Are you “affected” by the release of SARS’ Interpretation Note 127?
At a glance
- Taxpayers' financing method affects their taxable income calculation, with debt financing potentially allowing for interest deductions and equity financing not allowing for deductions on dividends or returns on capital.
- The South African Revenue Service (SARS) aims to prevent excessive intra-group debt that leads to excessive interest deductions and aligns with global initiatives against Base Erosion Profit Shifting.
- Thin capitalization rules were introduced in South Africa in 1995, and SARS provides guidance through Practice Note 7 and Interpretation Note 127 on applying the arm's length principle for intra-group loans, including conducting functional and comparative analyses.
A taxpayer that is financed through debt may, subject to certain conditions, exceptions and restrictions, become entitled to deduct interest payments that are incurred in the production of income. In contrast, a taxpayer that is financed through equity will not become entitled to deduct any dividends or returns on capital.
The South African Revenue Service (SARS), therefore, has a vested interest in ensuring that the South African tax base is not depleted by taxpayers with excessive intra-group, back-to-back or intra-group guaranteed debt which may result in excessive interest deductions. This is in line with the various ongoing Base Erosion Profit Shifting initiatives being implemented at a global level.
In this context, South Africa introduced thin capitalisation rules in 1995. Thin capitalisation refers to a taxpayer that has too much debt when considered against the amount of its equity. SARS’ guidance on what constituted excessive international financial assistance was first documented in Practice Note 2, dated 14 May 1996 (PN 2). PN 2 was withdrawn on 5 August 2019 with effect from years of assessment commencing on or after 1 April 2012. This coincided with the substitution of the transfer pricing provisions in section 31 of the Income Tax Act 58 of 1962 (Act) resulting in thin capitalisation no longer being governed by a separate subsection of 31, but instead the general transfer pricing provisions.
Another interpretive tool that provides guidance insofar as section 31 of the Act is concerned is SARS’ Practice Note 7, dated 6 August 1999 (PN 7). PN 7 sets out the guidelines and procedures to be followed in the determination of arm’s length prices in respect of various cross-border transactions (as opposed to only loan funding), taking into account the South African business environment.
More recently, and in response to the updated transfer pricing guidelines issued by the Organisation for Economic Co-operation and Development (OECD), SARS issued a draft interpretation note that provides guidance on the application of the arm’s length principle when pricing intra-group loans as contemplated in section 31 of the Act. After a round of public consultations, the draft interpretation note was finalised and published on 17 January 2023 as Interpretation Note 127 (IN 127).
In addition to providing guidance on the application of the arm’s length principle within an intra-group context, IN 127 also sets out the consequences for taxpayers if an intra-group loan is incorrectly priced after applying the arm’s length principle. Given the importance of this complex area of tax law, this article highlights and discusses some of the key guidelines and outcomes of IN 127.
The arm’s length principle
Section 31 of the Act targets “affected transactions”. An “affected transaction” is defined as, amongst other things, a transaction entered into between connected or associated persons where at least one party is either a South African tax resident or a non-resident with a permanent establishment in South Africa (whereas the other party is a non-resident), and the terms and conditions of the transaction are different from those that would have been agreed upon between persons acting at arm’s length (i.e independent parties).
In terms of the OECD Transfer Pricing Guidelines for Multinational Enterprise and Tax Administrations, dated 20 January 2022 (OECD Guidelines) (which SARS partially relies on as guidance on the application of and adherence to the arm’s length principle), the application of the arm’s length principle is based on a comparison of the conditions of the tested transaction with the conditions that would have existed had the parties been independent and undertaking a comparable transaction under comparable circumstances.
In the context of a loan, IN 127 establishes that SARS will consider a transaction to be non-arm’s length if, amongst other factors, some or all of the following circumstances exist:
- the taxpayer is thinly capitalised;
- the duration of the lending is greater than would be the case at arm’s length; or
- the repayment terms, interest rate or other terms are not what would have been entered into or agreed to between independent parties.
Therefore, when applying the arm’s length principle, IN 127 states that the conditions and economically relevant circumstances of a transaction must be compared with the conditions and economically relevant circumstances of a comparable transaction between independent parties. In order to do this, one needs to conduct functional and comparative analyses.
IN 127 refers to various conditions and economic factors as being relevant for consideration when identifying the commercial and financial relations of the parties. We outline these below:
- The contractual terms of the loan. This requires a consideration of the terms of the written agreement between the parties. In some instances, it may require that one also look at other documents (i.e. term sheets or other negotiation documents) as well as the conduct of the parties to ensure that the contractual form and actual conduct are aligned.
- The functions performed, assets used and risks assumed by the parties. For example, a lender’s decision as to the terms of the loan would be informed by an analysis and evaluation of the risks inherent in the loan, the capability to commit capital of the business to the investment, determining the terms of the loan, and organising and documenting the loan.
- Features and attributes of the transaction. For example, in the case of a loan, those characteristics may include, but are not limited to, the amount of the loan, its maturity date, the schedule of repayment and the nature or purpose of the loan (for example, trade credit, merger, acquisition, mortgage).
- Economic circumstances, which will include a consideration of the currency, geographic locations of the parties, local regulations, the business sector of the borrower and the timing of the transaction.
- Business strategies of the parties. For example, independent lenders may be prepared to lend on terms and conditions to an enterprise undertaking a merger or acquisition that might otherwise not be acceptable to the lender for the same business if it were in a steady state.
The conditions and economically relevant characteristics mentioned above must be applied against the backdrop of both the lender’s and borrower’s perspectives when comparing transactions.
From the borrower’s perspective this will include a consideration of the borrower’s ability to service the debt, and the risks related to the borrower’s acceptance and use of the funds.
From the lender’s perspective, this will include a consideration of, amongst other things, the risks that the debt arrangement carries for the lender. In this context, IN 127 highlights the use of credit ratings as the creditworthiness of the borrower is one of the main factors that independent investors take into account in determining an interest rate to charge and the amount of the debt. Credit ratings can serve as a useful measure of creditworthiness and therefore help to identify potential comparables or to apply economic models in the context of relevant party transactions.
Comparative analysis: Intra-group loan pricing
IN 127 also sets out the approaches that can be followed in conducting the comparative analysis (i.e. benchmarking / pricing an intra-group loan) which we discuss below:
- The comparable uncontrolled price (CUP) method. This involves benchmarking the tested loan against publicly available information that reflects independent parties acting in a similar manner and under similar conditions as the tested loan. IN 127 also mentions the possibility of testing the loan against internal CUPs.
- Loan fees and charges approach. Where loan fees and charges are imposed in terms of a loan (such as arrangement fees), they should be evaluated in the same way as any other intra-group transaction.
- The cost of funds approach. In the absence of comparable uncontrolled transactions, IN 127 suggests that this could be used as an alternative to price loans in some circumstances. The cost of funds will reflect the borrowing costs incurred by the lender in raising the funds to lend.
- The credit default swaps approach. Credit default swaps reflect the credit risk linked to an underlying financial asset. This approach can, therefore, be used where there is a lack of availability of information regarding the underlying asset, that could be used as a comparable transaction. In terms of this approach, taxpayers and tax administrations are allowed to use the spreads of credit default swaps to calculate the risk premium associated with intra-group loans.
- Economic modelling approach. Certain industries rely on economic models to price intra-group loans by constructing an interest rate as a proxy to an arm’s length interest rate.
- Bank opinions approach. In some circumstances taxpayers may seek to evidence the arm’s length rate of interest on an intra-group loan by producing written opinions from independent banks, sometimes referred to as a ‘bankability’ opinion, stating what interest rate the bank would apply were it to make a comparable loan to that particular enterprise.
Timing the arm’s length test
Another important aspect that is considered in IN 127 is timing – i.e. when should the arm’s length principle be applied to an affected transaction.
Section 31 of the Act requires a taxpayer to consider whether, at the time of concluding the relevant affected transaction, the amount of the loan or the rate of interest charged are arm’s length. However, this section also requires taxpayers to continuously reassess whether a loan amount or rate of interest charged continues to be arm’s length throughout that loan’s subsistence.
This is confirmed in IN 127, which notes that the frequency and timing of reassessment will depend on the nature of the particular taxpayer’s business and the amount of change and variability it experiences. Practically, IN 127 suggests that annual testing is sufficient. It also sets out the documentary requirements which are not insignificant.
Effect of being “affected”
Section 31(2) of the Act provides that where an affected transaction results in a tax benefit, the taxable income of the person who derives the tax benefit must be determined as if that transaction had been entered into on the terms and conditions that would have existed between independent persons dealing at arm’s length. For example, in the context of a loan where SARS deems the interest rate charged between connected persons to be higher than would be agreed between person’s acting at arm’s length, a portion of the interest paid will be disallowed as a deduction by the debtor taxpayer. This is known as the primary adjustment.
In addition, section 31(3) of the Act provides that to the extent that section 31(2) of the Act causes a difference in any amount applied in the calculation of a taxpayer’s taxable income, that difference is subject to a secondary adjustment. This secondary adjustment takes the form of either a deemed donation, where the taxpayer is a person other than a company, or a dividend in specie, where the taxpayer is a company.
Section 31 of the Act finds application where, for example, a foreign company lends money to its wholly owned subsidiary in South African pursuant to a loan agreement, and the terms of the loan are such that independent parties, operating at arm’s length, would not have agreed to such terms and conditions. These could be anything from the amount of the loan, the duration of the loan, the rate of interest charged, the lack of security and/or covenants, subordination, etc.
In terms of section 31(2), the subsidiary will be required to calculate its taxable income as if the loan agreement was entered into between independent parties dealing at arm’s length (primary adjustment). Further, any difference calculated from the application of section 31(2) which results in a tax benefit for the subsidiary (such as incurring a greater amount of tax deductible interest) will be deemed to be a dividend in specie in that resident company’s hands.
In IN 127, SARS clarifies that, in its view, the deemed dividend in specie in this instance does not confer an actual benefit on the South African resident company. Rather it is an amount calculated purely for tax purposes. As such, SARS argues that no “beneficial owner”, which is defined as the person entitled to the benefit of a divided in section 64D of the Act, exists. Therefore, SARS concludes that any South African resident company that receives a deemed dividend in specie under section 31(3) of the Act will not be entitled to the dividends tax exemption under section 64FA of the Act.
It is interesting to note that IN 127 does not deal with the position prior to the enactment of the Taxation Laws Amendment Act 33 of 2019 (2019 TLA). The 2019 TLA introduced specific amendments to address certain deficiencies in the law relating to the imposition of dividends tax on section 31(3) deemed dividends in specie. It is also interesting to note that IN 127 does not address the application of double tax treaties to secondary transfer pricing adjustments. Some double tax treaties, such as South Africa’s treaty with the US, specifically mention that double tax treaty relief should be afforded to secondary transfer pricing adjustments such as section 31(3) deemed dividends in specie.
Tools of interpretation
IN 127, and interpretation notes generally, are not binding legislation. Rather, they provide insight into how SARS will interpret and apply the Act when carrying out its functions (collecting tax). Therefore, at most, they can be considered an indication of a practice generally prevailing (albeit by SARS).
Despite this, IN 127 reflects many of the principles set out by the OECD insofar as intra-group transactions are concerned. In this regard, in ITC 1943 83 SATC 429, the South African tax court noted that it cannot be denied that the OECD Guidelines on Transfer Pricing are a world standard in transfer pricing matters and that countries should align themselves with the OECD Guidelines where appropriate.
Therefore, taxpayers should note the importance and impact of IN 127 on their intra-group funding and the guidance provided therein, especially considering how sparse transfer pricing cases are in South Africa.
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