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'Deemed loan' secondary transfer pricing adjustment to be scrapped

13 March 2014   (0 Comments)
Posted by: Author: David Warneke
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Author: David Warneke (BDO)

One of the tax proposals contained in the 2014 Budget review is the scrapping of the 'deemed loan' secondary transfer pricing adjustment contained in section 31(3) of the Income Tax Act, in favour of such an adjustment being treated as a dividend subject to the dividends tax or a 'capital contribution depending on the facts and circumstances'. The scrapping of the deemed loan treatment is generally to be welcomed although scant detail regarding the proposal was provided in the Budget Review.

In analysing the statement in the Budget Review, it appears that the words 'capital contribution' should have been 'return of capital'. This would make more sense as both a 'dividend' and a 'return of capital' are forms of what might loosely be referred to as a 'distribution'.

Possibly the intention is that the directors will have the power to decide whether the adjustment will be taken to reduce the contributed tax capital ('ctc') of the company, as is presently the case with 'normal' distributions. If, for example, a management fee payable by a South African resident company to its foreign holding company is overstated when compared with an independent arm's length charge, the excess will have reduced accounting reserves. To regard the excess as a dividend would seem appropriate. On the other hand, if a royalty of say R100 charged by the South African resident subsidiary to its foreign holding company was understated by R50, the transaction could be deconstructed into an arm's length royalty charge of R150 combined with a dividend of R50.The definition of 'contributed tax capital' does not exclude the possibility of, for example, a distribution being debited to accounting reserves but nevertheless reducing ctc by resolution of the directors. A non-resident holder of shares in a South African company (other than a company rich in South African immovable property) would not be subject to capital gains tax on the disposal of its shares and so one imagines that in such a case the tendency would be for the directors to resolve that the adjustment must reduce ctc.

Presumably, the dividend or return of capital treatment will only be appropriate in cases in which the 'affected transaction' benefitted the holder of a share in the taxpayer company. The paucity of information provided in the Budget review does not mention what, if any, consequence there would be if the transaction did not benefit the holder of a share. Presently any transfer pricing adjustment is subject to the deemed loan treatment, regardless of whether or not it benefitted the holder of a share.

In regarding the adjustment as a dividend, there is a return to the concept of the 'deemed dividend' treatment in terms of the Secondary Tax on Company ('STC') regime, in terms of which a transfer pricing adjustment was deemed to be a dividend subject to STC. Under current law if the majority foreign shareholder of a South African taxpayer company is benefitted by say, extracting too much from the subsidiary by way of a management charge, there is an argument to be made that the overpayment is a dividend if it is 'in respect of a share' and that it is also subject to the deemed loan treatment. It would appear that SARS does not tax the overpayment as a dividend in addition to the deemed loan treatment.

The deemed loan treatment has been regarded as problematic ever since it was enacted. The OECD Report on Transfer Pricing Guidelines states that:

'some countries … assert under their domestic legislation a constructive transaction (a secondary transaction), whereby the excess profits resulting from a primary adjustment are treated as having been transferred in some other form and taxed accordingly'.

However, concerns have been raised as to how the taxpayer can get rid of the deemed loan, which is purely a legal fiction. In the draft Interpretation Note that SARS issued in 2013 on Thin Capitalisation, the view is expressed that 'an amount will be regarded as having been repaid if, for example, the taxpayer is refunded the excessive interest or the other party pays the interest raised on the deemed loan'. As this draft Interpretation Note was issued in the context of thin capitalisation, the transactions under consideration were, of necessity, inbound loans. So the situation under consideration would be an excessive amount of interest charged by say, a foreign holding company to a South African taxpayer in respect of an inbound loan.

The view expressed in the draft Interpretation Note is open to criticism. If the excess amount of the interest were refunded by the foreign holding company, the refund would represent a partial reversal of the expense claimed by the taxpayer, thereby resulting in an independent arm's length amount of interest being reflected in the taxpayer's income statement. Presumably also, the refund would reflect an amendment to the agreement between the parties in terms of which the interest was charged, thus reducing the charge to an arm's length amount of interest in relation to the year of assessment in question. In this situation there would appear to be no case for the imposition of the primary adjustment in the first place. The wording of section 31(2) implies that a tax benefit must have been derived before a primary adjustment can arise.

Be that as it may, it would seem that the reference to a 'refund' in the draft Interpretation Note was meant to apply to situations in which the excessive interest had been physically paid by the South African taxpayer company to its foreign creditor. If the excessive amount of interest had not been paid but instead had been credited to the holding company's loan account, the question would be whether a reversal of the excessive amount by the taxpayer by way of journal entry on, say, the last day of its year of assessment would do the trick. SARS is notoriously against the practice of year end 'rectification' journal entries. On the other hand, one can question the necessity of a physical cash 'refund' by the holding company in circumstances where it had not received payment of the excessive interest.

If the deemed loan were not repaid and continued in existence until the full repayment of the actual loan, it would give rise to the situation where the actual loan was no longer in existence but the deemed loan would seemingly continue in existence indefinitely. This would surely not be desirable from a SARS audit perspective as there would be no indication from a review of the subsequent financial statements of the company that such an actual loan had ever been in existence, even though the deemed loan should continue to give rise to an adjustment.

At least the dividend or return of capital treatment proposed in the Budget Review would bring a definite end to the taxation arising from the adjustment. One assumes that such a dividend would be subject to relief provided by double taxation agreements. Once taxed as a dividend or regarded as a return of capital, the misery would be brought to a definite end.

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