Guidance on how ‘arm’s length’ principle should be applied to financing of intra-group transactions
03 May 2013
Posted by: Author: Mark Badenhorst
Source: Mark Badenhorst
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.
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.
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
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.
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
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)).
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.
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.
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
removed the safe harbor provisions and has stated that it will adopt a
risk-based approach in selecting potential thin capitalisation cases for audit.
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