- 1. INTRODUCTION
1.1 - In anticipation of a possible relaxation in exchange
controls, the Commission of Inquiry into certain aspects of the Tax
Structure of South Africa (under the chairmanship of Prof M M Katz)
recommended in its first and second interim reports that transfer pricing
provisions be introduced into the Income Tax Act, 1962 (the Act), inter
alia to counter thin capitalisation practices which may have adverse
tax implications for the South African fiscus.
Transfer pricing provisions are normally applied to adjust the prices of
goods and services in terms of certain transactions concluded between
related parties to reflect an arm's length price which would have applied
had the transaction been concluded on normal commercial grounds between
unrelated parties. The effect of the application of transfer pricing
provisions is to neutralise the tax benefit arising from such transactions.
On the other hand, thin capitalisation provisions are applied to limit the
deductibility of interest where there is a disproportionate ratio between
the loan capital and equity employed in, for example, a company.
In order to counter such practices, section 23 of the Income Tax Act,
1995 (Act No. 21 of 1995), substituted section 31 of the Act. Such
section consists of a combination of transfer pricing and thin
capitalisation provisions which may, for instance, be applied where
financial assistance is granted in respect of international
transactions.
- 1.2
- Measures to counter transfer pricing schemes are in essence contained
in section 31(1) and (2). Although these provisions may also, in certain
circumstances, be applied to combat thin capitalisation, the provisions of
subsection (3) are more specifically aimed at countering thin
capitalisation schemes.
Once the excessive portion of financial assistance has been determined
in accordance with the guidelines as set out in paragraph 4 of this
Practice Note, the provisions of section 31(2) must be applied to determine
whether the interest calculated on that portion of the financial assistance
falling within the 3 : 1 guideline provided in the aforementioned
paragraph, is based on an arm's length price (interest rate). In this
regard consideration should be given to the guidelines provided in
paragraph 2.2.
On a literal interpretation of section 31 the concept of financial
assistance would include not only interest-bearing financial assistance,
but also interest-free financial assistance. As the purpose of subsection
(3) is in essence to enable the Commissioner for Inland Revenue to
determine an acceptable debt/equity ratio in order to disallow a deduction
in respect of interest relating to the excessive portion of loan capital,
the application of subsection (3) will be limited to interest-bearing
financial assistance. This will, however, not have the effect that
financial assistance which is not interest-bearing, will be regarded as
permanent owners' capital.
On the same basis only, interest-bearing financial assistance will be
taken into account in the application of the transfer pricing provisions of
subsection (2) in cases where it is applied in conjunction with the
provisions of subsection (3) in order to determine whether the interest
calculated on that portion of the financial assistance falling within the
3 : 1 guideline, is based on an arm's length price (interest rate).
However, where the application of the thin capitalisation provisions are
not necessary because the financial assistance granted falls within the
prescribed guidelines, financial assistance may include financial
assistance which is not interest-bearing in the application of the
provisions of subsection (2).
- 1.3
- EXAMPLE:
A profitable South African company, TPS (Pty) Ltd, was capitalised in rand
by its shareholder who is a non-resident. The company's financial year
ends on 31 August. The RSA prime rate was 18.5% throughout the 1995/6 year
of assessment. The following further information is relevant for the
application of section 31:
| Fixed capital | R1,000,000 |
| Shareholder | |
| | |
| Loans | R4,000,000 |
| Shareholder granted loan # 1 on 1/9/95 @ 24% pa -
R2,000,000 | |
| Shareholder granted loan # 2 on 26/1/96 @ 0% pa -
R2,000,000 | |
| | |
| Interest | R480,000 |
| Loan #1: R2,000,000 at 24% | |
Section 31(3) is not applicable as the interest-bearing financial
assistance granted falls within the 3 : 1 guideline.
Calculation of excessive interest in terms of section 31(2)
| Interest falling within the 3 : 1 guideline | = R480,000
|
| | |
| Weighted average of financial assistance: | |
| R2,000,000 for 147 days | 294,000,000 |
| R4,000,000 for 219 days | 876,000,000 |
| 1,170,000,000 / 366 |
| = R3,196,721 |
| | |
| Effective interest rate of acceptable financial assistance |
= R480,000 / R3,196,721 |
| = 15% |
Excessive interest relating to the 1995/6 year of assessment is Rnil as
the 20.5% (18.5% + 2% (see 2.2 below)) limit has not been exceeded.
- 2. SECTION 31(1) AND (2)
2.1
- The scope of subsections (1) and (2) is limited to an
"international agreement" as defined. A transaction,
operation or scheme qualifies as an international agreement where such
agreement has been entered into between -
- a natural person ordinarily resident in the Republic or a person other
than a natural person managed or controlled in the Republic (hereinafter
referred to as a resident); and
- a natural person not ordinarily resident in the Republic or a person
other than a natural person managed or controlled outside the Republic
(hereinafter referred to as a non-resident).
Furthermore, paragraph (c) of the definition of "services"
in section 31(1) encompasses the granting of financial assistance,
including a loan, advance or debt and the provision of any security or
guarantee.
- 2.2
- Where in terms of section 31(2) a service, specifically the granting
of financial assistance, is provided by a non-resident to a resident who is
a connected person in relation to the non-resident and the consideration
relating to the financial assistance is excessive in the sense that the
consideration does not reflect an arm's length price, the Commissioner may,
in the determination of the taxable income of the resident, adjust the
consideration in the hands of the resident to reflect an arm's length
consideration in relation to the financial assistance granted.
Consideration, in the context of financial assistance, will be interpreted
to include not only interest or related finance charges, but also a
discount or premium. Where the loan, advance or debt is denominated in
rand, a rate not exceeding the weighted average of the South African prime
rate plus 2 percentage points will be an acceptable nominal annual interest
rate. Where the loan, advance or debt is denominated in a foreign
currency, a rate not exceeding the weighted average of the relevant
interbank rate plus 4 [reduced to 2 by
Government Notice 746 of 2002] percentage points will be an acceptable
nominal annual interest rate. Any interest exceeding the abovementioned
prescribed rates will be regarded as excessive interest and will consequently
not be allowed as a deduction for income tax purposes.
- 3. SECTION 31(3)
- Section 31(3) was introduced specifically to address thin
capitalisation transactions between certain related parties. The
provisions of this section will apply where financial assistance is granted
directly or indirectly by a non-resident of the Republic (the investor) to
-
- a resident (the resident) of the Republic who is a connected
person in relation to the investor; or
- a person other than a natural person who is managed or controlled
in the Republic (the recipient) in whom the investor has a direct or
indirect interest by virtue of which the investor is entitled to
participate in 25% or more of the dividends, profits or capital of the
recipient or is entitled to exercise, directly or indirectly, 25% or more
of the voting rights of the recipient.
Where in terms of such an arrangement the Commissioner is satisfied that
the financial assistance granted by the investor to the resident or the
recipient is excessive in relation to the fixed capital of the resident or
recipient, any interest relating to the excessive portion of the financial
assistance shall be disallowed as a deduction in the hands of the resident
or recipient.
- 4. DETERMINATION OF "DISALLOWABLE INTEREST" RELATING TO
EXCESSIVE FINANCIAL ASSISTANCE
4.1
-
As a general guideline, the Commissioner will not apply the thin
capitalisation provisions contained in section 31(3) where the financial
assistance/fixed capital ratio does not exceed 3 : 1. The excessive portion
of financial assistance granted by an investor will, therefore, be that
portion of the financial assistance which exceeds an amount equal to three
times the fixed capital of the resident or recipient of the financial
assistance. This approach will ensure a degree of continuity as it will,
to some extent, correspond with the current practice of the Exchange
Control Authorities. The interest (interest, finance charge or other
consideration including inter alia a discount or premium) in
relation to or in respect of financial assistance shall be apportioned
between the amount of financial assistance which is considered to be
acceptable and the amount of financial assistance which is regarded as
excessive. In order to determine which portion of interest relates to
excessive financial assistance in relation to an investor in respect of a
year of assessment, the following formula will be applied:
A = B x (C - D) / C
in which formula -
"A" represents the disallowable interest, limited to
interest incurred during such year in respect of financial assistance
granted on or after 19 July 1995;
"B" represents the total interest incurred during such
year in respect of all financial assistance, contemplated in subsection
(3), in existence during such year (whether or not such financial
assistance was granted before, on or after 19 July 1995);
"C" represents the weighted average of all
interest-bearing financial assistance which was in existence during such
year (whether or not such financial assistance was granted before, on or
after 19 July 1995); and
"D" represents the greater of -
- three times the fixed capital of the resident or recipient as at the
end of the relevant year of assessment; and
- the weighted average of all interest-bearing financial assistance
granted prior to 19 July 1995, which existed during such year.
- 4.2
- The financial assistance contemplated in section 31 to be used in
symbol C is an amount equal to the weighted average of the financial
assistance in existence during the relevant year of assessment and includes
interest-bearing financial assistance only. Where no significant variation
occurred in the level of financial assistance during the year of
assessment, the amount of financial assistance as it exists at the end of
the relevant year of assessment may be used. Trade credit which is
interest-bearing must be included in the amount of financial assistance
granted as contemplated in section 31(1).
Furthermore, where a South African company is partially owned by an
investor (e.g. 50%) and such investor is jointly and severally, together
with all other shareholders, liable in terms of a security provided in
respect of -
- a foreign bank overdraft of the South African company; or
- any other independent third party foreign loan to the South African
company,
a portion of the overdraft or loan, pro rata to the investor's
interest in the company, will be regarded as financial assistance granted
by such investor.
- 4.3.
- In determining the amount of fixed capital of the resident or recipient
in the Republic, the following items are to be taken into account on a
pro rata basis in accordance with the investors' interest in the
South African entity:
- share capital;
- share premium;
- accumulated profits of a capital and revenue nature; and
- permanent owners' capital (excluding any financial assistance) in
circumstances where there is no share capital.
Fixed capital will be reduced by any reserves and increased by any losses,
resulting from the revaluation of assets. The amount of fixed capital to
be used when calculating symbol "D" of the formula is an amount
equal to the fixed capital at the end of the relevant year of
assessment. However, the annual net trading losses sustained during the
current and immediately preceding two years of assessment, limited to
losses sustained for years of assessment during which the investor has
granted financial assistance to the resident or recipient, may be added
back to fixed capital to be used in symbol "D" of the
formula.
- 4.4
- In determining the fixed capital relating to investors, the
calculation should not be done on the basis of what the investors invested,
but rather on such investors' pro rata share of the total fixed
capital. Furthermore, fixed capital will exclude deferred tax as
determined for accounting purposes.
- 4.5.
- Where financial assistance is granted to a resident of the Republic by
more than one investor as contemplated in subsection (3), the rules of
section 31 will be applied to such investors, without reference to any
person other than an investor having an interest in the fixed capital of
the resident or recipient.
- 5. EXAMPLE
- A profitable South African company, TCS (Pty) Ltd, was capitalised in
rand by its shareholders, all of them being non-residents. Only X is an
investor. The company's financial year ends on 31 August. The RSA prime
rate was 18.5% throughout the 1995/6 year of assessment. The following
further information is relevant for the application of section 31:
| Fixed capital | | R15,000,000 |
| Shareholder X - (2/3) | R10,000,000 | |
| Various other shareholders - (1/3) | R 5,000,000
| |
| | |
| Loans | | R40,000,000 |
| Shareholder X granted loan # 1 on 1/9/95 @ 24% pa |
R30,000,000 | |
| Shareholder X granted loan # 2 on 26/1/96 @ 0% pa |
R10,000,000 | |
| | |
| Interest | | R8,277,049 |
| Loan # 1: R30,000,000 at 24% for 366 days |
R7,200,000 | |
| Loan # 2: R10,000,000 at 18% for 219 days |
R1,077,049 | |
Calculation of disallowable interest in respect of shareholder X in
terms of section 31(3)
| B = | R8,277,049 | |
| | | |
| C = | R30,000,000 for 147 days | 4,410,000,000 |
| R40,000,000 for 219 days | 8,760,000,000 |
| | 13,170,000,000 / 366 |
| = | R35,983,606 | |
| | | |
| D = | The greater of (R10,000,000 x 3) or Rnil | |
| = | R30,000,000 | |
| | | |
| A = | 8,277,049 x (35,983,606 - 30,000,000) /
35,983,606 | |
| = | R1,376,365 | |
Calculation of excessive interest in respect of shareholder X in
terms of section 31(2)
| Interest falling within the 3 : 1 guideline | = R8,277,049 -
R1,376,365 |
| = R6,900,684 |
| | |
| Effective interest rate of acceptable financial
assistance | = R6,900,684 / R30,000,000 |
| = 23% |
| | |
| Excessive interest relating to the 1995/6 year of assessment
| = R6,900,684 x (23 - 20.5) / 23 |
| = R750,074 |
- 6. COMMISSIONER'S DISCRETION
6.1
- Notwithstanding the guideline of the 3 : 1 ratio and the interest
rates referred to in paragraph 2.2, with regard to the application of
section 31, it is acknowledged that a higher level of financial assistance
in contrast with the guideline ratio of financial assistance to fixed
capital or a higher interest rate may be applicable as a result of
transactions and agreements entered into for commercial and economic
reasons rather than to obtain tax advantages.
- 6.2
- Where a taxpayer, therefore, can justify a higher level of financial
assistance in contrast with the guideline ratio of financial assistance to
fixed capital or a higher interest rate under particular or special
circumstances, he may approach the Commissioner, to exercise his
discretion in terms of section 31. This will, generally be of a temporary
nature and a period may be specified within which the 3 : 1 ratio should
be restored or the interest rate be reduced.
- 6.3
- Taxpayers falling within the 3 : 1 ratio will not be required to
justify their ratio. They must, however, submit the information requested
in the annual income tax return.
- 7. FINANCIAL ASSISTANCE IN CURRENCY OTHER THAN RAND
- Where financial assistance is denominated in a currency other than the
currency of the Republic, the equivalent currency value of the Republic
must be determined by applying the spot or relevant forward rate, as the
case may be, on the date the amount of financial assistance is to be
determined. However, where there is an increase in the rand value of the
financial assistance as a result of a weakening of the rand against the
relevant foreign currency, the rand value of the financial assistance may
be determined with reference to the spot or relevant forward rate, as the
case may be, on the following dates: In the case of a loan owing by a
person, the date on which the amount payable in respect of the loan was
received by such person and in the case of a debt owing by a person, the
date on which the debt was actually incurred.
- 8. BACK-TO-BACK ARRANGEMENTS
- In the application of section 31(3), the term "financial
assistance granted indirectly" includes back-to-back arrangements
through independent parties or co-investors. Where a foreign parent
company, therefore, makes a loan to a South African bank, a foreign bank
or any other person on condition that the bank or other person on-lends the
funds to the South African subsidiary of the parent company, the loan will
be treated as financial assistance. Where the foreign parent company
provides a guarantee to a foreign bank or any other non-resident as
security for a loan to the local subsidiary, the bank debt will be treated
as financial assistance. Where, however, the foreign parent company
provides a guarantee to a South African bank as security for a loan to the
local subsidiary, the bank loan will not be treated as financial assistance
as the foreign company will not receive any interest and the recipient of
the interest will be taxed thereon.
- 9. EXCESSIVE (see par.2.2) AND DISALLOWABLE (see par.4) INTEREST
SUBJECT TO SECONDARY TAX ON COMPANIES (STC)
- In the case of companies the total amount of the excessive and
disallowable interest will be deemed to be a dividend declared in terms of
section 64C(3)(e) of the Act and STC will be payable on the excessive and
disallowable interest. As the determination of the excessive and
disallowable portions of interest and the exercising of the Commissioner's
discretion are to be made at the time the relevant assessment is raised,
the dividend cycle in respect of such deemed dividend will, for purposes of
the definition of "dividend cycle" in section 64B(1), be regarded to end
on the date of assessment in respect of the year of assessment to which the
excessive and disallowable interest relates. Where, however the taxpayer
has been notified in writing by the Commissioner of the amount of the
excessive and disallowable interest prior to such date of assessment, the
dividend cycle will be regarded to end one month after the date of such
notification.
- 10. APPLICATION
- The provisions of section 31 shall inter alia only apply to any
services supplied on or after 19 July 1995. As already mentioned, the
supply of services includes the granting of financial assistance. Interest
incurred after that date on a loan or advance received or debt incurred
before that date will, therefore, not be subject to the provisions of
section 31.