South Africa introduces long-awaited interpretation note on thin capitalisation and loans with associated enterprises
Carla Smith
by Carla Smith
On 17 January 2023, the South African Revenue Service (SARS) published Interpretation Note 127 (IN127). The note covers several topics and offers taxpayers long-awaited guidance on the application of the arm’s length principle as it relates to the pricing of intra-group loans.
Taxpayers typically receive funding through a combination of debt and equity. Subject to certain restrictions, taxpayers may deduct interest payments incurred in the production of income from their taxable income. Conversely, taxpayers are not eligible for any deductions for dividend payments or capital returns when financed through equity. This means that taxpayers typically elect to receive funding via debt, which results in excessive interest deductions and the depletion of the South African (SA) tax base, particularly in cross-border transactions involving related parties.
A high debt-to-equity ratio means that taxpayers are what is termed “thinly capitalised”. SA introduced thin capitalisation rules into the Income Tax Act (ITA) in 1995. In 2012, these rules were deleted and, instead, the transactions fell into the general transfer pricing provisions. With a lack of targeted legislation, and to ensure compliance with the arm's length principle, taxpayers have gone to great lengths to conduct transfer pricing studies. Unfortunately, IN127 does not alleviate this problem.
Some key considerations in IN127 are as follows:
SARS will particularly consider a taxpayer’s debt to be non-arm’s length if:
the taxpayer is thinly capitalised;
the duration of the loan is longer than it would be at arm’s length; and
the repayment, interest rate or other terms would not have been agreed at arm’s length.
These are not safe harbour rules. Hence, meeting these requirements may not be sufficient to prevent a costly transfer pricing study.
The thin capitalisation regime should include both direct and indirect loans, along with back-to-back transactions and guarantees provided by group affiliates to support a borrower’s credit.
The views of both the lender and borrower must be considered when implementing the arm's length principle.
A primary adjustment and a secondary adjustment are the results of intra-group financing transactions that do not adhere to the arm's length standard. The primary adjustment is the resident taxpayer's entire or partial interest payments which are not deductible. The secondary adjustment is that the prohibited interest amount would be treated as a dividend in specie, and the resident taxpayer would be subject to dividend tax. It is noteworthy that IN 127 does not discuss the application of double tax agreements to secondary transfer pricing adjustments.
According to IN 127, SARS is considering implementing an advanced pricing agreement process which would be the outcome of a procedure where taxpayers and tax authorities agreed on the amount of debt that would be regarded as arm's length. The procedure would be carried out before the transactions are made or before filing a tax return.
Although the release of IN 127 is positive and offers taxpayers direction, it must be kept in mind that the legal status of the document is not enforceable. It merely provides an indication of SARS’s current perspective on the interpretation of the ITA.
Carla Smith is a Tax Consultant at Nolands Tax. She is a qualified Tax Advisor (SA) with the South African Institute of Tax Professionals, with her highest qualification being an Honours degree in Tax. Her tax interests are tax treaty law and applying such knowledge in complex cross-border operations. She is currently completing her Masters in International Tax at the University of Cape Town. Contact Carla.
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