When intra-group loans cost an arm and a leg
Section 31 of the Income Tax Act empowers SARS to alter the tax consequences arising from cross-border financial assistance between connected persons. In a recently published SARS Interpretation Note, it is evident that the manipulation of cross-border pricing to generate undue tax benefits or to artificially allocate profits, may cost corporate taxpayers an arm and a leg.
A corporate taxpayer can finance its operations typically via equity and debt. Subject to certain conditions, corporate taxpayers are entitled to claim an income tax deduction for interest incurred in respect of debt, whereas no income tax deduction can be claimed for dividend distributions or returns of capital.
A corporate taxpayer that funds more of its operations with debt than equity, may be considered to be thinly capitalised for South African tax purposes.
Debt will be considered excessive if the amount and the cost of the debt do not reflect arm’s length principles. In other words, if the:
- Quantum of the debt is greater than the amount that the taxpayer can afford on its own.
- Duration of the lending period is greater than the period that would be granted by an independent financier.
- Repayment, interest rate or other terms are more favourable than what would have been granted by an independent financier.
Where a corporate taxpayer procures debt from a foreign connected party that is regarded as being excessive, it could result in the erosion of the South African tax base through interest deductions that are not considered to be at arm’s length. Without the thin capitalisation rules contained in section 31 of the Income Tax Act, a corporate taxpayer would be able to claim an income tax deduction for the full interest incurred in respect of the debt, whereas the foreign lender may benefit from interest exemptions and reduced withholding tax on interest.
Simply put, where a debt is excessive, section 31 of the Income Tax Act alters the tax consequences to what the tax consequences would have been if the debt reflected arm’s length principles.
Company A pays a foreign connected party interest in the amount R500 000. If Company A procured the same amount of debt on the same terms from an independent financial institution, Company A would have paid interest of only R300 0000. If it is assumed that the differential of R200 000 (R500 000 – R300 000) is regarded as excessive in terms of section 31 of the Income Tax Act, Company A will only be able to claim an income tax deduction of R300 000. Company A will, therefore, forfeit a deduction for the excessive interest of R200 000. This is referred to as a primary adjustment. In addition, this will also be regarded as a dividend in specie for South African tax purposes subject to dividends tax at 20%. This is referred to as a secondary adjustment
THE TAKE AWAY
A corporate taxpayer that procures debt from a foreign connected party, must be able to prove that the debt is not excessive. This can be achieved by ensuring that a proper transfer pricing policy is in place. Where a corporate taxpayer is unable to prove that the debt is not excessive, SARS is entitled to make primary and secondary transfer pricing adjustments.
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