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South African Transfer Pricing - A Paradigm Shift In The Dark

01 May 2012   (0 Comments)
Posted by: Author: Johan Kruger
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South African Transfer Pricing - A Paradigm Shift In The Dark
Transfer pricing has always been a critical focus area in the South African tax environment since its introduction in 1995.The focus has, however, intensified during the last four years, with the establishment of the African Tax Administrative Forum (ATAF) in November 2009 and the announcement and implementation of radical changes to the South African legislative landscape for transfer pricing in 2010 and 2011.The latest budget presented by the Minister of Finance did not include any significant amendments to the South African transfer pricing regulations.This was as a result of the significant amendments announced in the 2010 and 2011 budgets.Reference was made to interest-free outbound loans from South African corporate taxpayers to African subsidiaries.

According to the budget proposal, interest free South African loans to African subsidiaries can be treated in line with the economic substance, i.e. potentially an equity contribution in line with the decision to treat certain forms of debt as equity.This will be applicable where it was the intention of the lender for the loan to essentially operate as additional fixed capital contributions in the African subsidiaries.

SARS also recognised that there are transfer pricing concerns with regard to the headquarter company provisions and have indicated that these anomalies will be addressed to encourage regional headquarter company investment.The latest budget proposal, however, made no reference to the practical application of the new deemed loan provision which replaces the STC liability on adjustments made under the transfer pricing rules contained in Section 31 of the South African Income Tax Act 58 of 1962, for financial years commencing on or after 1 April 2012.This, coupled with the lack of guidance provided by SARS relating to the implementation of these provisions and the new arm’s length test for thin capitalisation, has lead to a great deal of uncertainty in applying transfer pricing rules in South Africa.
Interest-free loans from South Africa to African subsidiaries can be treated in line with their economic substance.Bringing into play the concept of economic substance previously a controversial one in South Africa, the South African Revenue Services has historically adopted a strict legal interpretation of the legislation resulting largely in the rejection of the concept.This view has always been contradictory to the Organisation for Economic Co-Operation and Developments (OECD) view of considering the economic circumstances of cross border-related party transactions.The concept of quasi-equity has also been accepted by a number of tax authorities across the world, including the Australian Tax Authority (ATO), Her Majesty’s Revenue Commission (HMRC) and the Internal Revenue Services (IRS).  
The concept of quasi-equity is usually built around the original intention of the taxpayer extending the funds to its cross-border related party and justifies extending these funds free of any additional return or interest.This could imply that a legal financial arrangement is classified as equity, due to its economic intention to operate as additional share capital contributions in the recipient.Investment into Africa (for example, exploration activities) typically requires large amounts of funding and the African subsidiaries are frequently not in a position to repay the amounts invested by its offshore-related parties.These funds are seen as an investment into the African subsidiary and are treated as interest free loans from a legal and accounting point of view. 
The latest budget proposal that interest-free South African loans to African subsidiaries can be treated in line with the economic substance, therefore aligns the view of the OECD and some of the major tax authorities across the world with South Africa.This is also in line with SARS’s and National Treasury’s drive for investment into Africa and provides certainty to South African taxpayers on an issue that has always been controversial.Significant changes to the transfer pricing legislation will be introduced with effect from 1 April 2012 which will significantly widen the scope of Section 31 to permit the commissioner to adjust the terms and conditions of a transaction as opposed to the price, where he is of the view that these terms and conditions do not accord to the arm’s length principle.Further, in reviewing the arrangement, the commissioner is no longer restricted to the transaction stated but can look wider to the overall transaction, operation, scheme, arrangement, agreement or understanding of which the transaction(s) form part.The onus of proof has also been shifted from the commissioner to the taxpayer to show that the cross border-related party transactions are arm’s length.

Two key changes relating to financial assistance were also promulgated.The first applies to South African branches of foreign companies, to make financing into South Africa through a branch structure on par with that of a subsidiary structure.The second, and perhaps more radical change,is the move from a fixed capital test to an arm’s length test for debt in determining an appropriate funding arrangement.
The Taxation Laws Amendment Act 24 of 2012 dated 10 January 2012 also deems a transfer pricing adjustment to be a loan, on which interest at an arm’s length rate should be charged.This represents a significant change from the current law which deems any adjustment made under section 31 to be a dividend on which STC is levied.The proposed change effectively introduces a secondary adjustment on the South African taxpayer’s taxable income in the form of interest on the deemed loan amount. What makes this change problematic is that the adjustment made is deemed to be a loan until the point in time where the difference in pricing between the two related parties is settled through the repatriation of funds or through a possible mutual agreement procedure (MAP).
This creates problems where an arm’s length charge cannot be made due to certain restrictions imposed, either in terms of a joint venture agreement or, by virtue of regulatory restrictions in the recipient country.In such cases, companies may unilaterally make a transfer pricing adjustment to ensure compliance with the South African rules. In such cases these adjustments will now be deemed to be loans and will remain in force not only increasing each year, but also requiring an interest charge to be imputed.
Therefore, while there was much consternation around the previous regime resulting in a STC charge, which had a negative cash impact, the new regime is far from taxpayer-friendly. SARS argues that the proposed new changes will ensure closer alignment with the OECD guidelines for transfer pricing and with the approach adopted by OECD member countries.
There remain anomalies to be addressed to encourage regional headquarter company investment pertaining to the new transfer pricing provisions in relation to the new headquarter company provisions.These anomalies relate to, for example, a transaction between a headquarter company and its subsidiary, involving foreign exchange differences.The application of the new Section 31 will take into account foreign exchange differences, in determining whether a company’s cross-border related parties are arm’s length, compared to the amended provisions of Section 9I (2) (c), that provides for the exclusion of foreign exchange differences (identified in terms of Section 24I) from the gross income of the headquarter company.National Treasury’s media statement released on 13 March 2012 provides clarity on some of the anomalies identified with the new headquarter company provisions, but excluded any reference to the anomalies pertaining to the new transfer pricing provisions.SARS has, however, indicated in the latest budget proposals that it is looking into these anomalies.As yet the lack of clarity remains.
Guidance on the practical application of the new deemed loan provision that will apply as part of the new transfer pricing legislation remains a critical matter; for example, where a controlled foreign company of a South African company enters into an affected transaction with another non-South African group company that results in a transfer pricing adjustment.This adjustment could potentially result in a deemed loan between the controlled foreign company and the non-South African group company.This, in turn, could result in a deemed amount of interest income that could be imputed in the taxable income of the South African company.
There is also currently a lack of guidance pertaining to the exchange control treatment of a deemed loan created in terms of the new Section 31.The creation of such a deemed loan would most probably also result in a deemed interest charge at an arm’s length rate from the South African company to its offshore group company.
In general, outbound loans from South African companies to their offshore related group companies should be declared to and approved by the South African Reserve Bank (SARB). Such an application is typically accompanied by a loan schedule and agreement providing details on the terms of repayment and applicable interest rate.There is currently no guidance for the taxpayer on the exchange control requirements with regard to a deemed loan created as a result of the new Section 31.

Practical guidance on this matter is therefore critical and would hopefully be resolved with the issuing of an updated practice note or interpretation note on the new transfer pricing provisions.In general,South African taxpayers are currently in the dark when it comes to the practical implications and application of the changes to the transfer pricing legislation and environment in South Africa.This is due to a lack of guidance from SARS in the form of an updated practice note or interpretation note. SARS has indicated that it will most probably be in a position to release a new interpretation note only by the end of March 2012, which gives taxpayers very little time for proper tax planning.
Source: By Johan Kruger (TaxTALK) 


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