Secondary adjustment for thin capitalisation purposes
20 June 2014
Posted by: Author: BDO
The 2014 Budget review proposes that the ‘deemed loan' secondary adjustment contained in section 31(3) of the Income Tax Act be scrapped. It was proposed that an alternative treatment be followed where the secondary adjustment will be deemed a dividend or ‘capital contribution' which in turn would be subject to dividends tax. This seems to be closer to the STC regime of the old transfer pricing legislation prior to the change with effect of years of assessment commencing on or after 1 April 2012. In its present form, section 31 forces all terms or conditions as part of any transaction, operation, scheme agreement or arrangement in a cross-border context between connected persons to be at arm's length. The treatment applies to the extent that either party obtains a tax benefit as a result of the term or condition not being that which would have been obtained on an arm's length basis.
The difference in taxable income thus arising may be termed the ‘primary adjustment'. Section 31 goes further and in effect levies a market-related interest on the primary adjustment as a further inclusion in the taxpayer's taxable income. This further inclusion may be termed the ‘secondary adjustment'. The OECD defines a secondary adjustment in the Glossary of the OECD Transfer Pricing Guidelines (OECD Guidelines) as "A constructive transaction that some countries ill assert under domestic legislation after having proposed primary adjustment in order to make the actual allocation of profits consistent with the primary adjustment. Secondary transactions may take the form of constructive dividends, constructive equity contributions, or constructive loans”. The proposal is therefore that the secondary adjustment be treated as a dividend or capital contribution rather than a deemed loan, a suggestion which is in line with the European Union's Joint Transfer Pricing Forum suggestion to its EU Member States.
There is, however, much about the proposal that is unclear. One of these is the possibility of double taxation resulting from additional withholding tax. A secondary adjustment would still be compulsory and would be treated as a form of profit distribution or possibly a return of capital. In circumstances where the dividend treatment applies, the dividend would be subject to withholding tax at 15%, unless the rate is possibly reduced by the terms of a double taxation agreement. However some jurisdictions, like Italy, do not provide relief on withholding tax charged on secondary adjustments.
Another consideration would be the effect of secondary adjustments on intercompany loans. As of 1 January 2015, SARS will levy a withholding tax of 15% on any interest paid on financial assistance provided by a non-resident. Certain exemptions apply and the withholding rate may be reduced by the terms of a double taxation agreement. Ignoring the exemptions, if SA Co obtained a R2,000,000 loan from Foreign Co at an interest rate of 10%, it would have to pay 15% withholding tax on all interest payments made on or after 1 January 2015. Let's say interest payments for FY2015 amounted to R200,000 resulting in withholding tax of R30,000. If SARS made an adjustment, stating that only 8% of the interest is arm's length, the primary adjustment for FY2015 would be R40,000. The secondary adjustment will deem the primary adjustment i.e. R40,000 to be a dividend or a return of capital charging 15%. This would result in double taxation as the lender had already suffered 15% interest withholding tax on the same amount. The legislator should ensure that all non-arm's length portions of interest not be subject to interest withholding taxes in order to prevent double taxation from arising.
Currently the proposal for the elimination of the secondary adjustment as a deemed loan is welcomed. Taxpayers are alleviated from the burden that the deemed loan treatment created. Hopefully there will be clarity regarding issues of transition from the old to the new legislation. Under the present wording of the provision, transfer pricing adjustments apply automatically. If taxpayers are aware that some of their cross-border transactions with connected persons were not concluded at arm's length, differences resulting in a tax benefit need to be calculated as their IT14 has to be submitted as if all transactions were concluded at arm's length. In respect of secondary adjustments arising prior to the proposed amendment, the taxpayer would have to account for interest on the deemed loan. It is far from clear how such adjustments, previously made, will be treated when the proposals become effective. One can only hope that these issues will be addressed when the 2014 tax amendments are drafted.
This article first appeared on bdo.co.za.