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Guidance on how ‘arm’s length’ principle should be applied to financing of intra-group transactions

03 May 2013   (0 Comments)
Posted by: Author: Mark Badenhorst
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Source: Mark Badenhorst

The South African Revenue Service (SARS) recently issued a new draft interpretation note on thin capitalisation to provide guidance to South African enterprises that receive financial assistance from foreign related companies. The new interpretation note is intended to provide clarity on how the ‘arm’s length’ standard should be applied to intra-group financial assistance. 

The interpretation note is in line with a five-year strategic plan recently issued by SARS for the period 2012/13 to 2016/17 setting out its mandate and core outcomes, as well as its strategy to achieve these outcomes. In the strategic plan, SARS states that transfer pricing will be one of its key focus areas for the next few years as it has been identified as a major risk area because of the growing presence of a number of multinational organisations in South Africa. Finance Minister Pravin Gordhan also announced in the February Budget Review that the thin capitalisation provisions would be addressed. 

Mark Badenhorst, a Tax Partner in PwC’s Transfer Pricing Division, says: "CEOs and directors have to contend with a raft of tax issues, such as transfer pricing and thin capitalisation amidst the recent economic uncertainty and increased scrutiny from governments, tax authorities and other interested stakeholders. South Africa has introduced a number of laws designed to protect the tax base – these include a number of anti-avoidance provisions. One of the most common anti-avoidance measures used by the tax authorities is the thin capitalisation rules. "The rules are designed to prevent companies that are part of multinational groups from shifting large amounts of profits offshore to low tax jurisdictions, in order to reduce the group’s effective tax rate,” explains Badenhorst.

Many South African companies with foreign parent companies receive financial assistance in the form of loans. South Africa introduced thin capitalisation rules in 1995. The SARS Commissioner was empowered under the rules to have regard to the financial assistance provided, by scrutinising the transaction in question. Interest paid or payable on the financial assistance was disallowed if the funding was considered excessive having regard to the lender’s fixed capital in the borrower. The Commissioner’s views on what was considered ‘excessive’ were initially contained in a practice note (Practice Note No. 2 of 1996), which will be repealed and only applies to companies’ years of assessment commencing before 1 April 2012. 

The practice note contained safe harbor provisions for the amount of financial assistance a taxpayer could borrow as well as the interest rates that could be applied to the funding. These safe harbor provisions provided much needed certainty for taxpayers.

For companies’ years of assessment commencing after 1 April 2012, thin capitalisation is dealt with under the general transfer pricing provisions contained in the Income Tax Act (section 31(2)). 

Under the current law a taxpayer is required to determine what amounts it would have been able to borrow in the open market, and under what terms and conditions, and at what price. The arm’s length principle is applied to financial assistance in the same way as it is applied to any other transaction.

Badenhorst says that in practice the application of the arm’s length principle to financial assistance is likely to be difficult, as third party providers of financial assistance have many issues to consider. Deciding on what constitutes an arm’s length amount of financial assistance and the related pricing is a very subjective matter, he says. 

One of the most significant changes is that taxpayers must determine an acceptable amount of debt based on an arm’s length principle. SARS will require taxpayers to consider the transaction from both the perspective of the lender and the borrower at an arm’s length. 

The draft interpretation note sets out the documentation which a taxpayer will have to prepare and retain in order to demonstrate that the financial assistance received is arm’s length. "These documentation requirements will result in a substantial increase to compliance costs for taxpayers. This will have a negative impact, especially on smaller multinational entities”, says Badenhorst.  

SARS has removed the safe harbor provisions and has stated that it will adopt a risk-based approach in selecting potential thin capitalisation cases for audit.

"Organisations need to review their existing financing and business arrangements to assess the potential implication of the rules and must carefully consider any current or proposed financial assistance to ensure compliance with the regime,” warns Badenhorst.


Section 240A of the Tax Administration Act, 2011 (as amended) requires that all tax practitioners register with a recognized controlling body before 1 July 2013. It is a criminal offense to not register with both a recognized controlling body and SARS.


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