National Treasury and the South African Revenue Service (SARS) recently released the draft Taxation Laws Amendment Bill 2014 (Bill). One of the key proposals in the Bill is to change the secondary transfer pricing adjustment mechanism from a deemed loan to a deemed dividend.
Transfer pricing is a concern because, where for example a local party undercharges a foreign connected party for goods or services, or where the foreign connected party overcharges the local party, the parties to the transaction can effectively manipulate their income and taxable profits can be shifted from South Africa to other jurisdictions.
Section 31 of the Income Tax Act, No 58 of 1962 (Act) contains South Africa’s transfer pricing rules. Essentially, where connected persons enter into international transactions on terms that are not arm’s length, s31 of the Act allows SARS to disregard any such manipulations and tax the parties as if they were transacting on an arm’s length basis. This is referred to as the primary adjustment mechanism.
Section 31 of the Act also provides for a secondary adjustment mechanism. Where for example a local party has undercharged a connected foreign party, or the foreign party has overcharged the local party, the actual amounts paid are not affected despite the primary adjustment.
In order to get parties to actually pay arm’s length amounts, the difference in pricing is deemed to be a loan outstanding between the parties, on which arm’s length interest accrues, which interest is taxable.
In the explanatory memorandum to the Bill, SARS states that the deemed loan mechanism is problematic because in practice it is simply never repaid. The reason for this is that:
there are no contracts setting out the repayment terms because it is a deemed loan and not an actual loan; and
there may be exchange control restrictions that prevent the repayment of a deemed loan.
It is proposed in the Bill that the relevant amount not be deemed to be a loan, but rather a dividend in specie paid by the local party, on which dividends tax would in principle be payable. The effective date would be 1 January 2015.
At a recent workshop hosted by National Treasury and SARS on the Bill, stakeholders voiced various concerns in respect of this proposal. Some of the comments included that:
the Bill does not take into account the situation where the relationship between the parties is that of shareholder and subsidiary and the provision deems an amount to be a dividend paid by the shareholder to its subsidiary – in such circumstances the participation exemption in a relevant tax treaty might not be available;
the Bill does not take into account the situation where the local party is a natural person, which cannot as such pay a dividend;
the Bill does not say when the dividend is deemed to arise;
the Bill does not say to whom the dividend is deemed to be paid; and
it is not clear how current deemed loans will be affected and whether the Bill will have retrospective effect.
National Treasury and SARS initially appeared adamant to proceed with the proposed amendment in its current form, but eventually did take note of the concerns raised and indicated that further consultation will be held in respect of this matter.