Fourteen years ago, someone at the Kenya Revenue Authority (KRA) found out that Unilever was selling its Nairobi-produced Omo washing powder and Close-Up toothpaste at lower prices in Uganda than in Kenya.
The local committee of the Income Tax Department on September 17, 2003 ruled against the multinational for diverting part of its profits to its Ugandan subsidiary, denying Kenya taxes. Unilever Kenya Ltd moved to High Court in the same year to appeal against KRA decision.
Unilever Kenya Ltd and Unilever Uganda Ltd had entered into a contract dated August 28, 1995 whereby the Kenyan unit was to manufacture on behalf of the Unilever Uganda and supply to it such products, as it required in accordance with the orders issued.
Unilever Kenya supplied such products to the Uganda unit during years 1995 and 1996. According to KRA, Unilever Kenya charged lower prices to Unilever Uganda than it charged its domestic buyers and importers not related to Unilever Kenya.
The Commissioner of Income Tax raised assessments against Unilever Kenya in respect of years 1995 and 1996, in respect to the sales made to the Uganda unit on the basis that Unilever Kenya’s sales to Unilever Uganda were not at what is called at “an arm’s length” prices — which means that any transaction between two entities of the same firm should be priced as if the transaction was conducted between two unrelated parties.
KRA noted major differences in prices offered by a related party — Unilever Uganda with exclusive marketing rights — were approximately 25 per cent lower than those offered to the independent third parties in Kenya exporting to the Tanzanian market.
KRA formed the opinion that the prices offered to the related subsidiary in Uganda offended the arm’s length principle, which states that the amount charged by one related party to another for a given product must be the same as if the parties were not related.
What the law says
Section 18(3) of the Kenya Income Tax Act says “Where a non-resident person carries on business with a related resident person and the course of that business is so arranged that it produces to the resident person 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 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.”
According to Section 18(6) of the Act, the two companies were related by virtue of the fact that a third person (Unilever Plc) participated directly or indirectly in the management, control or capital of the business or both.
“On examination of the sales account and invoices, major differences were noted in prices offered to related parties against local customers and independent (third-party) exporters of the same commodities to the Tanzanian market,” KRA official said, in its submissions. But the taxman faced a major obstacle: at the time there were few people on its staff familiar with these transactions, and there was inadequate regulatory framework in place to deal with what is commonly known in accounting parlance as transfer pricing. Unilever won in the appeal.
High Court Judge Alnashir Visram sitting in Nairobi on October 5, 2005 ruled that due to the absence of Kenyan transfer pricing legislation, a major manufacturer and distributor of popular, fast-moving consumer goods like Omo could not be faulted for having applied internationally recognised principles in setting their transfer pricing policy.
Transfer pricing refers to the pricing arrangements set by multinational-related entities in transactions between themselves such as the sale of goods, provision of services, transfer of intangible assets, lending or borrowing of money and any other transactions that could affect the profit or loss of the entities.
Single parent firm
This happens whenever two related companies – a parent company and a subsidiary, or two subsidiaries controlled by a common parent – trade with each other. All transactions within the corporations are subject to transfer pricing including raw material, finished products, and payments such as management fees, intellectual property royalties, loans, interest on loans, payments for technical assistance and know-how, and other transactions. The rules on transfer pricing requires multinationals to conduct business between their affiliates and subsidiaries on an “arm’s length” basis.
If two unrelated companies trade with each other, a market price for the transaction will generally result. This is known as “arms-length” trading, because it is the product of genuine negotiation in a market. This arm’s length price is usually considered to be acceptable for tax purposes.
Taxation woes
But when two related companies trade with each other, they may wish to artificially distort the price at which the trade is recorded, to minimise the overall tax bill. This might, for example, help it record as much of its profit as possible in a tax haven with low or zero taxes.
After losing the case, it was back to the drawing board for KRA. It was forced to suspend audits of other companies. This gave rise to a raft of regulatory changes aimed at roping in firms that were abusing their tax obligations.
The tax agency would later drop a similar case against Sara Lee before it developed national rules on transfer pricing in the 2006/7 financial year that have guided self-evaluation by companies to the present time.
KRA then went back to the drawing board and in 2008 formed a transfer pricing team that focuses on transfer pricing audits. The agency then resumed the transfer pricing audits from 2009. KRA says although Kenya has been among the most aggressive in pursuing transfer pricing cases, it has not been easy.