Author: AJ Jansen van Nieuwenhuizen (Grant Thornton)
Earlier this year, SARS released a draft Interpretation Note (IN) on how they would determine a taxpayer’s taxable income from certain international transactions. The draft IN provides taxpayers with guidance on how to apply the arm’s length principle when determining whether a taxpayer is thinly capitalised under section 31 of the Income Tax Act. If the taxpayer is thinly capitalised, the IN sets out how to calculate taxable income without claiming a deduction for the expenditure incurred on the excessive portion of finance.
What is thin capitalisation?
In essence, where a company has debt from a related party that is a tax resident outside South Africa, and such debt exceeds a certain ratio or level, such company is considered to be thinly capitalised. The effect of being thinly capitalised is that a revenue authority will contend that too much interest is being claimed as an income tax deduction.
Importantly, this draft IN also extends to the interest rate charged on debt arrangements between related parties, where one such party is a non-resident. SARS propose that the draft IN should be effective for years of assessment commencing on or after 1 April 2012, which means that it will be effective for all companies already. The draft IN withdraws Practice Note 2 which was issued in 1996, along with the 2002 addendum. The need for the new IN is driven primarily by the change to section 31 of the Act, which now determines the tax position of funding arrangements on an arm’s length basis, as opposed to the safe harbour debt to equity level of 3:1 set out by the soon-to-be-withdrawn practice note.
To what will the IN apply?
Both direct and indirect funding transactions will be affected. Indirect funding will include back-to-back funding arrangements, guarantees and the use of special purpose vehicles (SPVs). International Financial Reporting Standards (IFRS) rules will provide guidelines on what is defined as debt and what is defined as equity. Arrangements that are economically equivalent to debt (finance leases, structured derivative financial instruments and components of hybrid instruments) will also be included. Importantly, the scope of the IN will be expanded to include permanent establishments.
What will be considered arm’s-length?
In addition to the OECD guidelines on arm’s length principles, SARS have introduced some additional points for consideration. In essence, the arm’s length amount is the lesser of what could’ve been borrowed and what would’ve been borrowed. The IN proposes that one should look at both lender and borrower’s perspective – what would the lender have lent and what could the borrower have borrowed in the circumstances? The draft IN suggests that the position should be tested at least annually, but more regularly if required.
What happens practically?
A primary adjustment would see the disallowance of interest, finance charges and other considerations (all costs, including forex losses) on both the excessive portion of any funding as well as interest rates in excess of an arm’s length rate.
A secondary adjustment will see the establishment of a deemed loan to the non-resident related party, equal to the disallowed deduction. This is perhaps one of the most contentious proposals in the IN. Deemed interest income on loan will be included in the taxpayer’s taxable income and capitalised annually, and such deemed arrangement will continue until the deemed loan is repaid
Are you at risk?
SARS have indicated that they will follow a risk-based audit approach, specifically looking at the indicators listed below – importantly; these are NOT safe-harbours:
- A debt to EBITDA ratio greater than 3:1 will be seen as a greater risk (not to be confused with the outgoing safe harbour of debt to equity of 3:1)
- A loan from a non-resident related party to a related South African taxpayer (i.e. an inbound loan), which is denominated in Rands, and the weighted average interest rate is 2% higher than Johannesburg interbank rate. If the loan is denominated in a foreign currency, an interest rate 2% higher than the weighted average base rate in that country will have an increased risk.
What does this mean for you?
Although the IN is still in draft format, section 31 of the Income Tax Act has been with us for some time now. We would therefore recommend that before finalising any new funding arrangements as envisaged in the draft IN, you consider whether it would stand up to scrutiny from SARS’ proposed interpretation of the thin capitalisation laws. All existing funding arrangements should also be tested. On a final note, the IN also sets out what documentation should be retained to support a taxpayer’s “capitalisation position” – all that we can say is that the requirements are extensive and onerous.