Authors: Jens Brodbeck, Jo-Paula Roman, Megan McCormack and Scott Salusbury.
Transfer pricing is a self-assessment mechanism that aims
to ensure that taxpayers identify all potential cross-border
transactions, operations, schemes, agreements or understandings that
have been entered into between connected persons (referred to as potentially affected transactions), to ensure that all such potentially affected transactions have been concluded and implemented on an arms length basis.
Ideally,
where a taxpayer has been a participant to a potentially affected
transaction, the taxpayer would ensure upfront that the potentially
affected transaction has actually been concluded and implemented on an
arms length basis.
However, where the terms and conditions of
that potentially affected transaction differ from those that would have
existed at arms length, the taxpayer is required, in terms of section
31(2) of the Income Tax Act, 1962 (Income Tax Act),
to calculate its taxable income as if the terms and conditions of the
potentially affected transaction had been arms length. To the extent
that this results in a difference in taxable income, this amount is
typically referred to as the primary adjustment.
Furthermore,
in terms of section 31(3) of the Income Tax Act, if the taxpayer is a
company, and subject to certain exceptions, the amount of the primary
adjustment is deemed to be a distribution of a dividend in specie
declared and paid by the taxpayer. Where the taxpayer is a person other
than a company, the amount of the primary adjustment is deemed to be a
donation. This re-characterisation is referred to as the secondary adjustment.
Paragraph
4.8 of the Explanatory Memorandum to the Taxation Laws Amendment Bill,
2011, which introduced the secondary adjustment in its previous form (a
deemed loan between the parties bearing interest at a marked-related
rate), states the following, with reference to statements published by
the Organisation for Economic Co-operation and Development (OECD):
The
OECD refers to a secondary adjustment within the following context: To
make the actual allocation of profits consistent with the primary
transfer pricing adjustment, some countries having proposed a transfer
pricing adjustment will assert under their domestic legislation a
constructive transaction (a secondary transaction), whereby the excess
profits resulting from a primary adjustment are treated as having been
transferred in some other form and taxed accordingly. In view of the
above, the amount of the primary adjustment will be deemed to be a loan
by the South African taxpayer to the non-resident.
In our view, the general principle behind this re-characterisation may be summarised, on a high-level basis, as follows:
Were
it not for the extraordinary expenditure charged between the related
parties to the affected transaction, the payor would have had increased
profits, which it would likely have repatriated to the non-resident
related payee in the form of a dividend. The hidden profits that were
transferred under the non-arms length affected transaction should
accordingly be re-characterised as a dividend.
In respect of the
secondary adjustment in its current form, it has been noted that an
adjustment in the form of a deemed dividend is less burdensome to
administer than the previous deemed loan, from the perspective of both
the taxpayer and the South African Revenue Service (SARS)
(a more detailed discussion in this regard can be found at paragraph
5.2 of the Explanatory Memorandum to the Draft Taxation Laws Amendment
Bill, 2014).
In principle, the deemed dividend imposed under the
secondary adjustment should be treated, for tax purposes, as any other
distribution of an asset in specie paid by a resident company
to a non-resident person. This dividend would, accordingly, be subject
to South African dividends tax at a rate of 20%. On the same basis, the
taxpayer should, in principle, be able to avail of a reduced rate of
dividends tax in terms of any applicable agreement for the avoidance of
double taxation (DTA), provided that the requirements
for claiming such relief in terms of 64F(2) of the Income Tax Act are
met. This treatment accords with the principle behind the secondary
adjustment, as discussed above.
However, in the 2018 Draft Taxation Laws Amendment Act (Draft TLAB),
National Treasury has proposed an amendment to the definition of
dividend contained in section 1 of the Income Tax Act, to specifically
exclude, from the scope of the definition, any amount deemed to be a
dividend in specie under the secondary adjustment. This
proposed amendment would effectively prevent taxpayers from benefiting
from any relief that may otherwise have been available under domestic
law or any applicable DTA (where the circumstances are such that
domestic law or the relevant DTA affords relief) in respect of dividends
in specie. Where the recipient of the deemed dividend is a company, it
has been the approach of SARS to deny domestic law and/or treaty relief
that may have been available to the taxpayer under the provisions of
sections 64F/64FA of the Income Tax Act, for, inter alia, for reasons that:
- in order to rely on the relief, the beneficial owner would have had to submit to the company declaring the dividend, the required written declaration and undertaking;
- it is SARS view that there is no beneficial owner in relation to deemed dividend for purposes of section 31. For a more detailed discussion in this regard, please refer paragraph 4.3.3(c) of the SARS Comprehensive Guide to Dividends Tax (Issue 2), dated 12 October 2017.
It
is accordingly submitted that DTA relief would therefore in any event
generally only be available under limited circumstances, including where
the applicable DTAs definition of dividend includes within its
scope, deemed dividends (for example, the United Kingdom/South Africa
DTA). In this regard, the Draft Explanatory Memorandum on the Taxation
Laws Amendment Bill, 2018 (Draft 2018 Explanatory Memorandum),
suggests that the reason for the proposed amendment is to address the
anomaly that a secondary adjustment may, in certain circumstances, be
afforded treaty relief.
In the Draft Response Document on
Taxation Laws Amendment Bill, 2018 and the Tax Administration Laws
Amendment Bill, 2018, published by the National Treasury on 12 September
2018, based on hearings by the Standing Committee on Finance in
Parliament, National Treasury has noted comments from the public that
the policy concern of the proposed amendment is not understood, and
has stated that the draft explanatory memorandum will be revised to
provide clarity on the policy concern the proposed amendment seeks to
address and further expound how such concern will be addressed. The
effect of denying potential treaty relief to secondary adjustments
(which, as considered above, would in any event only be available where
the relevant DTAs definition of dividend is broad enough to include
secondary adjustments), appears punitive.
In our view, this is
not in line with the principle behind the secondary adjustment and it
has been submitted that it does not appear to take cognisance of the
already punitive measures imposed on taxpayers as a result of the
operation of various provisions contained in section 31 of the Income
Tax Act and the Tax Administration Act, 2011 (TAA), including, inter alia,
understatement penalties which may be imposed under the TAA at rates of
up to 200%. In our view, it is arguably inappropriate to regard the
deemed dividend in terms of a secondary adjustment as punitive on the
basis that:
- this penalty penalises taxpayers who, out of their own accord, on a self-assessment basis, correct their tax computations to ensure compliance with the Income Tax Act; and
- this blanket penalty is not aligned with the penalty regime codified under the TAA, which reflects the necessity of imposing penalties congruent with the blameworthiness of the relevant taxpayer (refer to Mr A & XYZ CC v CSARS).
We await the release of the TLAB in amended and final form to provide further commentary on the implications should the above proposed amendment be promulgated.
In the interim, it is clearly becoming more important that taxpayers analyse any potentially affected transactions they may be party to and to ensure upfront that such transactions have been concluded and implemented on an arms length basis before their annual financial statements are finalised.
Jo-Paula Roman is a candidate attorney in ENSafrica’s tax department.
Jens Brodbeck
tax | executive
jbrodbeck@ENSafrica.com
cell: +27 83 442 7401
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Megan McCormack
tax | senior associate
mmccormack@ENSafrica.com
cell: +27 82 382 8963
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Scott Salusbury
tax | associate
ssalusbury@ENSafrica.com
cell: +27 82 560 5441
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