GOT IT!
Apple changed the valid locations where Safari can read it's proxy pac file from.
As I understand it (much help from this thread https://discussions.apple.com/thread/4136735 ), Safari reads the network settings when it starts up and if a proxy pac file is defined, it reads the file.
However - and this is the important thing - it is only allowed to read it from a list of specific locations. If it's anywhere else, Safari will fail to read it (silently) and simply not work. You can validate this by looking for this error in your system logs:
27/07/12 12:59:42.243 AM sandboxd[24973]: ([24972]) WebProcess(24972) deny file-read-data /Library/Internet Plug-Ins/custom-proxy.pac
This is where it gets a little tricky, in Mountain Lion the list of valid locations appear to have changed. You need to look in (and this is different from Snow Leopard and Lion)
/System/Library/PrivateFrameworks/WebKit2.framework/WebProcess.app/Contents/Reso urces/com.apple.WebProcess.sb
To see the list.
In my case I created the /Library/Managed\ Preferences directory which did not exist. Copied the pac file there, set the new location in my network preferences and restarted Safari to get it to read the file.
Now everything works.