The new South African transfer pricing rules – latest developments


More than a year has passed since the announcement was made in the middle of 2010, that the South African transfer pricing rules would undergo a substantial redrafting process in order to align them with international best practice. In the meantime, the initially envisaged effective date of the 1 October 2011 has come and gone and the third updated version of the new section 31 of the Income Tax Act 58 of 1962 (“the Act”) has just been introduced by the Minister of Finance to Parliament in terms of the Taxation Laws Amendment Bill, 2011 (No. 19 of 2011) (“the 2011 Amendment Bill”), which if promulgated in its current form, will come into operation on 1 April 2012, applying in respect of all financial years commencing on or after that date.  


Before analysing the latest version of section 31 in more detail, first a short summary of the South African Transfer Pricing Rules, as they currently stand, is appropriate.

Section 31 of the Act essentially requires that an arm’s length, that is, market related, price be paid or charged in respect of the cross-border supply of goods or services between connected persons. Should the Commissioner for the South African Revenue Service (“SARS”) be of the opinion that an arm’s length price has not been paid or charged, he is entitled to adjust the consideration for the transaction in order for it to reflect an arm’s length price, resulting in a potentially higher tax liability for the taxpayer. Furthermore, the excessive portion of the consideration is currently subject to Secondary Tax on Companies (“STC”) at a rate of 10%, since the payment will be regarded as a deemed dividend under section 64(C)(2)(e) of the Act. The Commissioner is also entitled to impose additional tax of up to 200% on the under payment of tax, together with interest.

According to SARS’ view, the current wording of section 31 is causing structural problems and uncertainty, as the literal wording unduly focuses on isolated transactions as opposed to arrangements driven by an overarching profit objective. In addition, SARS is of the opinion that the language gives rise to an excessive emphasis of the Comparable Uncontrolled Price (“CUP”) method as opposed to other more practical transfer pricing methodologies. Further, SARS is also of the opinion that the current legislative emphasis on “price” as opposed to “profits” does not align with the wording in the associated enterprises articles in the tax treaties concluded by South Africa.

Latest draft of section 31 in terms of the 2011 Amendment Bill

In order to eliminate the above uncertainties, the new rules have been worded similar to the wording of Article 9 of the OECD Model Convention on Income and on Capital (“OECD Model Convention”), with the focus on the economic substance of the arrangements between related parties, rather than the pricing of specific transactions. Accordingly, the latest version of section 31(2) will apply to any transaction, operation scheme, agreement or understanding where:

  • that transaction constitutes an affected transaction; and
  • any term or condition of that affected transaction is different from what would have existed had the affected transaction taken place between independent persons dealing at arm’s length; and
  • results, or will result in, any tax benefit being derived by a person that is party to the affected transaction.

The term “affected transaction” is defined in section 31(1) and includes any transaction, operation, scheme, agreement or understanding has been directly or indirectly entered into or effected between or for the benefit of either or both a resident and a non-resident which are connected persons in respect to each other and where any of the terms or conditions agreed upon are not of an arm’s length nature.

Where the above described requirements are met, the taxable income or tax payable by any person that is party to such a transaction, operation or scheme and derives a tax benefit must be calculated as if that transaction, operation or scheme had been entered into on the terms and conditions that would have existed had those persons been independent persons dealing at arm’s length.

Accordingly, the discretion currently granted to the Commissioner to adjust the consideration has been replaced with an obligation on the taxpayer to calculate its taxable income, as if all transactions had been entered into on an arm’s length basis.

In addition, and only introduced in terms of the 2011 Amendment Bill, the automatic deemed dividend rules in respect of transfer pricing mentioned above have been replaced with new rules proposing that the amount of the transfer pricing adjustment (that is, the primary adjustment) will be deemed to be a loan by the South African taxpayer to the non-resident connected person. As this deemed loan (that is, the secondary transaction) will constitute an affected transaction, it will attract interest at an arm’s length rate. While not included in the latest draft version of section 31, SARS has indicated in the Explanatory Memorandum to the 2011 Amendment Bill, that the primary adjustment will not be regarded as a deemed loan, if “repaid” within the same financial year, in which the primary adjustment is made. This, together with the obligation on the taxpayer to calculate its taxable income on an arm’s length nature now allows a taxpayer to make so-called “voluntary” transfer pricing adjustments without the current automatic “penalty” in the form of the deemed dividend rules and the subsequent obligation to pay STC.

While the move away from the current automatic deemed dividend approach is a positive development, there are a number of scenarios where the proposed new rules could result in a deemed loan of an indefinite nature, due to the fact that the deemed loan cannot be repaid by the non-resident connected party, due to commercial, legal or regulatory issues.

One example would be a South African business operating in a foreign jurisdiction through a company jointly owned with a local joint venture partner, where the contributions to be made by the joint venture partners and the remuneration thereof are negotiated in terms of the joint venture agreement. In these scenarios, the joint venture partners might agree to provide goods or services at a price that is not necessarily an arm’s length price for commercial purposes. Although we understand that this might require an adjustment from a transfer pricing perspective, it might not be possible for the South Africa joint venture party to convince or renegotiate the joint venture agreement with the joint venture partner to allow for the repayment of the deemed loan resulting from the transfer pricing adjustment.

Another example would be that of a South African company with a subsidiary in an African jurisdiction that still has exchange controls or other regulatory limitations that apply to the payment of fees to non-residents. In such a scenario, it would be extremely difficult for the operating entities in the African jurisdiction to convince the respective authority of the existence of a deemed loan due to transfer pricing adjustments made in South Africa and the repayment thereof.

In terms of both examples, the adjusted amount would be regarded as a deemed loan and attract interest at an arm’s length rate until the deemed loan has been repaid. However, due to commercial restrictions or local legislation, the non-resident connected person might not be able to repay the loan, with the consequence that the loan would remain in existence indefinitely, increasing on an annual basis by the amount of interest imposed in terms of the transfer pricing legislation.

Thin capitalisation rules

In line with the OECD’s views, SARS has stated that it views the issue of thin capitalisation as part of the transfer pricing mandate. Accordingly, the current section 31(3), which allows the Commissioner to disallow the deduction of interest by a taxpayer where financial assistance has been provided and where the Commissioner regards such financial assistance as excessive in relation to the fixed capital of the taxpayer, will be deleted when the new transfer pricing rules come into force on 1 April 2012. With the deletion of the specific thin capitalisation provision, the current 3:1 debt to equity ratio safe harbour provided in Practice Note No. 2 will also disappear.

Instead, the new rules require that the arm’s length principle be applied to financial assistance in the same way it is applied to any other transaction, operation, scheme, agreement or understanding. In practice, this will have the result that a taxpayer will have to determine what amounts it would have been able to borrow (that is, its lending capacity) in the open market, on what overall terms and conditions, and at what price.

Although the introduction of the arm’s length standard to the thin capitalisation rules seems to be commendable, in practice the application of the arm’s length principle in the context of thin capitalisation has proven to be extremely difficult, as the factors considered by third party providers of financial assistance are often multi-faceted and not necessarily limited to an analysis of the debt to equity ratio. SARS has acknowledged this and has undertaken to issue an interpretation note in respect of the new transfer pricing rules in general and the application of the arm’s length principle to thin capitalisation specifically before 1 April 2012. Based on international precedence and discussions with financial institutions, we would expect that the interpretation note will again provide some form of safe harbour, although in all likelihood not relying on the current debt to equity ratio. Instead, SARS might follow the approach of countries such as Germany or France and limit the interest deduction to a certain percentage of operating income or EBITDA, that is, earnings before interest, tax and depreciation allowances.