The Zambia Revenue Authority ("ZRA") performed a transfer pricing audit with respect to Nestlé Zambia Trading Limited's ("Nestlé Zambia") operations on the basis that Nestlé had consistently reported losses for a period of five years, between 2010 and 2014 (inclusive).

The ZRA issued an assessment adjusting Nestlé Zambia's profit to ZMW 56,579,048 and levied a gross tax of ZMW 13,860,103. Nestlé Zambia lodged an appeal with the Tax Appeals Tribunal Holden at Lusaka ("Tribunal").

Nestlé Zambia's grounds for appeal were the following:

• Ground one: the ZRA wrongfully assessed that Nestlé Zambia had been liable for the gross tax, as the ZRA did not perform any test to assess Nestlé Zambia's non-compliance with the arm's length principle.
• Ground two: the ZRA issued its assessment on the basis that Nestlé Zambia could not run at a loss since incorporation, but disregarded Nestlé Zambia's reasons for the losses.
• Ground three: the ZRA failed to objectively test the related party transactions, but rather relied on (unreasonable) assumptions and estimates.
• Ground four: the ZRA characterized Nestlé Zambia as a limited risk distributor, which is not the case as Nestlé Zambia performs functions, builds customer relationships and assumes risks akin to a fully-fledged distributor.
• Ground five: the ZRA's benchmarking study was neither comparable to the nature of its business nor the economic conditions in Zambia.
• Ground six: the ZRA added back unrealized foreign exchange losses due to financial assistance that were not included as part of expenses in the financial statements.

Nestlé Zambia succeeded on Grounds one, two, three, five and six but the Tribunal found for the ZRA with respect to Ground four. Taking into account that the Ground the ZRA won deals with the recharacterisation of Nestlé Zambia from a fully-fledged distributor to a limited risk distributor, this summary will specifically focus on the arguments brought forward by both the ZRA and the taxpayer in relation to the characterization of Nestlé Zambia.

Nestlé Zambia's arguments:

• Nestlé Zambia bears credit risk associated with the failure of customers to honor payments.
• Nestlé Zambia bears full risk associated with the inventory and therefore the ZRA's assumption that it did not have the financial capacity to assume the risk was incorrect.
• Whilst Nestlé Zambia receives strategic direction from the head office, it bears its own marketing and promotion expenses and associated risks.
• Nestlé Zambia bears all foreign exchange risk due to fluctuations in currency.

In addition, Nestlé Zambia filed an expert witness, asserting that Nestlé Zambia is licensed to distribute products in Zambia and conducts business by ordering products, managing the logistics process, identifying and building the customer relationships, undertaking selling and distribution functions, managing inventory and conducting marketing and advertising activities.

The expert witness then concluded that Nestlé Zambia can be characterized as a marketer distributor.  

ZRA arguments:

• 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 is not entirely assumed by Nestlé Zambia, but is partly assumed by 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 has a lean staff complement mainly in marketing, stores and accounting.
• Nestlé Zambia's customers collect orders from the warehouse using their own transportation.

The Tribunal's analysis and conclusions

The Tribunal, based on testimonies of witnesses, is of the view that there is a significant level of control by Nestlé Zimbabwe as regards the strategic direction of the operations. Specifically, the Tribunal pointed out that Nestlé Zambia's first witness, 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 as there was no witness from Nestlé Zambia. This supported the ZRA's view with respect to control and oversight of operations in Zambia.

In addition, the witness stated 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. The tribunal argued that, whilst the services are essential, the fact that the services are performed by related parties further supports the ZRA's argument on control.

Furthermore, the ZRA submitted into evidence the General License Agreement ("License Agreement") between Nestlé SA and Nestlé Zambia and specifically referred to the definition of "know-how" and Clause 27 of the License Agreement, which states that the "know-how" will remain the exclusive property of Nestlé SA as licensor. According to the Tribunal's interpretation, Nestlé SA retains ownership in the products, and therefore the ultimate risks in marketing, distribution, storage and/or selling of the products lies with Nestlé SA, not Nestlé Zambia. On this basis, the Tribunal found for the ZRA.

Our views

Whilst the Tribunal found for Nestlé Zambia with respect to Grounds one, two, three, five and six, there is potentially a conflict in that characterizing Nestlé Zambia as a limited risk distributor would require a whole of entity approach with respect to benchmarking the distribution activities.

Under a (limited) distribution agreement, the principal, will indemnify the limited risk distributor with respect to certain costs, specifically those related to risks that could materialize in the course of the limited risk distributor's operations. This will include risks such as inventory risk, foreign exchange risk, product liability risk, etc. as the limited risk distributor performs routine functions and does not assume significant risks. This is then reflected in the transfer pricing policy applied, being a guaranteed routine margin earned by the limited risk distributor.

The provision of services by related parties to Nestlé Zambia does not imply that such related parties exercise control over the operations of Nestlé Zambia. Services within a multinational enterprise ("MNE") can be outsourced to specific entities within the MNE and it is common practice for independent parties to outsource the provision of certain services to third parties. The question here should be which of the above-mentioned services, in the context of a fully-fledged distributor, are value adding functions and which are support functions. For example, procurement and supply chain management, in the context of a fully-fledged distributor may be considered to be a value-add function, for which arguments can be made concerning whether or not such a function can be outsourced.

The interpretation of the License Agreement by the ZAR and the Tribunal was in our view not correct as "know-how" refers to:

• "technical and non-technical information and data"
• that would be made available by Nestlé SA to Nestlé Zambia
• for or in relation to "packaging, storage, supply, import, export, marketing, promotion, distribution and/or selling"

The "know-how" is that which would remain the property of Nestlé SA, according to clause 27. Taking into account the implications of the possible incorrect interpretation of the License Agreement and the weight placed by the Tribunal on the License Agreement, the Tribunal's conclusion could be seen as flawed.

The ZRA raised an interesting point concerning the low level of investment in Nestlé Zambia, which in their view meant Nestlé Zambia does not assume most of the risk. The ZRA argued that Nestlé Zambia was thinly capitalized, however there had been no thin capitalization rules in Zambia. The Tribunal dismissed the argument on this basis.  

This point is not completely unfounded as it could speak to the financial capacity of Nestlé Zambia to assume risk. Therefore, if Nestlé Zambia were a fully-fledged distributor, it arguably would have sufficient capital to control and manage certain risks. At the same time, given that Nestlé Zambia had been incorporated in 2010, would significant levels of capital be expected for such an entity that is a new entrant in the market?

The recharacterisation of Nestlé Zambia from a fully-fledged distributor to a limited risk distributor could potentially have a worse off effect with regards to the quantum of the assessment and the tax expense which could arise from the adjustment should a new benchmarking study be performed. This of course, will depend on the final set of comparables and the margins achieved.

Lastly, given Nestlé Zambia's recharacterisation by the ZRA, any future profits above the benchmarked margin would be attributable to the principal, i.e. the supplier. Therefore, the ZRA may not argue in future for higher profit margins.

Written By Okkie Kellerman, Senior Executive, and Sedzani Phundululu , Transfer Pricing Associate, Tax  Practice,  Baker McKenzie Johannesburg