Economy, Washington D.C.
2012, p.
1096
See for example The Investment Promotion Act, 2004 cap 485Bas revised 2009. An Act provide
for promotion and facilitation of investment and other assistance and in obtaining tax incentives
and for related purposes. See section 15(2) (iii).
 271

transform Kenya in a newly industrialized global competitive and prosperous middle

income country.1097

Consequently, the government of Kenya continued to attract, maintain and retain

foreign investments. The rationale behind was their contribution to economic

development providing employment, technology, for example, in communication

sector like introduction of mobile transactions such as M-Pesa money transfer,

facilitating transfer of capital and investments together with increasing foreign

exchange earnings and tax revenue.1098 It is estimated that Kenya is having more

than 100 MNCs operating in the country.1099 Such MNCs are ranging from

communication sectors, for example, Safaricom and Airtel, manufacturing such as

British American tobacco, Bamburi cement and banking like Barclays, to mention a

few. Such MNCs are part of the large tax payers in Kenya contributing 70 to 80

percent of the revenue. However, Kenya Revenue Authority (KRA) has no specific

data on the extent of contribution of MNCs alone operating in Kenya due to

complications in identifying actual transactions between associated MNCs.1100 All

these culminated in an increase in MNCs‘ operations in Kenya whereby transfer

pricing is practiced. However, while foreign investments have been seen important

for developing the country‘s economy, they are also sources of vulnerable to such

1097
Kenya Bureau of statistics, Foreign Investment Survey, Preliminary Report 2015, p.1 available at
www.knbs.or.ke.
1098
Shihata I. F., Legal Treatment of foreign Investment, The World bank Guideline, Martinus Nijhoff
Publishers 1993, p.9-12. See also Nyamori B., note 46 p.153; Kenya Bureau of statistics, Foreign
Investment Survey, Preliminary Report 2015, p.1 available at www.knbs.or.ke. Accessed 2015.
1099
Interview with TRA officials Nairobi Kenya December 2014. See also KRA: Large Taxpayers
Office, available at <http://www.revenue.go.ke/index.php/domestic-taxes/large-taxpayersoffice/
about-lto/vision.
1100
Ibid.
 272

economy. This is because transfer pricing manipulation has been eroding tax base of

Kenya.

For example, transfer pricing audit made by KRA discovered loss of 25 billion

Kenya shillings (Kshs.) due to abuse of transfer pricing rules.1101 That is achieved by

either under-pricing or overpricing of goods and services between associated MNCs

or by declaring losses.1102 It is also established that for 10 years between 2004 and

2013, Kenya lost Kshs.11. 5 billion transfer pricing related tax annually.1103

Consequently, associated MNCs‘ transactions have become under serious

investigation by the government in order to curb transfer pricing manipulation. This

is sought to be achieved by sharpening transfer pricing laws.

7.3 Transfer Pricing Laws in Kenya

The legal and regulatory framework of transfer pricing comprises three major

sources, namely, the Constitution of Kenya, legislation and their rules and tax

treaties.

7.3.1 The Constitution of Kenya 2010

The Constitution of Kenya clearly empowers nation government to impose taxes and

charges on income tax, value added tax (VAT), customs duties and other duties on

1101
Andae G., Tax Evasion Sting recovers sh. 25 Billion from Multinationals, Business daily, July 14,
2014.
1102
Ibid, The amount which is equivalent to half the budget Kenya has allocated to 47 counties in the
in 2014 financial year to tackle unemployment, the broken health system and to revamp
infrastructure.
1103
Global Financial integrity report 2014 and 2015 which reports that Sub –Saharan Africa is losing a
lot of money mainly due to trade invoice mispricing. 2015 report p. 43.
 273

import and export goods as well as excise tax.1104 It provides authority to collect

revenue to support the economy‗s efforts towards generating, serving and investing

adequate funds to sustain needs for the country as well as promote sustainable

national development.1105 The fact that, to a great extent, the economy of Kenya

depends on its internal revenue, the Constitution provides for principles of public

finance. It requires openness, accountability and public participation in financial

matters.1106 It also requires public finance system to promote an equitable society by

sharing the burden of taxation fairly.1107 Accordingly, the revenue raised should be

nationally equally shared and expenditure should promote equitable development.1108

The constitution declares that the primary source of revenue for national is taxation.

The power to impose tax lies with parliament exercised through legislation.1109

Accordingly, it prohibits any tax or licensing fee to be imposed or waived or varied

except as provided under legislation.1110 However, where the relevant legislation

provides for waiver or variation, proper record and reason for waiver or variation are

recorded and reported to Auditor General.1111 Generally, the Constitution of Kenya

adheres to principles of good taxation.

1104
Article 209 (1) of the Constitution of Kenya 2010.
1105
Kenya National Development Civic Education, Ministry of Justice, National Cohesion and
Constitutional affairs, 2012 p.158.
1106
Article 201 (a) of the Constitution of Kenya 2010.
1107
ibid, Article 201 (b) (1).
1108
Ibid, Articles 202(1) and 203 respectively.
1109
Ibid, Article 209.
1110
Ibid, Article 210.
1111
Ibid, Article 210(2) (a) and (b).
 274

7.3.2 The Income Tax Act 2010

The Income Tax Act (ITA) of Kenya was passed on 2010. 1112 It repealed and

replaced the 1973 ITA. There are three objectives of the ITA, firstly, it provides for

charges, assessment and collection of income. Secondly, it provides for

ascertainment of income to be charged. Thirdly, it provides for administration of

charge, collection and ascertainment of the same.1113 The ITA has xiv parts, part I

provides for commencement and interpretation. Party II deals with imposition of

income tax, part III is about exemption from tax, part iv is on ascertainment of total

income, party v is geared towards personal reliefs and part vi is on rates, deductions

and set-off and double taxation relief. Part vii provides for persons assessable, part

viii is about returns and notices, part ix is for assessments, part x deals with

objections, appeals relief and relief for mistakes, part xi provides for collection

recovery and payment of tax, part xii is about offences and penalties, part xiii is on

administration and part xiv deals with miscellaneous provisions.

Generally, the ITA imposes tax on both residents and non-residents on income

accrued from Kenya.1114 For the purpose of this work, a company is regarded a

resident of Kenya if it is incorporated under the laws of Kenya or management and

control of affairs of the body is exercised in Kenya for that particular year of

income.1115 Accordingly, the company is resident of Kenya if it is declared by the

1112
Cap 470 RE 2014.
1113
See preamble of the ITA R.E 2014.
1114
Ibid, Section 3 (1).
1115
Unlike OECD and UN model and their guidelines, the ITA deviated from the world ‗effective
management‘ which normally brings confusion.
 275

Minister in the government gazette for any year of income. 1116 The income taxed is

profit obtained from business carried out, service rendered, a right granted for use or

occupation of who has, and habitually exercises, authority to conclude contracts in

the name of that person and property in Kenya for whatever period.1117 In addition,

interest, dividends1118 and natural resources are also taxed.1119 MNCs also can be

taxed on net gain derived from an interest in a corporation if the interest derives

twenty percent or more of its value directly or indirectly from immovable property in

Kenya.1120 Therefore, any income arising out of stated activities are also taxable to

associated MNCs.

7.3.2.1 Application of Arm’s Length Principle in Kenya

Part IV of the ITA is of particular interest because it provides for ascertainment of

income and arm‘s length principle for transfer pricing between associated parties.

Section 18(1) provides for ascertainment of business profit or gain in relation to a

non-resident who carries on business in Kenya. A person is said to carry on business

in Kenya for transfer pricing purposes if such business is carried on from land or

water, a product or produce, sells or delivery outside Kenya, including contract of

sale made outside Kenya and utilization of the product or produce outside Kenya. 1121

The profit or gain is also derived from Kenya where a bank, which is a permanent

1116
Section 2 of ITA, Cap 470 R.E 2014. However, the law is silence on criteria for the Minister to
declare a company as a resident.
1117
Ibid, section 3 (2) (a). Business profit is deemed to be derived from Kenya even if the business
which gave rise of it is partly carried on in and partly carried out of Kenya; see section 4(a) of ITA.
1118
Ibid, section 3 (2) (b).
1119
Ibid, section 3(h).
1120
Ibid, section 3(2) (g), 3 (3) (c) and section 5A.
1121
Ibid, section 18(1).
 276

establishment of a nonresident person holds outside Kenya any deposits, assets or

property acquired from its operations in Kenya.1122

Section 18 (3), in particular, provides for the arm‘s length principle. The provision

provides that,

―Where a non-resident person carries on business with a related

resident person or through its permanent establishment and the
course of that business is such that it produces to the resident person
or through its permanent establishment either no profits or less than
the ordinary profits which might be expected to accrue from that
business if there had been no such relationship, then the gains or
profits of that resident person or through its permanent establishment
or from that business shall be deemed to be the amount that might
have been expected to accrue if the course of that business had been
conducted by independent persons dealing at arm's length.”1123

This section sets arms‘ length principle as the basis for associated MNCs to be taxed.

From the wording of section 18(3), the rationale behind is to ascertain the business

profit or gains of associated MNCs by using independent persons as a benchmark.

The policy underlying arm‘s length principle, in particular, section 18(3) is the need

to hinder cross-border transactions between associated parties that have undesirable

effect of shifting taxable income from Kenya.1124 But neither the ITA nor Transfer

Pricing Rules provide for meaning of arm‘s length principle. However, the TP Rules

define arm‘s length price to mean the price payable in a transaction between

independent enterprises.1125 For the purpose of regulating transfer pricing, the

1122
Ibid, section 18(2).
1123
Ibid, section 18(3). .
1124
Nyamori note 46 p. 155. See also, Mbiuki J.M., The Legal and Institution Frame work of
Transfer Pricing in Kenya: A Case Study of Unilever Case and its Aftermath, A Thesis Submitted
in partial fulfillment of the requirements for a award of a Master of Laws (LL.M) Degree of the
University of Nairobi, 2009, p. 29.
1125
Rule 3 of TP Rules 2006.
 277

persons are associated1126 to each other if ―either person participates directly or

indirectly in the management, control or capital of the business of the other; or a

third person participates directly or indirectly in the management, control or capital

of the business or both.‖1127 Accordingly, any individual, who is associated by

marriage, is a blood relative or has an affinity to an individual involved in the

management, control or capital of the business of the other is considered to be an

associated party.1128 The threshold for control is 25 percent of the shareholding or

voting power in the entity.1129 Accordingly, it recognizes bank as a permanent

establishment of the non- resident person established outside Kenya but deposits

assets or property acquired from its operations in Kenya. 1130 Permanent

establishment is defined as a fixed place of business and includes a place of

management, a branch, an office, a factory, a workshop, and a mine, an oil or gas

well, a quarry or any other place of extraction of natural resources, a building site, or

a construction or installation project that has existed for six months or more where

that person wholly or partly carries on business.1131 However, the ITA is silent on

aspects that do not constitute permanent establishment for transfer pricing purposes.

In ascertaining business profit derived from Kenya for transfer pricing purposes, the

law clearly prohibits any deductions for expenditure incurred outside Kenya in

respect of remunerations for services rendered by non-resident directors of non-

resident company in excessive of five percent or twenty five thousand Kenya

1126
It is important to note that ITA has used the word ‗related‘ throughout , but for the purposes of
consistence of this work, the word ‗associated ‗is used.
1127
Section 18 (6) (a) and (b) of ITA R.E 2014.
1128
Ibid, section 18 (6) (c).
1129
Ibid, paragraph 32(1) of part IV of the second schedule.
1130
Ibid, section 18(5).
1131
Ibid, section 2(a). The definition of permanent establishment is imparimateria with UN model.
 278

shillings, whichever is high.1132 Accordingly, no deduction in excess of one hundred

and fifty thousand Kenya shillings shall be allowed.1133 In addition, no deduction is

allowed on executive and general administrative expenses except to the extent that

the Commissioner may determine that expenditure to be just and reasonable.1134

However, the ITA does not provide any guideline as to when the expenditure is

deemed to be reasonable and just. The terms just and reasonable are vague and may

be used inappropriate manner. The ITA also prohibits deductions in respect of non-

resident person carries business in Kenya through permanent establishment in

interest or royalties or management or professional fee purported to be paid to the

nonresident person.1135 In implementing requirement of arm‘s length principle as

provided under section 18(3), the law empowers the Minister of Finance to issue

guideline for determination of arm‘s length price of a transaction.1136

In ascertaining taxable income of permanent establishment, the law requires be taxed

on profit attributable to it only. However, the KRA is of the opinion that permanent

establishment as an independent entity may have an opportunity to make profit from

transactions that its foreign related parties had undertaken in Kenya. The rationale

behind is that by virtue of relationship between permanent establishment and its head

office as well as other permanent establishments, it may pass off the opportunity to

those associated while playing a key role in generating income. In this context,
1132
Ibid, section 18(4) (a).
1133
Ibid.
1134
Ibid, section 18(4) (b). Unlike Kenya, the law does not clearly provide for ascertainment of
business profit for transfer pricing purposes.
1135
Ibid, Section 18(5) as amended by section 9 (b) of the Finance bill 2014, provided that for the
avoidance of doubt, the expression "non-resident person" shall include both the head office and
other offices of the non-resident person.
1136
Ibid, Section 18 (8) (a), however, as of October 2016 no transfer pricing guideline has been
issued.
 279

where MNCs carry out business in Kenya through permanent establishment they are

also taxed on profits that relate to the permanent establishment but arise from

activities conducted outside Kenya.1137 Furthermore, where a permanent

establishment situated in Kenya makes payment to any other person in management

or professional or training fee, royalty, interest, and use of property, it is considered

to be income derived or accrued from Kenya.1138

In ascertaining total income for the year of income, no deduction is allowed for

capital expenditure, or any loss, diminution or exhaustion of capital.1139

Notwithstanding any deductions, no deduction expenditure incurred in production of

income deemed under section 10 of ITA to have accrued in or to have been derived

from Kenya where that expenditure was incurred by a nonresident person not having

a permanent establishment in Kenya.1140 Accordingly, no deduction in respect of

interest, royalties or management professional fees paid or purported to be paid by

permanent establishment to nonresident persons including head office and other

unrelated offices of such non- resident.1141 However, any exchange loss or gain in

respect of foreign exchange loss and gain with respect of net assets including liability

is disregarded.1142

1137
Ernest and Young 2013, p.2.
1138
Section (10, a –f) of ITACap 479 R.E 2014.
1139
Ibid, section16.
1140
Ibid, section 16 (2) (f).
1141
Ibid, section 18(5).
1142
Ibid.
 280

7.3.2.2 Transfer Pricing Adjustment

Where it is established that a transaction between associated MNCs produces no

taxable income or less than what could have been expected to the parties dealing

with each other independently, the Commissioner is empowered to adjust such

income. However, section 18 is silent on modalities of transfer pricing

adjustments.1143Consequently, general anti-avoidance provisions of the ITA become

applicable.1144 The provision provides that,

―Where the Commissioner is of the opinion that the main purpose

or one of the main purposes for which a transaction was effected
(whether before or after the passing of this Act) was the avoidance
or reduction of liability to tax for a year of income or that the
main benefit which might have been expected to accrue from the
transaction in the three years immediately following the
completion thereof was the avoidance or reduction of liability to
tax, he may, if he determines it to be just and reasonable, direct
that such adjustments shall be made as respects liability to tax as
he considers appropriate to counteract the avoidance or reduction
of liability to tax which could otherwise be effected by the
transaction.”

For the Commissioner to invoke this provision, two conditions must exist, firstly, the

main purpose or one of the purposes of the transaction must be avoidance or

reduction of liability to tax. Secondly, the exercise of the Commissioner‘s power

must be just and reasonable.1145 The fact that there is no specific provision of

transfer pricing adjustment, it is likely transfer pricing adjustments are done in

context of general anti-avoidance tax. The problem with this approach is that transfer

1143
Unlike Kenya, In Tanzania the law clearly provides for modalities for transfer pricing adjustment.
See chapter six para 6.3.2.4.
1144
Section 23 of Cap 470, ITA, R.E 2014. The policy underlies section 23 is that taxpayer ought not
to pay less tax thanwhat could have expected for being induced by tax avoidance motive but rather
should be in accordance with the intention of the law.
1145
Commissioner of Income Tax v C.W Armstrong, KE, CA, 1962.
 281

pricing adjustment entails specific procedures that must be followed, unlike other

ordinary adjustments. This can be substantiated by the fact that any additional tax

arising out of transfer pricing adjustment is subject to additional penalties of twenty

percent for late payment and two percent interest rate per month on tax amount

remaining to be paid.1146 Yet, the taxpayer is also liable for tax avoidance penalty

equal to double the amount that would have been avoided.1147

The Tax Procedure Act also imposes tax avoidance penalty to any taxpayer who

knowingly makes false or misleading statement or omits from statements any

information made to an authorized person.1148 Seventy five percent of the tax

shortfall for if the statement was made deliberately or twenty five percent in any

other case.1149 Such penalty will be increased for ten percent if it is the second

application and twenty five percent for the third application.1150However, it is

unclear whether errors could be considered false declarations and criteria to

determine if an act is deliberate.1151 Although the Tax Procedure Act is silent on

transfer pricing, the Act is applicable by analogy to transfer pricing because the Act

clearly states that in absence of specific procedure under tax law, the provision of

TPA shall apply.1152 The law also is silent as to whether or not transfer pricing

adjustments can be passed through financial statements or through income tax

computation. However, a taxpayer is allowed to make self-adjustment if by reason of

1146
Section 72D and 94 (1) of ITA R.E 2014
1147
Section 85 of the Tax Procedure Act, 2015.
1148
Section 84(1) and (8) of TPA, 2015.
1149
Ibid, section 84 (2) (a) and (b).
1150
Ibid, section 84(3) (a) and (b).
1151
PWC, Kenya‘s New Tax Procedure Act seeks to harmonize and consolidate tax administration,
Tax Insights from International Tax Services, March 2016. p.2.
1152
Section 2 (2) of Tax Procedure Act, 2015.
 282

some mistake of fact or errors leading to excessive assessment by applying to the

Commissioner within seven years.1153 In addition, the law is silent on corresponding

adjustment.

7.3.3 Income Tax (Transfer Pricing) Rules 2006

Income Tax (Transfer Pricing) Rules (TP Rules) were established in 2006 and came

into force on 1st July, 2006.1154 The TP Rules came out following decision in

Unilever case whereby the court, in reaching its decision, relied on OECD rules

because by then Kenya had no detailed transfer pricing rules. There are two

objectives of TP Rules, first, to provide guidelines for associated enterprises in

determining the arm‘s length price for transactions of goods and services between

them.1155 Second, to provide administrative regulations for transfer pricing

documents submitted to the Commissioner General (Commissioner).1156 The TP

Rules applies between associated MNCs operating within and outside Kenya.1157

Also applies between permanent establishment and its head office in which

permanent establishment is treated as a distinct as well as separate from its head

office or other related branches.1158 The TP Rules define associated parties for

transfer pricing purposes to mean one or more or third person enterprises

participating directly or indirectly in management, control or capital of the other

1153
Section 90 of ITA R.E 2014.
1154
Legal Notice No. 67 of 2006.
1155
Rule 3(a) of the TP Rules 2006.
1156
Ibid, Rule 3(b).
1157
Ibid, Rule 5(a).
1158
Ibid, Rule 5(b).
 283

enterprise.1159 To the contrary, the ITA defines related parties to include an

individual who participates in management, control or capital of the business is

associated by marriage, consanguinity or affinity.1160 Arguably, even in absence of

control, entities may still be deemed related because control is not the only

criterion.1161 ITA widely defined related persons, a pattern, which ensures that

transfer prices can be adjusted not only to MNCs related but also to individuals who

are related in a particular business. To the contrary, the TP Rules clearly exclude

individuals.1162 Accordingly, the TP Rules define associated enterprises and not

associated persons for transfer pricing purposes as provided under enabling Act and

the scope of application of TP Rules is limited to related enterprises. 1163 Ordinarily,

in case there is conflict between rules and enabling Act, the enabling Act will prevail

over rules. However, exclusion of related individual under the rules may bring

problems in its implementation.

TP Rules provide for transactions, which are subject to adjustment under arm‘s

length principle. They include the sale or purchase of goods or lease of tangible

assets, the transfer, purchase or use of intangible assets, provision of services;

lending or borrowing of money and any other transactions, which may affect profit

or loss of the enterprises involved.1164 The TP Rules provide a wide range of

transactions that are subject to transfer pricing adjustment, in particular, it gives a

wide room for KRA to adjust such transfer pricing. Although the TP Rules recognize

1159
Ibid, Rule 2.
1160
Section 18(6) of ITA.
1161
Deloitte, Global Transfer Pricing Country Guide 3, Kenya, 2015, p. 133.
1162
See definition of related enterprises regulation 2.
1163
Rule 5 of the TP Rules 2006.
1164
Rule 6(a)–(f).
 284

services, tangible and intangible assets including goods, neither the TP nor the ITA

provides for definition of such terms for transfer pricing purposes like it is done by

other countries.1165 The absence of proper definition of such terms may render

uncertainty in application of arm‘s length principle to such transactions.

7.3.3.1 Determination of Arm’s Length Price

To arrive at arm‘s length price, the TP Rules provide methods to be applied. They

include Comparable Uncontrolled Price (CUP) resale price method; cost plus method

profit split method and the transactional net margin method.1166 Essentially, these

methods are replica of OECD methods.1167 In applying these methods, the taxpayer

is free to choose any method it deemed fit for a particular transaction.1168

Accordingly, no issued guidelines describe procedures to be followed while

determining arm‘s length price. In this context, it is not an offence for the associated

MNCs to select any method in determining arm‘s length price even if the most

relevant method is available. Notwithstanding, this requirement, a tax payer is

obliged to apply the most appropriate methods, depending on nature of transactions

or class of transactions or related persons or function performed.1169 Arguably, the

1165
See for example transfer Income tax (Transfer Pricing Rules) of Tanzania 2014. Definition means
interpretation given by any written law to a word or expression. See section 3 of the Interpretation
and General Provisions Act, Cap 2 of the laws of Kenya, Revised Edition 2014. See also, Kiunsi
H.B., Money and Politics in Tanzania: An Evaluation of The Election Expenses Act in the 2010
General Election, Elixir Criminal Law 51 (2012) pp 10841-10849, p. 10845 stating the rationale
behind defining word or expression is to provide certainty to its meaning, or to limit its ordinary
meaning or to extend its ordinary meaning, and in some cases merely to avoid repetitions.
1166
Rule 7 (a) – (d) read together with Rule 8(1) of the TP Rules 2006.
1167
According to KRA officials there are two reasons for this, first, at the time TP Rules were
established only OECD model was available and it was viable option. Second, OECD Model
provides for international standard of arm‘s length principle.
1168
Rule 4 of TP Rules 2006.
1169
Ibid, Rule 8(2).
 285

law contradicts by imposing no hierarchal application of methods, on one hand, and

on the other hand, requiring the most appropriate method to be employed.

Generally, KRA prefer CUP method where comparables are available and in the

absence of comparables, it renders determination of arm‘s length price via CUP

difficult.1170 The problem is exacerbated by lack of local comparable data base

although it subscribed pan-European data base like Amadeus.1171 To the contrary,

associated MNCs in Kenya prefer spilt profit margin method, which is comparatively

more complicated than CUP. It is believed that MNCs take advantage of the law

because it is silent on the range of profit margins.1172 The TP Rules deviates from

OECD by allowing any other method prescribed by the Commissioner to be used in

case the arm‘s length price cannot be determined by using methods prescribed in the

TP Rules.1173 Yet, neither the TP rules nor the ITA provide what constitutes other

methods. It is also unclear whether or not that other methods eventually will lead to

arm‘s length price or will be something else more or equivalent to arm‘s length

methods. However, according to KRA officials, the practice has shown that

formulary apportioned method has been used in such cases. The problem with this

method is that no law regulates the same. Therefore, there is risk of such methods to

be applied arbitrarily as well as may affect both the taxpayer and KRA.

1170
An interview with KRA officials.
1171
Ibid,
1172
Ibid.
1173
Rule 7(e) of TP Rules 2006.
 286

7.3.3.2 Transfer Pricing Comparability Factors

Application of any method in determining arm‘s length price depends on comparable

available, but the TP Rules are silent on factors to be compared. 1174 However, in

context of TP Rules, a transaction is comparable if there are no material differences

or reasonable accurate adjustment that can be made to eliminate material

difference.1175 Comparability of transaction for transfer pricing purposes presupposes

presence of local comparable data. Kenya, like any other developing countries, is

lacking local comparables.1176 Consequently, use of Kenya comparables may be very

limited and may lead to absence of comparables. In practice, MNCs in Kenya have

been using commercial foreign databases such as Amadeus and Orbis as benchmark

studies.1177 The problem with foreign comparables is that they may not be very

relevant and they may be expensive.

Accordingly, the TP Rules are silent on whether or not foreign data are accepted

provided that no material differences or can reasonably be adjusted. Yet, in practice,

KRA occasionally challenges use of foreign comparables on basis of non-inclusion

of country adjustment.1178 However, no guideline on how adjustment can be made

when foreign comparable is used.

1174
Unlike Kenya, Tanzania clearly provides comparability factors . see Rule 6 of TP Rules 2014 of
Tanzania.
1175
Rule 2 of TP Rules 2006.
1176
See discussion in chapter 6, para 6.4.3.2.
1177
Deloitte, note 71. See also KPMG, Global Transfer Pricing Review, Kenya, 2015, p.4.
1178
Ibid.
 287

7.3.3.3 Application of Arm’s Length Principle to Intangibles, Services and

Intercompany Financial Transactions

The TP Rules require transfer of services, intangibles and finances between associate

MNCs to be made at arm‘s length price.1179 In Kenya, there are no clear guidelines

on application of arm‘s length principle to such transactions. To start with services,

in practice, the KRA requires the tax payer to demonstrate that intra group services

were actually rendered based on the agreement if any.

However, there is no guideline as to when the services are said to be actually

rendered.1180 In practice, the KRA requires taxpayer to show that service was needed

and there is no duplication of activities and that the fee was properly charged. 1181

This is sought to be achieved by providing evidence of such transactions. While such

requirements may be valid, if they are not regulated may not compel a taxpayer to

comply. Likewise, the law does not provide any guideline on range of services to be

taken into account for transfer pricing purposes. The problem with this is that it may

render difficult to ascertain the amount of tax to be charged. This is obvious despite

prohibition of deduction on services rendered by the nonresident directors of the non-

resident company.1182 Yet, the law empowers the Commissioner to determine

whether or not administrative expenses between associates are reasonable and

just.1183

1179
Ibid, section 10 and Rule 3 (a), and 6 (c), (d) and (e) of TP Rules, 2006.
1180
In Tanzania for example there is clear guideline showing circumstances that the service was
actually rendered. See TRA, Transfer Pricing Guidelines, para 14.
1181
Omond, F., Transfer Pricing –An East African Perspective, A paper presented in IBFD 1st Africa
Tax Symposium, June 2015 Livingstone Zambia, p. 16.
1182
Section 18 (4) (a) R.E 2014.
1183
Ibid, section 18 (4) (b).
 288

With regard to intangible, in practice, the KRA requires the taxpayer to show the

owner of the intangible and if it is registered in Kenya. Accordingly, it evaluates the

value of intangible and contribution of Kenya to the value of intangible. 1184

Arguably, both ITA and TP Rules are silent under circumstances a person can be

regarded as owner of intangible. Sometimes the owner of the intangible may not be

vested with the legal ownership but contributed substantially in developing such

intangible but no guideline on arm‘s length payment. Accordingly, the law is silent

about aspects that constitute intangibles for transfer pricing purposes. Moreover, it

does not provide guideline method to be applied in intangibles in absence of

comparables or where intangible is of high value.1185This is necessary because of a

variety of intangibles that may present different problems.

With regard to intergroup financing, generally, the KRA has not been focusing much

on this area. There are few explanations for this such that, to a great extent, the law

in Kenya has restricted interest and deemed interest deduction in ascertaining taxable

income. For example, the law does not allow deduction of interest to a company if

the ratio of all liabilities in which the interest is charged exceeds three times the sum

of revenue reserves and issued and paid up capital.1186 The 3:1 ratio applies to other

companies except for extractive industries (mining, petroleum and geothermal) in

which 2:1 ratio of debt to equity applies.1187 Accordingly, the law does not allow any

deduction of interest paid by permanent establishment to non-resident person for

1184
Omond, F., note 92.
1185
Unlike Kenya, in Tanzania, the law requires be transferred by using CUP method. see Rule 11(2)
of TP Rules 2014 of Tanzania.
1186
Section 16(j) (i) commonly known as 3.1 ratio.
1187
Deloitte, International Tax, Kenya Highlights 2016 available at
 289

transfer pricing purposes.1188 In context of ITA, debt means loans, overdrafts,

ordinary trade debts, overdrawn current accounts or any other form of indebtedness

for which a company is paying financial charge, interest and discount premium.

However, there is no clear guideline on what constitutes intergroup financing for

transfer pricing purposes. Absence of a clear guidelines on such transactions may be

potential for associated MNCs to manipulate prices and hence, jeopardize KRA

efforts for collecting tax for viable development.

7.3.3.4 Transfer Pricing Documentation Requirement

Neither the ITA nor the TP rules make mandatory transfer pricing documentation

requirement. However, when person avers application of arm‘s length principle, the

TP Rules require that the person should develop transfer pricing policy and provide

documentation to evidence their analysis.1189 Required transfer pricing

documentation includes those related to selection of transfer pricing method and their

reasons for selection including their application, the global organizational structure

of the MNC, details of transaction under consideration, assumptions, strategies and

policies applied in selecting the method plus any other information as may be

necessary for such transaction.1190 Notwithstanding such requirement, the tax payer

is not under obligation to produce such document with other tax returns but rather,

can produce upon the request by the Commissioner thirty days upon request.1191

1188
Ibid, section 18 (5).
1189
Rule 10.
1190
Rule 9 (2)(a) to (f).
1191
Rule 10 (i).
 290

Arguably, the existing TP Rules do not compel associated MNCs to produce transfer

pricing documents but rather, maintain documents. The ITA requires the tax payers

to maintain their records for ten years.1192 To the contrary, the Tax Procedure Act

requires the tax payer to maintain any tax document as required by law in either

English or Kiswahili for a period of five years.1193 Notwithstanding these

requirements, the law requires corporate taxpayers to notify KRA any changes in

their business structure, in particular, changes in shareholders, beneficial ownership

as well as cession or sale of business within thirty days of such changes.1194 Despite

existing conflicting requirements, there is no specific penalty for non-compliance

with the documentation requirement.1195 Consequently, the general provisions of the

ITA relating to fraud, failure to furnish returns, penalties and interest for late

payment of tax are made applicable to TP issues as well.1196

7.4 Administration and Enforcement of Transfer Pricing Rules in Kenya

7.4.1 Institutional Framework for Transfer Pricing

Generally, administration and enforcement of tax matters are vested with Kenya

Revenue Authority (KRA). The KRA was established in 1995 and became effective

on 1st July, 1995.1197 Essentially, KRA is a body corporate with perpetual succession

and common seal. The main function of the KRA under general supervision of the

minister responsible for finance is to collect and receipt of all government

1192
Section 55(2) of ITA R.E 2014.
1193
Ibid, Section 23 (1) (a) and (c).
1194
Ibid, section 54B, (a) and (b) (i), (ii) (v).
1195
Unlike Kenya, Tanzania clearly provides penalty for non compliance of TP rules. see Rule 7(5) of
TP Rules 2014 of Tanzania.
1196
Rule 11 and 12 of TP Rules 2006. It worth to note that, following establishment of the Tax
procedure Act, this requirement might be affected as some of the provision have been repealed and
other amended.
1197
Section 3 of Kenya Revenue Authority Act, RE 2016.
 291

revenues.1198 In performing a given function, the KRA is also responsible in

administering and enforcement of tax laws. Other responsibilities include advising

government on administration and collection of revenue and to perform any other

duties that may be assigned by the minister in revenue collection.1199 The KRA is

manned by Board of Directors and KRA management under the Commissioner

General.The Board, under chairman as presidential appointee, is responsible for

approval and review of the policy and monitoring of performance of the KRA. 1200

The function of the Commissioner General is to oversee daily operations of the KRA

in collection of government revenue.1201 In performing its responsibilities, the KRA

is divided in to two main department, namely, domestic tax payer, which consists of

domestic taxes and large tax payer office (LTO) and custom and excise. The LTO is

of particular interest because it deals with taxpayers, whose annual turnover is from

750 million and above.1202 As a result, most MNCs are within the LTO. The LTO

was established in 2006 as full-fledged department with objective of administering

domestic tax matters affecting large tax payers. One of the responsibilities of LTO is

administration of taxes to all companies with their subsidiaries falling under LTO. It

is in this context that KRA has established transfer pricing unit (TP Unit). The TP

Unit was established in 2009. The TP Unit is manned by less than twenty staffs and

is responsible for handling transfer pricing audits. Selection for transfer pricing audit

is based on risk profile such as consecutive losses, use of tax haven countries,

intercompany loan, management fee, large investment deductions and disclosure in

1198
Ibid, section 5(1).
1199
Ibid, section 5(2).
1200
Ibid, section 6(1) and 6(6).
1201
Ibid, Section 11(2) and Section 5 of Tax Administration Act, 2015.
1202
http://www.revenue.go.ke/lto/lto.html
 292

tax return as well as financial statements.1203 The major focus area includes

management fee, tangible goods, intangible and royalties and financial arrangement.

Since its establishment, considerably, there is increase in transfer pricing audits that

resulted into transfer pricing adjustment to Kenya billion shillings. Accordingly,

more cases currently are under audit and some cases have been decided at tribunal

level and a few at high court appeal stage.1204

Despite considerable good performance, the TP Unit is facing challenges in

implementing its works. The existing TP Rules do not provide for a clear guidelines

on transaction related to service, intangibles, royalties and intercompany financial

arrangement. Such situation has led to less related transaction audits. Apart from

legal challenges, absence of reliable local comparables, poorly prepared documents

and lack of information of foreign associated parties are other challenges.1205 In

addition, the TP Unit has low number of transfer pricing experts compared to transfer

pricing audits, which are likely to occur.

7.4.2 Transfer Pricing Dispute Resolution Mechanism

The existing transfer pricing laws do not provide for specific mechanisms for transfer

pricing disputes. Such disputes have been handled just like any other tax matter. In

most cases, transfer pricing disputes arise from additional assessment by the

Commissioner if he considers that the taxpayer under-declared his income.1206 If the

tax payer is aggrieved by the decision of the Commissioner, he has the right to
1203
www.kra.ke.go large tax payer office.
1204
Omond F., Transfer Pricing- An East African Perspective, a paper presented in Zambia, June
2015.
1205
An interview with KRA officials.
1206
Section 73 and 77 of ITA R.E 2014, and section 28 of Tax Procedures Act, 2015
 293

appeal to Tax Appeal Tribunal (TAT)1207 within thirty days upon receipt of the

decision by the Commissioner.1208 The function of TAT is to hear appeals filed

against any decision of the Commissioner.1209

The Tax Appeal Tribunal (TAT) is composed of the chairman and not less than 15

but not more than 20 members. For a person to become TAT member she/he should

be the holder of degree in law, business, finance, economics, insurance or related

discipline from university or institution recognized in Kenya, 1210 among other

qualifications. This requirement is very useful when dealing with transfer pricing

cases because such disputes are not premised on taxation only but rather, a

combination of the said disciplines. Empirical evidence shows that absence of such

qualifications may provide potentials for revenue authority to lose cases. For

example, a study by European Commission revealed that before establishment of Tax

Appeal Tribunal, local committee members were lacking specialist experience in tax

and transfer pricing, a situation, which rendered difficult to come up with well

reasoned, researched precedents.1211 Likewise, in Unilever case, the Judge was

1207
Section 3 of the Tax Appeals Tribunal Act, 2013 which came in to force on April 2015 by Legal
Notice No. 32 of 20th March 2015.
1208
Ibid, Section 12 and 13 (1) (a) respectively. Prior to establishment of TAT, appeals on decision of
commissioner including transfer pricing disputes were filed either to Local Committee or Tribunal.
See Mbiuki note 1124, p 70; Ado, M., Transfer Pricing Disputes In Kenya: Advance Pricing
Agreements the Way Forward? Master‘s programme in European and International Tax Law, Lund
University, 2015, p.16.
1209
Section 3 of Tax Appeals Tribunal Act, 2013 and Rule 2 (a)–(f) of the Tax Appeals Tribunal
(Procedure) Rules, 2015.
1210
Ibid, section 4 (3) (b) (ii). However, unlike repealed section 82 of ITA, the Tax Appeals Tribunal
Procedure Rules does not include degree in Taxation as one of the qualification for the members.
1211
EU Commission Transfer pricing and Developing countries, Kenya (2011):, Appendix D: Country
Study-Kenya, p. 16.
 294

concerned with failure from local committee to include reasons for their

decisions.1212

The proceedings of the TAT is of judicial nature and that it carries out its writs

processes, orders and rules just like any ordinary court of law. 1213 The burden of

proof lies with appellant1214and it has the power to engage expert evidence.1215 The

TAT also has power to grant parties to settle matters out of TAT at any stage during

the proceedings.1216 The decision of TAT is made in writing and the law requires

such decision to be reasoned.1217 It is interesting to note that the TAT clearly

excludes application of the Civil Procedure Act.1218 This is very important because it

may help to reduce technical issues used by lawyers in civil cases. However, any

part aggrieved by Tax Appeal Tribunal decision has the right to appeal to High Court

of Kenya within thirty days after decision of the TAT under High Court rules.1219

Where any part is aggrieved by the decision of High Court, he has the right to appeal

to Court of Appeal.

Although the Tax Appeal Tribunal has kept all tax disputes under one roof and taken

in account significantly pertinent issues that might be potential in solving transfer

disputes, it is likely to face some challenges from taxpayers. There are two reasons

for this, first, the Constitution confers on the High Court unlimited jurisdiction in all

1212
Unilever case , In which the Judge stated, ―Unfortunately I do not have the benefit of the
reasoning of the Local Committee and I am bound therefore to consider this appeal in terms of
arguments advanced before me…‖ See also Ado, M., note 104.
1213
Section 24 of Tax Appeal Tribunal Act, 2013.
1214
Ibid, section 30.
1215
Ibid, section 23.
1216
Ibid, section 28.
1217
Ibid, section 29(5) and (7).
1218
Ibid, section 14.
1219
Ibid, Section 32.
 295

civil and criminal matters.1220 For that reason, some taxpayers may directly institute

tax cases to the High Court, seeking for prerogative orders before passing to ordinary

tax disputes mechanism.1221 For example, in Keroche Industries v Kenya Revenue

Authority & 5 others 1222 it was stated that,

―The respondents‟ argument that the applicant came to court

prematurely without exhausting the internal tax objection process
as regards each category of tax, is a serious misdirection […] the
issues raised were greater than any of the internal tribunals could
handle. The task before the court is not, and has not been that of
counting the shillings, it has been one of adjudicating on
illegality, the doctrine of ultra vires, irrationality, procedural
impropriety, Wednesbury unreasonableness (sic), oppression,
malice, bias, discrimination and abuse of power.”1223

Unfortunately, the Tax Appeal Tribunal does not pose any requirement that all tax

disputes should first be filed to TAT before proceeding to High Court. Since the

TAT is still new, it remains to be seen whether or not tax related cases will first be

taken at TAT before the High Court. Secondly, tax including transfer pricing appeals

from TAT lies to High Court and Court of Appeal. However, unlike TAT, the High

Court is likely to lack specialist knowledge on transfer pricing issues. This is because

there is no pre-requisite for bench of Judges to have prior knowledge in taxation,

finance, marketing and economics, which are important aspects in determining

transfer pricing cases. Accordingly, currently, under hierarchy of Kenyan court

system, there is no high court tax division designed to handle such issues. The

requirement for such division seems to be desirable by the court itself. In Republic v

1220
Article165 and Article 2 respectively of the Constitution of Republic of Kenya 2010.
1221
Ado note 104, p16, Mbiuki, note 1124, p. 72, see also EU P.34.
1222
2007.
1223
Keroche‘s case p.34
 296

Kenya Revenue Authority Ex-Parte Abdalla Brek Said T/A Al Amri Distributors & 4

others,1224 the court stated that,

―The court avails itself of this opportunity to call for the

establishment of a specialized Tax Division of the High Court
which may give expeditious hearing of tax disputes in the
interests, on the one hand, of a quick determination of the tax
liability for the tax payers‟ benefit and, on the other hand, in the
interests of the Public at large who eventually benefit for the
proceeds of taxation.”

In such circumstances, transfer pricing cases are likely to be handled just like any

other civil cases in which Civil Procedure Act and other High Court Appeal rules are

applicable. One issue is crystal clear. While TAT ousted application of Civil

Procedure Act in its proceedings, such provisions are likely to be applied in High

Court proceedings to the same dispute and therefore, it may represents the same

problem, which TAT aimed to avoid.

7.4.3 Court Interpretation and its Impact to Transfer Pricing Law

Transfer pricing disputes poses serious challenges when determined by the court of

law. This part focuses on decision of the High Court of Kenya and its influence on

transfer pricing regime in Kenya. To illustrate this point, the study uses the High

Court‘s decision of Unilever Kenya Ltd v Commissioner of Income Tax.1225

The facts of the case were as follows:- Unilever Kenya Limited (UKL) and Uganda

Unilever Limited (UUL) are both subsidiaries of Unilever group of companies

incorporated in United Kingdom (UK). Both subsidiaries are related companies

under the laws of Kenya. In August 1995, UKL and UUL entered into a contract

1224
2015
1225
Income tax appeal no. 753, of 2003 KE: HC September 2005.
 297

agreeing that UKL will manufacture and supply goods to UUL. However, UKL

charged UUL lowered prices than it charged its domestic buyers and importers not

related to UUL. The Commissioner of Income Tax raised assessment against UKL in

respect of sales made by UKL to UUL and found that they were not made at arm‘s

length price.

As a result, such arrangements produced less tax than would have been produced if

transactions had been carried out by an Independent Corporation. Hence, the

Commissioner assessed UKL for additional tax. Two main issues were of concern.

First, ―whether t the transaction between UKL and UUL was so arranged to produce

less profit.‖1226 Second, ―whether in the absence of specific guidelines from the KRA

on this issue, the OECD Guidelines and methods prescribed there under for

calculation of an arm‘s length price are a proper, reasonable and objectively

acceptable bases for the determination of arm‘s length price as required by section

18(3)‖.1227 In this case, the HC ruled in favour of the tax payer, the UKL.

In reaching decision whether the OECD Guidelines was applicable in absence of

Kenyan guidelines, the HC agreed with UKL that in absence of Kenyan guidelines to

determine what constitutes arm‘s length price, the UKL was justified to resort to

OECD Guidelines because they are internationally accepted principles of

international business so long as they are not in conflict with Kenyan law. 1228 In his

words, the Judge stated that,

1226
Ibid, p.3.
1227
Ibid, p. 4.
1228
Ibid, p.12 and 13.
 298

“We live in what is now referred to as a „global village.‟ We cannot

overlook or sideline what has come out of the wisdom of tax payers
and tax collectors in other countries. And especially because of the
absence of any such guidelines in Kenya, we must look elsewhere.
We must be prepared to innovate, and to apply creative solutions
based on lessons and best practices available to us. That is indeed
how our law will develop and our jurisprudence will be enhanced.
And that is also how we shall encourage business to thrive in our
country.”1229

This decision offers an important insight in transfer pricing jurisprudence in Kenya.

First, the court also had dilemma for fear from discouraging investors if they had to

decide against MNCs. This can be inferred from the judge‘s statement that ―…and

that is also how we shall encourage business to thrive in our country.‖ Second, the

judgment influenced KRA to establish transfer pricing rules modeled in OECD one

year after the judgment.1230 Arguably, the court interpreted Kenyan law in light of

the OECD.

However, the provisions of the OECD are standard-based (ex post) as opposed to

rule-based (ex ante).1231 Eduardo posits that the full meaning of the OECD provision

can be provided by case law only or something functionally equivalent to case

law.1232 This shows that precise meaning of the OECD standard-based will be found

in decentralized domestic court case laws with public good character. 1233 In this

context, courts normally have wide room to construe provision of tax treaty to take

1229
Ibid.
1230
See Income Tax Act (Transfer Pricing Rules) 2006 of Kenya.
1231
For difference between rule based and standard based see Baistrocchi, E., The use and
interpretation of tax treaties in the emerging world: Theory and implications, in British Tax Review,
2008 Issue 4 p. 386.
1232
Ibid.
1233
In other words case law is a public good character if it sets good precedent to be referred future
cases when similar circumstances happen. See Baistrocchi, E., note 639 p.388 . Stating that, case
law is a public good (rather than a private good) if it allows a representative person to predict the
probable outcome of a future court‘s decision.
 299

into account strategic consideration.1234 In reaching decision of the two issues the

court used standard-based rather than rule-based of Section 18(3).1235 The judge,

whether knowingly or unknowingly, interpreted section 18 (3) as if he was

interpreting OECD model provision. This was so because the judge specifically

referred to OECD principle by stating that,

―I have no doubt in my mind that OECD principle on income and

capital and the relevant Guidelines such as „transfer pricing‟
principles, the CUP method adopted for calculation of what ought
to be the income, the cost plus return method as well as resale
minus method are not just there for relaxing reading … would be
fool- hardy for any court to disregard any international accepted
principles of business…..To do otherwise would be highly short-
sighted.”1236

This statement implies that the OECD standards are stronger than domestic laws and

judges are ready to opt for OECD rather than substantive laws of the country.

Additionally, the OECD standards were made applicable even in absence of tax

treaty to OECD non-members like Kenya. It is also true that section 18 (3) is a

replica of Article 9 of the OECD model. Nevertheless, it was supposed to be

construed in rule-based. As Bosire pointed out that while resort could have been

made to foreign jurisprudence, ultimately, it is a substance of Kenyan law to be

construed and applied.1237 The court‘s interpretation in favour of OECD makes

existing domestic transfer pricing laws ineffective. The main implication of the

judgment is that the court reaffirmed use of OECD and its transfer pricing Guidelines

1234
Ibid, The good example of such kind of interpretation can be found in the Union of India and
Azadi Bachao Andolan (2003) SC 56ITR INDIA in which the court interpreted the India-Mauritius
tax treaty in light of the India-US tax treaty.
1235
ITA, RE 2014.
1236
Judge Alnashir Visram in Unilever case p.13.
1237
Nyamori B., An Analysis of Kenya‘s Transfer pricing Regime, International Transfer pricing
Journal , March/ April 2012, p.157.
 300

in Kenya. The biggest impact is that it influenced Kenya to establish transfer pricing

rules, which replica of OECD transfer pricing Guidelines. This was partly to remedy

concern by the KRA that the OECD model was not part of Kenyan law and partly to

reaffirm desire for MNCs to apply OECD, which for a great part allows them to

obtain more taxing rights than host countries.1238

The Unilever case also has brought insight on difficulties involved by revenue

authorities in proofing before the court of law an alleged manipulation of transfer

prices. In this case, it was not disputed that UKL and UUL are related parties within

the meaning of section 18(3) of Income Tax Act of Kenya. The argument by KRA

was that transacted between them were arranged as to produce less profit. Produced

evidence showed that UKL had designed a scheme to cheat on its incomes with the

view of reducing its tax liability.1239 UKL sold its products to Tanzania and Somalia

higher than those sold to UUL and that price to UUL was set without considering

market force. In addition, transfer pricing policy of Unilever group of companies was

offending Section 18(3).1240 Whether the transaction was so arranged, the court held

that there was no such arrangement between UKL and UUL. 1241 In reaching the

decision, the judge stated that, ―the business so arranged must be such as to show

less income to enable the tax authority to challenge it and that there was no evidence

of tax cheating or tax fraud.‖1242 According to judge, only evidence tendered by

KRA was with regard to method used for computation of arm‘s length price. Thus,

1238
See discussion chapter five at para 5.3
1239
Unilever case p.11.
1240
Ibid.
1241
Ibid p.13.
1242
Ibid.
 301

according to the judge, the method used by UKL was lawful and permissible so long

as there was no fraudulent trading with a view to evade tax.1243

The statement by the court shows that even where revenue authorities have strong

indication or rather, evidence showing that actually in the course of business, the

transaction was so arranged it is difficult to prove before the court of law. The

difficult is inherited from the long and cumbersome procedure involved in arriving at

arm‘s length price, which involves economic, accounting, marketing and law as well

as information technology. Accordingly, the whole process is done solely by the

taxpayer and the revenue authority comes into play when there is suspicious that the

arms‘ length was not adhered to. Given complexities involved in setting up arm‘s

length price, sometimes judges may not easily understand such transaction and

actually, they detect malice arrangement between associated MNCs. Such situation

may discourage revenue authorities to take transfer pricing cases to the court of law.

This can be evidenced by the recent development in Kenya that established an

alternative dispute resolution mechanism in which transfer pricing disputes are

channeled.1244 Accordingly, such kind of decision may pull away legislators from

crafting transfer pricing laws commensurate with domestic tax demands. One year

after the decision, Income Tax (Transfer Pricing Rules) 2006 were officially

established.

1243
Ibid p.13.
1244
An interview with KRA officials, department of big tax payers held on November 2014, Nairobi.
 302

7.5 Base Erosion Profit Shifting Action Plan in Kenyan Context

As noted before that the existing arm‘s length principle, to a great extent, has

encountered serious challenges in curbing transfer pricing manipulation, BEPS

Action plan was thought as a rescue. The rationale behind BEPS is to ensure that

profit by MNCs is taxed where economic activities generating that profit are

performed or where the value of intangible is created. On the basis of existing

transfer pricing laws as examined in this chapter, there is no any inclusion or

reference to Base Erosion Profit Shifting Action Plan 2013. Accordingly, the KRA

has not stated its position on implementation or adoption of the plan.

7.6 Conclusion

The presented analysis and examination of transfer pricing laws in Kenya reveal

inadequacy of law in curbing transfer pricing manipulations. The arm‘s length

principle still remains as a sole solution in curbing transfer pricing manipulation.

While existing transfer pricing laws are premised on arm‘s length principle, they lack

clarity and in some instances, they contradict each other. Accordingly, where clear

provisions exist, they are not implementable, either because of lack of pre-requisites,

requirement in practice, such as comparables or lack of experience and knowledge of

transfer pricing by tax officers. Nobly, the law is silent on transaction related to

extractive sectors. The situation is exacerbated by lack of specific transfer pricing

penalties and specific transfer pricing adjustment. In addition, lack of clear guidance

on services, finance and intangibles, which provide high risk on manipulation, are

likely to hinder Kenyan desire to finance its expenditure through local taxes.
 303

CHAPTER EIGHT

CONCLUSION AND RECOMMENDATIONS

8.1 Introduction

This chapter presents conclusion of the study which essentially sums up insights of

the study, provide recommendations and suggestions for future research.

8.2 Main Insights of the Study and Key Findings

The study has carried out in depth examination and analysis on transfer pricing laws

in particular legal challenges that EAC countries face in applying arms‘ length

principle. The study sought to address potentials of losing revenue from international

transactions between associated MNCs emerging from the increase of foreign

investments in the regional. The main focus of the study was the examination of

adequacy of EAC transfer pricing laws and international standards in curbing

manipulation of transfer prices between associated MNCs operating in the region.

The study was guided by the following research questions;-

(i) Do existing transfer pricing rules and standards in EAC adequately curb

transfer pricing manipulation?

(ii) To what extent are the general principles and guidelines of OECD and UN

Model relevant in curbing transfer pricing manipulation in EAC countries?

(iii) What strategies should be considered and employed in formulating an

effective transfer pricing regime for EAC?

The study has demonstrated that the existing transfer pricing laws are inadequate in

curbing such malpractice. The traditional doctrinal legal research methodology were
 304

mainly employed and supplemented by empirical and comparative methods.

Tanzania and Kenya are used as case study for EAC countries. The literature review

revealed that although substantive literature has been developed, such scholarly

writing is missing from EAC perspective. The preoccupation of this study was to

provide comprehensive transfer pricing literature from EAC perspective.

The theoretical and concept of transfer pricing analysis and discussion made in

chapter two reveals that transfer pricing theories have been developed exclusively

and addressed from profit maximization and minimization of tax point of view.

Consequently, suggested transfer pricing methods reflects maximization of profit. It

is further found that the existing transfer pricing manipulation originates from

transfer pricing theories. And that the existing manipulation of prices between

associates MNCs originates from managers of entities who are afraid to be evaluated

on basis of their profit performance. To date same managers are still concealing

relevant information not only for purpose of evaluation but rather for purpose of

lessening tax liability. Furthermore it was found that manipulation of transfer pricing

is not only done by infringing the purpose of the law, but rather the whole processes

is done on bases of accounting, economic, marketing and taxation. Therefore to

handle such situation it requires combination of such disciplines and lawyers.

To counteract transfer pricing theories, the study reveals that market price under

arm‘s length principle is viable option to regulate transfer prices from legal and

economic point of view. The study found that arm‘s length is capable of

counteracting transfer pricing theories with a view of allocating right share of income

for both taxpayer and governments. This is because arms‘ length principle takes in to
 305

account transfer prices comparability requirement, separate account evaluation and

transfer pricing methods as advanced by such theories and counteract them. The

Arms‘ length principle obliges related parties be evaluated as independent party and

compare their transaction and prices to non related parties so as to arrive at market

price which is real transfer price. A review of transfer pricing standards under

international instrument in chapter three reveals that arms‘ length principle is a

cornerstone for any taxation of profit between associated MNCs. Countries are

required to craft their domestic laws based on this principle. However, transfer

pricing instrument reveals that originally, the transfer pricing laws were established

to avoid double taxation as primary concern and not to deter MNCs from

manipulation of transfer prices.

Accordingly such rules were developed all along based on experience and practice of

developed countries and therefore not necessarily reflecting needs for developing

countries like EAC. The experience was based on problems faced in exporting

capital and their desire to maximize profit and minimization of tax. Such experience

has never felt by EAC countries for a great extent because all along have been capital

importers. Hence, the standards developed based on solving their problems by

limiting source countries in which MNCs operates to tax. Consequently, issues of

concern for EAC and other developing countries were not taken in to account.

For example transfer pricing standards all along have been silent in relation to

natural resources such as minerals, gas and oil. This might be because at the time of

establishment these were not material concerns. Additionally, international transfer

pricing standards did not take in to account the difficulties involved in implementing
 306

arm‘s length principle for developing countries like EAC. The rules also all along

have been not sufficiently addressing changes brought by technology in electronic

transaction between associated MNCs. Presentation and discussion of EAC transfer

pricing regional instrument under chapter four found that arm‘s length and other

transfer pricing standards as enshrined in EAC regional instrument affirms use of

such principle to regulate transaction between associated parties in EAC.

The study further found that transfer pricing standards as enshrined in EAC

instruments lack clarity and clear guideline on handling transfer pricing issues. Such

discrepancies lead to non uniform application of the arms‘ length principle in the

region giving advantage to MNCs. The study observed that the increase of foreign

investment in the regional in which EAC increasingly integrated in to world

economy, influenced existing transfer pricing standards in the region. It was found

that EAC countries have been caught in between desire to attract foreign investment

and desire to obtain revenue out of MNCs transaction within the regional.

However, the desire to attract more investors seems to outweigh desire to obtain

revenue out of such investment. This is substantiate by the fact that all along EAC

countries have been changing and improving policy and laws to attract foreign

investments and less efforts in tax laws to keep pace with such increase of

investments. This demonstrates the extent to which EAC countries have bound

themselves in obligation that potentially affect and shape their policy choices in tax

law in particular transfer pricing. This show that the existing transfer pricing laws of

EAC are not adequately addressing transfer pricing manipulation.

 307

The discussion and analysis of relationship between transfer pricing standards and

manipulation of transfer prices through aggressive transfer pricing has found the

following. First, Transfer pricing standards provides potentials for transfer pricing

manipulation and therefore associated MNCs stand to benefit more than revenue

authorities in absence of aggressive transfer pricing laws. Second, the arms‘ length

principle and other standards is vulnerable to transfer pricing manipulation because

associated MNCs have been using loopholes found in transfer pricing laws to

manipulate prices. Third, manipulations of transfer prices are done under auspices of

aggressive tax planning by using same transfer pricing standards. Forth, the BEPS

Action plan which brought to rescue the existing transfer pricing laws is still

premised on arm‘s length reaffirms arm‘s length principle as an ideal in regulating

transactions between associated parties. same principle has been employed over and

over again with slightly modification within the ambit of arms‘ length principle.

BEPS Action Plan came to capture tax which could be shifted to other countries

through transfer pricing manipulation. The study further reveals that, to date arm‘s

length principle remains as sole solution in curbing transfer pricing manipulation. It

was further found that, currently there is no alternative to arm‘s length principle

because formulary apportionment sought to be alternative to arms‘ length price, was

found to be not sufficiently addressing transfer pricing manipulations.

The analysis and discussion of transfer pricing laws in Tanzania under chapter six

found that the existing transfer pricing laws lack coordination and clarity in some

instances. Although arms‘ length principle is enshrined in various tax laws actual

implementation of arm‘s length principle remains unimplemented to a great extent

 308

on account of factors provided in respective chapters. The study found that the

failure is due to limited provision of arm‘s length principle as provided under section

33 of ITA. Although more requirements are provided under Transfer pricing rules,

legally speaking rules cannot override enabling Act.

Other factors include conflict of the provision of the law governing transfer pricing,

lack of local comparables and lack of clear guideline in absence of comparables, lack

of clear mechanism to handle transfer pricing disputes, lack of capacity and

experience by revenue officials in handling transfer pricing issues and lack of clear

mechanism in transfer pricing audits. In addition, lack of provisions for

ascertainment of taxable income for transfer pricing purpose and lack of clear

transactions subject to transfer pricing among others. These discrepancies leads to

conclusion that the existing transfer pricing laws as enshrined in Tanzania is

inadequate in curbing transfer pricing manipulation between associated MNCs. The

analysis and discussion of transfer pricing laws in Kenya under chapter seven found

that the existing transfer pricing laws lack coordination and clarity in some instances.

Although arms‘ length principle is enshrined in various tax laws actual

implementation of arm‘s length principle remains unimplemented to a great extent

on account of factors provided in respective chapters.

The study found that although section18 of ITA to a great extent covers arms‘ length

principle, Kenya still faces challenges in curbing transfer pricing manipulations.

Such challenges are caused by factors as conflicting provision of the transfer pricing

law, inadequate of provision and clear transfer pricing rules governing intra company

service, intangibles and finances. Other factors include lack of clear auditing
 309

mechanism, lack of local comparables and clear guideline in absence of

comparables, low number of transfer pricing experts in handling transfer pricing

issues, lack of special transfer pricing disputes mechanisms, lack of comparability

factors, lack of specific transfer pricing penalties, lack of clear modalities of transfer

pricing adjustment for arm‘s length price and failure of the law to clearly state and

regulate other methods capable to arrive at arm‘s length price among other factors.

These discrepancies leads to conclusion that the existing transfer pricing laws as

enshrined in Kenya is inadequate in curbing transfer pricing manipulation between

associated MNCs.

8.3 Recommendations

Basically, the EAC countries require comprehensive tax reforms that recognize

special nature of transfer pricing between associated MNCs. Such countries need

transfer pricing provisions that expedite determination of transfer pricing in

capturing the right share of tax to both government and MNCs. This approach is

necessary because EAC countries still rely solely on arm‘s length principle in

curbing transfer pricing manipulation. Consequently, such reforms must be based on

arm‘s length principle as a bench mark without departing from international

practices.

Generally, the study recommends amendments of transfer pricing law in Tanzania

and Kenya countries. Such amendment should aim at capturing the right share of tax

arising from business profit by associated MNCs. This is sought to be achieved by

counteracting MNCs and transfer pricing theories while taking into account

economic situation of EAC countries. Understanding economic situation is

 310

important in setting up transfer pricing law between associates. This is important

because it will help to understand the competitive advantage potentially for

maximizing profit and minimizing cost prompted to invest in such countries and

counteract manipulation of them. Equally important, capacity of EAC countries

outbound investment should be taken into account so as to establish any potential

likely to minimize tax liability. The suggested amendment of the transfer pricing law

in Tanzania and Kenya should take in account the following aspects:

Firstly, there is need for clear clarification on ambiguous concepts and phrases. The

law should be amended to provide clear definition of transfer pricing concept and

clarification of all ambiguous words as well as phrases. The definition of legal

transfer pricing is important in explaining and identifying circumstances, which a

taxpayer did or did not transact at arm‘s length price. The concept will also help in

identifying special circumstances between associated parties, which are unavailable

to unrelated parties. This is particularly necessary in making comparability for

purpose of comparing comparables and characterization of transaction for adjustment

purposes. Consequently, when the transfer pricing concept used will clearly

eliminate possibility of providing two conflicting results and enhance certainty of

law.

Secondly, there is need for hierarchal application of transfer pricing methods. The

law should clearly state certain types of transactions should not rely on traditional

methods that are irrelevant.1245 Accordingly, there is a need to establish the best

choice rule in selecting transfer pricing method. The best choice should guide
1245
It should be noted that the study could not suggest specific method to a specific transaction
because it involves calculations which require combination of accounting, mathematics, economist
and taxation which is beyond this study.
 311

taxpayers to choose one method that will provide the best arm‘s length results. The

rule should take into account relevance of the method to be chosen to a particular

transaction and advantage and disadvantage of the method chosen. Additionally,

selection of the best method rule should not only depend on comparables available

only but also should depend on nature of goods and services under transaction.

Where the taxpayer is not complied with the rule, the law should clearly provide

relevant penalty for non-compliance.

The penalty should either compel the taxpayer to use the best method or fine, which

will deter the taxpayer from committing such offence in future. An exception should

be provided to peculiar goods and services under transactions that may require

specific method(s) to be followed. For example, Tanzanite and other precious

gemstone are available in Tanzania only. As a result, in order to obtain comparables,

it may be difficult. In this context, specific method(s) should be clearly stated based

on policy and reliable research by revenue authorities.

Accordingly, the law should clearly state other methods that may be prescribed by

the Commissioner where traditional transfer pricing methods fail to provide desired

results. This is necessary because if there are other methods that can yield results

equivalent to arm‘s length price, such method(s) ought to be regulated by the law so

as to avoid arbitrary application and uncertainty of the law. Thirdly, in regard to

comparability factors, the law should clearly provide requirements for use

comparables from African continent before embarking on foreign comparables. This

is thought to be achieved by establishing domestic, regional and continental data

bases. Such databases should be updated from time to time so as to keep pace with
 312

any changes in business arena. The common denominator factor is that African

economic situations are more or less the same and therefore, they are sharing

common features. Notably, such commitments require resources, both human and

financial.

However, national bureau of statistics of countries in collaboration with revenue

authorities can be utilized in developing data bases as benchmarking information.

For that reason, foreign databases may be used as a last resort. Where there is no

possibility of comparables, revenue authorities may do away with comparability

aspect and adopt a fixed margin. However, this is subject to serious research. In

addition, the law should clearly state the modality to be followed where there is no

comparable. Fourthly, elimination of tax incentive and tax holidays: the law should

be amended to clearly limit the extent of tax incentive and tax holidays offered to

foreign investors. This is necessary in eliminating any risks of transfer pricing

manipulation during period of tax holidays. In related matters, the law should clearly

provide for requirement of application of arm‘s length principle in any international

agreement where one part to an agreement is expecting to transact with a related

party for transfer pricing purposes.

Fifth, the law should clearly empower transfer pricing units full mandate in handling

transfer pricing issues. Thus, any other government institutional audits from any

aspect of transactions including mining, gas and petroleum should be obliged to

submit any transfer pricing audit query to TP Units. This requirement is important in

providing consistency in application of the law. Sixth, the law should require tax

advisers to be regulated by a board of authority. This is necessary in curbing tax

 313

avoidance schemes aiming at manipulating transfer pricing between associated

MNCs.

Seventh, capacity building for tax officials: there is need for revenue authorities to

build transfer pricing capacity both human resources, financial and working tools. In

this context, transfer pricing unit officials should be well equipped by acquiring

knowledge based on continuous processes of learning while taking into account new

tactics of aggressive planning, technology changes, new products and business

methods. This is thought to be achieved by using institutes of tax administration and

higher learning institutions in respective countries. Accordingly, working tools and

financial resources should be sufficiently made available to transfer pricing units.

The TP Units should be composed of officials from various expertise such as tax,

law, economics, accounting and marketing. Capacity building should be extended to

enforcement instruments such as tribunals and courts of law. This is envisaged to be

achieved by conducting regular transfer pricing seminars, workshops and training,

short-term and long-term courses. The invitation of transfer pricing experts in

handling transfer pricing cases may also be used. In near future, it is important to

consider establishment of a High Court Tax Division.

Eighth, enhancing tax compliance: the government, through tax authorities, has to

strengthen tax policy to promote tax compliance to taxpayers. Negative attitude

towards MNCs in profit shifting should change and handle MNCs just like any other

taxpayers.

Ninth, building economies of EAC: the economies of countries under the study need

to be improved, which, in turn, will enhance growth of domestic MNCs. In addition,

 314

fair treatment should be considered to domestic MNCs so as to put both investors on

equal footing. The enabled domestic MNCs may have outbound investment not

necessarily to developed countries but at least at regional level and in Africa.

Countries‘ desires to obtain foreign investment should not outweigh desire to obtain

tax out of profit by associated MNCs. EAC countries should make diligent research

and be aware of gains obtainable by agreeing on sharing resources and avoid any

chances that will lead to lose their right share of tax.

Accordingly, revenue authorities must be in a position to foresee future prices for

goods and services between associated MNCs. In due regard, such authorities must

not focus on transactions, which they believe are of high risk, but rather, the whole

transactions should be thoroughly analyzed. Tenth, Actions 8,9,10 and13 of Base

Erosion and Profit shifting Action plan 2013 may be customized and adopted.

Eleventh, there is need to adopt formulary apportionment for MNCs operating within

countries. There is a need for revenue authority to conduct serous studies to see

whether or not formulary apportionment should be used to domestic MNCs.

However, any recommendation for use of such method should be well regulated by

the law.

Apart from general recommendations for Kenya and Tanzania, the following are

specific recommendations for individual countries. In Tanzania, Section 33 of

Income Tax Act, should be amended to include the following:- One, meaning of

business and under circumstances the business is said to be carried on by resident or

nonresident for transfer pricing purposes should be clear. Two, relevant transfer

pricing transactions that are subject to adjustment should be clearly stated. Three,
 315

ascertainment of income for transfer pricing should clearly state inclusion and

deduction allowed. Four, relevant intercompany financial services should be stated

and ratio of interest deduction as enshrined in BEPS action plan may be customized

and adopted. Five, relevant intercompany services for transfer pricing purposes

should be stated and defined. Associated parties for transfer pricing purposes should

be provided.

Six, clear elements of transactions, which the Commissioner is empowered to

disregard should be clearly stated so as to avoid irrational use of power. Seven,

penalties and APA should be clearly provide in ITA rather than being in the TP

Rules only. Accordingly, such APA should be regulated and guidelines should be

issued to that effect. Eight, the TP Rules should be amended and clearly state

interpretation of provisions of transfer pricing law to be construed in a manner

consistent with enabling Act and not as per OECD and UN models. Such amendment

will harmonize well with requirement that in case of conflict between regulation and,

enabling Act and international instrument, the enabling Act shall prevail. Ten, the

term meaning of permanent should be amended to take into account electronic

commerce.

In Kenya, the law should be amended to provide the following: first, clear guidelines

on intercompany financial services for transfer pricing should be stated. Second, the

relevant intercompany services for transfer pricing purposes should be stated and

defined. Third, advance pricing agreement (APA) should be introduced and regulated

well in Kenyan law. Fourth, the law should provide clear factors to be taken into

account for comparability purposes.

 316

8.4 Suggestions for Future Research

Future research may be taken by considering the following: first, similar research can

be conducted in the same countries by suggesting alternative to arm‘s length as

means to curb transfer pricing manipulations within countries. Second, a similar

research may be taken in other EAC countries other than Kenya and Tanzania.
 317

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