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The Kenya Tax Appeals Tribunal has upheld a decision by the Kenya Revenue Authority (KRA or Respondent) to change a company’s transfer pricing (TP) method on intercompany transactions from the Comparable Uncontrolled Price (CUP) method to the Resale Price Method (RPM). This change in method resulted in a significant tax liability.

Background

The Appellant is a company incorporated in Kenya; its principal business activity is sale of power generators, commercial engines and spare parts for the power generators and commercial engines.

The items are sourced from related-party manufacturers in India and the United Kingdom. The Appellant is a subsidiary of X Ltd., which is registered in Mauritius. The parent entity is a joint venture of two nonresident legal entities.

The Appellant applied the CUP method to pricing equipment sourced from its nonresident related parties. The KRA contended that the Appellant should have applied the RPM.

The Respondent issued the Appellant an assessment of 119,328,977 Kenyan shilling (KES) in relation to corporate income tax. The Respondent also made an additional assessment of KES 2,219,333,335 (approximately US$17m) based on other issues.

The Appellant lodged an appeal at the Tax Appeals Tribunal (TAT).

Issues for determination

The questions at issue were:

1. Whether the Respondent was justified in concluding that X Ltd. lacked substance in Mauritius and was thus taxable in Kenya
2. Whether the Respondent was justified in imposing a different TP method on Appellants’ intercompany transactions

Appellant’s position

The Appellant stated that X Ltd. was legally registered in Mauritius as a private company and key decisions were made in Mauritius. To substantiate that X Ltd. had substance and was tax-resident in Mauritius, the Appellant stated that X Ltd. operates different subsidiaries in various countries in East Africa and its income is taxed independently in each jurisdiction of operation. Additionally, all board meetings and key business activities, like compliance are reporting, were conducted in Mauritius.

The Appellant highlighted that Paragraph 2.15 of the OECD TP Guidelines provides that where it is possible to locate comparable uncontrolled transactions, the CUP method is the most direct and reliable way to apply the arm's-length principle. Additionally, the Appellant stated that the application of CUP method was supported by the absence of differences between the transactions at issue and transactions of comparable enterprises that could affect the prices in an open market. Reasonable adjustments could also be applied to eliminate material differences. The Appellant asserted that it had conducted an economic analysis through a benchmarking study that resulted in a 5% markup. During the year under review, the Appellant had realized a 7.71% margin on its sales and was thus in line with the arm’s-length requirement.

Respondents’ position

The Respondent argued that the Appellant held 50% of the shares of X Ltd., which was significant control. Additionally, one of the directors held dual roles in the Appellant and X Ltd. and, thus, key management decisions were initiated in and passed through Kenya. The Respondent therefore concluded that X Ltd. was tax-resident in Kenya.

The Respondent averred that the CUP method is appropriate for evaluating prices of property/services in a controlled transaction where there are comparable uncontrolled prices. However, referring to the OECD guidelines, the Respondent stated that the RPM is appropriate where the reseller purchases tangible goods from a related entity and the reseller does not physically alter or add substantial value to the tangible goods.

The Respondent stated that it had performed benchmarking based on similar businesses. Notably, the Respondent indicated that the Appellant had classified its services as low-value, adding intragroup transactions, while they were actually core business activities.

TAT analysis and findings

The TAT determined that the Appellant did not discharge its duty of proving that X Ltd. had substance in Mauritius and did not have taxable presence in Kenya.

Additionally, the TAT held that for marketing operations, the RPM was considered more appropriate; however, the TAT also observed that the Respondent did not consider various factors in the intercompany transactions, namely the service and workshop costs. The Respondent was thus asked to make the necessary adjustments to its computation based on RPM.

The TAT also disregarded the additional KES 2,219,333,335 assessment, which was not included in the KRA’s initial objection decision (i.e., notice of assessment) and was introduced afterward by the Respondent, contrary to tax dispute-resolution procedures.