By:Joel Cooper, Eustace Ngoma, Vicki Bales M.A. A.C.A., James Dalley, DLA Piper UK LLP
Global Tax Alert
On March 28, 2019, the Tax Appeals Tribunal (TAT) delivered its decision in Nestlé Zambia Trading Limited v Zambia Revenue Authority  TAT 03. The case is very likely to have important future implications for multinationals with operations in Zambia with cross-border related party transactions.
The Zambia Revenue Authority (the Revenue) performed a transfer pricing audit with respect to Nestlé Zambia’s operations on the basis that Nestlé Zambia had reported losses for the financial years 2010-2014. Nestlé Zambia had declared losses since incorporation, and the net profit margins were negative for the five-year period under review.
As a result of the audit, the Revenue had adjusted Nestlé Zambia’s profit to ZMW56,579,048 (approx. USD4.4 million), resulting in an additional tax liability of ZMW13,860,103 (approx. USD1.1 million), plus penalties and other levies.
Nestlé Zambia filed an appeal to the Tax Appeals Tribunal. Specifically, Nestlé Zambia challenged the Revenue’s assessment on six grounds:
- The Revenue wrongfully assessed that Nestlé Zambia was liable for the additional tax, as Nestlé Zambia’s non-compliance with the arm’s length principle had not been tested.
- The Revenue had erred in law by issuing its assessment on the basis that Nestlé Zambia could not run at a loss since incorporation (disregarding Nestlé Zambia’s reasons for such losses).
- The Revenue failed to objectively test the related party transactions, relying instead on assumptions and estimates that were excessive and unreasonable.
- The Revenue had incorrectly characterised Nestlé Zambia as a limited risk distributor (LRD), which was not the case, as Nestlé Zambia performs functions, builds customer relationships and assumes risks akin to a fully-fledged distributor.
- The Revenue’s benchmarking study was not comparable to the nature of Nestlé Zambia’s business, or the economic conditions in Zambia.
- The Revenue had erred in law and in fact when it added back unrealised foreign exchange losses attributable to a loan, when they had not been recorded as part of Nestlé Zambia’s expenses in the financial statements.
With specific reference to Nestlé Zambia being recharacterised as an LRD, the revenue argued that:
- Nestlé Zimbabwe controls and oversees Nestlé Zambia’s operations.
- The sourcing and invoicing of Nestlé Zambia’s products is performed by Nestlé Ghana.
- Inventory risk does not entirely lie with Nestlé Zambia, but is partly borne by suppliers who are Nestlé manufacturing entities.
- The level of investment in Nestlé Zambia is low, which indicates that most of the risks are not assumed by Nestlé Zambia.
- Nestlé Zambia employs a relatively small number of staff, predominantly engaged in marketing, stores and accounting functions.
- Nestlé Zambia’s customers collect orders from the warehouse using their own transport.
Nestlé Zambia succeeded on all grounds of appeal, except for its position on the characterisation of the entity as an LRD.
The Tribunal found that there was a significant level of control by Nestlé Zimbabwe as regards the strategic direction of its operations. The Tribunal observed that one of Nestlé Zambia’s witnesses – a financial controller for the Nestlé South Cluster (i.e., Zambia, Zimbabwe and Malawi) employed by Nestlé Zimbabwe – appeared to know more about Nestlé Zambia’s operations than Nestlé Zambia’s employees (there was no witness from Nestlé Zambia). This supported the Revenue’s view with respect to the control and oversight of operations in Zambia.
The financial controller for the Nestlé South Cluster further gave evidence that Nestlé Zambia receives strategic management services; sales support services; marketing support services; finance, accounting and legal services; procurement and supply chain management services; human resources management services; and information technology support services. This, the Tribunal found, further supported the Revenue’s argument in relation to control.
Additionally, the Tribunal considered a General License Agreement between Nestlé SA and Nestlé Zambia – submitted into evidence by the Revenue – providing that “know-how” remained the exclusive property of Nestlé SA as the licensor. According to the Tribunal’s reasoning, this meant that Nestlé SA retained ownership in the products, and thus the ultimate risks in marketing, distribution, storage and/or selling of the products lay with Nestlé SA rather than Nestlé Zambia.
For these reasons, the Tribunal found for the Revenue on ground four, and considered that there was nothing wrong with its characterisation of Nestlé Zambia as an LRD.
This case – the first of its kind in Zambia – may well have significant implications on the transfer pricing practices for multinationals with operations in Zambia with cross-border related party transactions and cluster operating models. The decision provides the first substantive piece of Zambian jurisprudence in the establishment of arm’s length arrangements between related parties.
First and foremost, it is important to note that both the Tribunal and the Revenue referred to the OECD Transfer Pricing Guidelines and UN Practical Manual on Transfer Pricing for Developing Countries (the UN Practical Manual) as there was no substantive transfer pricing regulation in place for the period under review. The Tribunal acknowledged and accepted the use of the OECD Transfer Pricing Guidelines and UN Practical Manual where local laws and regulations did not provide any or sufficient guidance on a particular issue. This should provide comfort to multinationals that already follow this practice and serve as a guide for those who have yet to align their transfer pricing practices in Africa based on these international arm’s length standards. That being said, detailed transfer pricing regulations for Zambia were issued last year (The Income Tax (Transfer Pricing) (Amendment) Regulations, S.I. No. 18 of 2018), which would now be the first reference point for transfer pricing practices in Zambia.
The Tribunal emphasised the need for transfer pricing analyses to be ideally conducted on a “transaction-by-transaction” basis, unless transactions are so closely linked that the aggregation approach would be justified. This is an important requirement that, in line with international standards, businesses need to take into account in their transfer pricing practices. That being said, this position is difficult to reconcile with the Revenue’s argument and the Tribunal’s approach to characterize the entity as an LRD, which implies their acceptance of a degree of aggregation.
The characterization of Nestlé SA as an LRD by the Zambian tax authorities is also somewhat surprising, as this is the characterization that will most likely lead to consistently low profits being reported in the country. Additionally, unusual arguments have been put forward to justify such a characterization. For example, whilst Nestlé SA may retain exclusive ownership of the know-how, it does not necessarily follow that the functional profile of Nestlé Zambia is that of an LRD.
The decision also demonstrates the continued challenges faced by multinationals and the Revenue in finding appropriate comparables domestically and within the African region for benchmarking purposes. Rather than challenging the approach submitted by Nestlé Zambia, the Revenue performed its own benchmarking analysis, which the Tribunal, in turn, found to be disproportionate due to the use of businesses in Western Europe as comparables.
Many multinationals operate their inbound investments into Africa using the cluster models that are at the centre of the dispute in this case. These cluster models exist for different commercial reasons and can operate differently. This case shows that a good understanding and evidencing of business facts and circumstances is important to support the transfer pricing classification and pricing of transactions – from the provision of cluster management services to functional management and pricing as an LRD.
Cross-border tax and transfer pricing have become increasingly high-profile issues for multinationals in recent years. Governments in established markets, as well as in Africa and other emerging markets, are taking steps to protect their tax bases. Global developments are being watched closely by African countries, including Zambia, that then seek to apply these approaches domestically through new laws, new approaches to audits of specific issues, and capacity building.
These developments mean that the tax environment is changing rapidly. Businesses with operations in Zambia, and those looking to establish or expand their operations on the African continent more broadly, need to be proactively addressing these emerging tax issues.
Find out more about the content of this article by contacting one of the authors or your usual DLA Piper advisor.
Transfer Pricing Director