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Transfer Pricing and Thin Capitalisation: A Documentation Nightmare

Friday, 06 December 2013   (0 Comments)
Posted by: Author: BDO
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Author: BDO
Section 31 of the Act, dealing with transfer pricing, was substituted with effect for years of assessment commencing on or after 1 April 2012. The substituted provision is different to its predecessor in a number of important respects.
The new provision:
  • Applies automatically and is not subject to the discretion of the Commissioner for SARS;
  • Does not directly deal with thin capitalisation, which is seen to be a form of transfer pricing;
  • Contains a so-called 'secondary adjustment'; and
  • Introduces the spectre of penalties and interest applying where transfer pricing disputes with SARS arise.

The transfer pricing 'safe harbours' contained in the now obsolete Practice Note 2 no longer apply. In effect this means that the taxpayer would have to be able to justify both the quantum and rate on inbound loans when compared with the quantum and rate that would have been obtainable from a third party lender dealing at arm's length. SARS issued a draft interpretation note on thin capitalisation which has subsequently not been issued in final form. This draft interpretation note indicates that in evaluating the terms and conditions of such a loan, one must disregard guarantees provided by companies other than the borrower. This means that where, say, a foreign holding company guarantees a loan from a third party lender to its South African subsidiary, the relevant enquiry must be: without any guarantee or other form of financial assistance, how much would a third party lender have been prepared to lend to the South African subsidiary, and at what rate of interest? The draft interpretation note also requires a 'would' test to be applied, which asks the question: how much would a responsible board of directors, with the best interests of the company at heart, have applied for by way of borrowing? The 'permissible' quantum of debt is the lesser amount in terms of the 'could' and 'would' tests.

The documentation that would be required required to defend both the quantum and rate of borrowings is often voluminous and expensive in order to obtain. Unfortunately, however, without any thin capitalisation safe harbours to rely on, taxpayers are required by implication to be able to adequately defend such transactions or arrangements.

The necessity to have adequate supporting documentation to defend transactions or arrangements is not limited to thin capitalisation situations. Taxpayers need to consider all transactions or arrangements taking place between connected persons in relation to themselves in an international context, or more correctly in an 'affected transaction' as defined. The typical types of transactions that give rise to transfer pricing adjustments include:

  •  Proceeds from the sale of goods;
  • Cost of sales;
  • Interest (on inbound and outbound loans);
  • Royalties (inbound as well as outbound charges); and
  • Management and other service fees (inbound as well as outbound charges).

Taxpayers also need to take into account situations in which there is no charge for an outbound service, such as the making available of intellectual property by a South African holding company to its African subsidiaries. The relevant test is whether an independent party rendering the identical service in the same circumstances would have charged for it.

It should be noted that there is presently a carve out from section 31 for financial assistance and the right to use intellectual property that is provided to a relatively highly taxed controlled foreign company with a foreign business establishment as defined in section 9D where the resident that provided the service (or a fellow group company) holds at least 10 % of the equity shares and voting rights in the controlled foreign company.

A further carve out relating to so-called 'equity' loans is proposed in the Taxation Laws Amendment Bill of 2013.

An 'affected transaction' is defined as any transaction, operation, scheme, agreement or understanding where:

1. (aa) a person that is a resident; and
(bb) any other person that is not a resident;

2. (aa) a person that is not a resident; and
(bb) any other person that is not a resident that has a permanent establishment in the Republic to which the transaction, operation, scheme, agreement or understanding relates;

3. (aa) a person that is a resident; and
(bb) any other person that is a resident that has a permanent establishment outside the Republic to which the transaction, operation, scheme, agreement or understanding relates; or

4. (aa) a person that is not a resident; and (bb) any other person that is a controlled foreign company in relation to any resident,
and those persons are connected persons in relation to one another; and
any term or condition of that transaction, operation, scheme, agreement or understanding is different from any term or condition that would have existed had those persons been independent persons dealing at arm's length.

The issue of the 'secondary adjustment' is problematic. Section 31(3) requires the amount of a primary transfer pricing adjustment to be regarded as a 'loan that constitutes an affected transaction'. In effect this means that interest on the primary adjustment must itself be taken into account as a transfer pricing adjustment. It is not clear in terms of normal commercial transactions how this deemed loan would ever be repaid. A repayment of the excessive amount of any charge levied by a foreign holding company to its South African subsidiary does not appear to resolve all issues relating to the deemed loan, as the draft interpretation note on thin capitalisation, for example, appears to imply.

In our view we have an inappropriate situation bearing in mind the need for a developing country such as South Africa. We have legislation similar to that in the first world with the absence of thin capitalisation safe harbours. However, unlike for example the United Kingdom, we do not have the certainty afforded taxpayers by way of advance pricing agreements. The longer the current situation continues, the more foreign investment we are likely to drive away.

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