The Impact of Transfer Pricing on Social Impact Investment
Transfer pricing refers to the way in which prices for goods and services are set between associated or related parties, with one of the parties being a non-resident for tax purposes. Associated enterprises (for example in a group of companies) can set their own prices for services or goods exchanged within the group, which may have the effect of shifting taxable profits from one jurisdiction to another.
Transfer pricing is therefore a tax avoidance strategy. Uganda like any other country, has in place rules to check on tax avoidance by way of transfer pricing. The Income Tax (Transfer Pricing) Regulations of 2011 mandates that prices set for goods and services should follow the arm’s length principle, meaning that price which would have been applicable to a person outside of a group transacting at an arm’s length basis. Where there is a deviation from the arm’s length price which may create a tax advantage for one of the parties, or erosion of the taxable income, Uganda Revenue Authority is mandated to readjust the price following the arm’s length basis. Associated companies view transfer pricing as an opportunity to competitively and efficiently allocate resources, source goods and services and basically manage their supply chains for goods and services within the group in a manner to maximize competition.
Unfortunately, anti-avoidance legislation such as The Income Tax (Transfer Pricing) Regulations of 2011 are based on the blanket assumption that all transfer pricing efforts are intended to escape tax liability. The effect may be so, but there are circumstances when transfer pricing is beneficial not only to the companies in the group but to the country as well. For example, in the case multinational NGOs or socially oriented companies and impact investors would benefit from a transfer price to optimally allocate prices and therefore increase their level of investment in the recipient community or country.
The assumption here is that managing the intragroup pricing would enable such entities to have vast capital reserves which can be ploughed back into investment. The legislation however does not consider transfer pricing that may be undertaken by associated entities that are not entirely profit oriented such as non-profit entities or NGOs or impact investors. The Regulations are applicable to all transactions between “associates” as defined under the Income Tax Act. All transactions by associates are therefore subject to the regulations, regardless of specific circumstances of each.
An empirical study published in 2018 by the IMF (At a cost: The Real Effects of Transfer Pricing Regulations) concluded that transfer pricing legislation had the effect of reducing investments by multinationals by more than 11 percent, and even larger if the transfer pricing legislation is enforced strictly. According to the study, this could be due to a higher cost of capital for the multinational resulting from the transfer pricing regime, or reallocation of investment to other affiliates in other jurisdictions. One of the implications of the study is that countries like Uganda have to choose between one of two evils: base erosion of taxable profits, or reduction of investment by multinationals. Effects on Impact Investment Impact investment refers to the allocation of capital resources to socially oriented entities with clear and measurable social and environmental impact, alongside financial returns.
It basically means the financing of projects or ventures that also carry the promise of social returns such as reduction of inequality, environmental protection, gender mainstreaming among others. Impact investment is based on the idea of “doing well by doing good”. From an accountability perspective, there are no universally agreed metrics for measuring the social or environmental returns from Impact Investment, with the same ease that the financial returns may be measured. As such Impact Investment may to some, not be the best candidate for exemption from the wide and wholesome application of transfer pricing regulation. However, if transfer pricing is viewed from the perspective of the multinational involved, it presents an opportunity to make capital savings by reducing the tax liability, with the objective of reinvesting the capital into socially impactful projects.