Thin Capitalisation, Transfer Pricing and Cross Border Loans
02 July 2013
Posted by: Author: Betsie Strydom
Author: Betsie Strydom (Bowman Gilfillan)
Section 31 of the Income Tax Act, no 58 of 1962 ("the ITA”) was amended with effect from 1 January 2013. Effectively the "old” thin capitalisation rules have been removed and are now dealt with under the rules that regulate transfer pricing.
Section 31 allows for an adjustment of the price payable in respect of the supply of goods or services between connected persons, in respect of cross border "affected transactions” if one of the parties receives a tax benefit. Such an adjustment will be made if the consideration for the goods or services is not at an arm’s length price. In effect, thin capitalisation is regulated by the general arms length rule contained in this provision.
A company is a connected person with reference to another company if at least 20% of the equity shares or voting rights are held by the other company and (in certain circumstances) also where the two companies form part of the same group of companies.
Where the cross border transaction consists of cross border financial assistance (such as a loan, or an advance, debt, security or guarantee) between a resident and a non resident the old test of considering the ratio of fixed capital to the loan no longer applies.
The questions that now have to be answered are as follows:
- Are the parties involved a resident and non resident ?
- Are the parties connected persons?
- If so, has a tax benefit arisen? A tax benefit would include (for example) the right of the South African company to deduct interest paid/payable. The tax benefit is more apparent where the interest rate or the amount of debt, is high.
- If these questions are answered in the affirmative, then the simple enquiry is what amount an arm’s length lender would be prepared to lend to the borrower.
In a recent media release dated 29 April 2013, SARS have indicated that they are considering the introduction of so-called "safe harbour” provisions in respect of interest paid to non residents. The safe harbour is that interest should not exceed 30% of taxable income. The statement reads as follows –"C. Transfer pricing interpretation note and potential safe harbour
As a general matter, cross-border interest between connected persons are subject to the facts and circumstances restrictions [sic] of transfer pricing as outlined in the proposed interpretation note (see Draft Interpretation Note on: ‘Determination of the taxable income of certain persons from international transactions: thin capitalisation’). However, given the general restrictions on debt as now proposed, the need for transfer pricing to address excessive debt and hybrid debt is reduced. Therefore, under consideration is a safe harbour that will be added to the transfer pricing rules (e.g. via a binding general ruling). In order to fall within this potential safe harbour, interest on connected person cross-border debt must satisfy the following two criteria:
- Firstly, interest on the connected person debt may not exceed 30 per cent of taxable income (with no adjustment for other interest received, accrued, interest paid or incurred); and
- Secondly, the interest rate depends on the currency denomination of the loan. The interest on the debt may not exceed the foreign equivalent of the South African prime rate if denominated in foreign currency. The interest rate on the debt may not exceed the South African prime rate if denominated in Rands.
Under current law, it should be noted that amounts viewed as excessive for transfer pricing purposes are permanently denied (not merely subject to an ongoing limitation on a carryover basis).”