The South African Revenue Service (SARS) is consulting on a draft interpretation note to provide taxpayers with guidance on the application of the arm’s length basis in the context of determining whether a taxpayer is thinly capitalized and, if so, calculating taxable income without claiming a deduction for the expenditure incurred on the excessive portion of finance.
The application of the arm’s length basis is said to be inherently of a detailed factual nature and takes into account a wide range of factors particular to the specific taxpayer concerned. SARS has provided what it considers to be indicators of risk within the note, acknowledging that the risk indicators may not constitute an arm’s length position for a particular taxpayer or industry.
It is indicated that thin capitalization typically becomes an issue in cases where a South African taxpayer is funded either directly or indirectly by non-resident connected persons. The funding of a South African taxpayer with excessive intra-group, back-to-back or intra-group-guaranteed debt may result in excessive interest deductions from taxpayer’s income, thereby depleting the South African tax base.
South Africa introduced thin capitalization rules in 1995. Under these rules, the Commissioner was empowered to have regard to the international financial assistance rendered and, if it was considered excessive in proportion to the particular lender’s fixed capital in the borrower, the interest and finance charges relating to the excessive financial assistance could be disallowed.
However, for years of assessment commencing on or after April 1, 2012, thin capitalization is now governed by the tax code’s general transfer pricing provisions. One of the most significant changes is that taxpayers must determine the acceptable amount of debt on an arm’s length basis.
Accordingly, if the actual terms and conditions of an affected transaction involving loans and other debt are not those that would have been agreed if the lender and borrower had been transacting at arm’s length, and if this difference results in a tax benefit to any of the parties, then that taxpayer is required to calculate its taxable income based on the arm’s length terms and conditions that should have applied to the affected transaction.
This means that the interest, finance charges and other consideration relating to the excessive portion of the debt are disallowed as a deduction in computing the taxpayer’s taxable income.
In applying the arm’s length basis, SARS requires taxpayers to consider the transaction from both the lender’s perspective and the borrower’s perspective. That is, whether the amount borrowed could have been borrowed at arm’s length (what a lender would have been prepared to lend and therefore what a borrower could have borrowed), and whether the amount would have been borrowed at arm’s length (what a borrower acting in the best interests of its business would have borrowed).
For example, taking all the relevant facts and circumstances into account, the arm’s length amount of debt may be nil in circumstances where a taxpayer with a very healthy balance sheet, excess cash reserves and spare borrowing capacity borrowed from an offshore parent company, when all the relevant facts indicate that there was no business need or reason, or commercial benefit, for the additional finance.
The terms and conditions of an affected transaction may be tax motivated, however this is not a requirement. A taxable income adjustment may be required irrespective of whether or not the choice of funding was tax motivated.
It is confirmed that SARS will consider a taxpayer to be thinly capitalized if, amongst other factors, the taxpayer is carrying a greater quantity of interest-bearing debt than it could sustain on its own; the duration of the lending is greater than would be the case at arm’s length; or the repayment or other terms are not what would have been entered into or agreed to at arm’s length.
SARS adopts a risk-based audit approach in selecting potential thin capitalization cases for audit. In selecting cases, SARS will consider transactions in which the Debt: EBITDA ratio of the South African taxpayer exceeds 3:1 to be of greater risk.
The ratio is, however, not a safe harbor and does not preclude SARS from auditing a taxpayer who is within the range of the abovementioned ratio. The ratio is merely indicative of the level of risk set by SARS for the purpose of selecting cases for audit. It is accepted that the ratio may vary in different industries and according to the creditworthiness of the particular taxpayer.
Taxpayers are required to file a return which has been prepared on an arm’s length basis. Accordingly, taxpayers must be able to demonstrate that debt which meets the definition of an affected transaction is at arm’s length, or that a tax deduction has not been claimed for the expenditure incurred on the portion of the debt that is not arm’s length.
SARS will welcome comments and suggestions of areas for further guidance (including views on what that guidance may be). Comments should be submitted by June 30, 2013.