Home Articles ANALYSIS: In the interest of arm’s length financial assistance

ANALYSIS: In the interest of arm’s length financial assistance

While Doris Lessing, British novelist, poet and playwright, had the luxury of believing that “borrowing is not much better than begging and lending with interest is not much better than stealing”, South African taxpayers in multinational groups have to contend with the reality of intra-group financial assistance.

Since 2011, there have been some significant developments in section 31, South Africa’s transfer pricing legislation. Many of these developments affect the cross-border provision of financial assistance between connected persons. The purpose of this article is to summarise the currently applicable transfer pricing legislation governing cross border finance, looking specifically at:

  • Thin capitalisation
  • Financial assistance provided by South Africa resident companies to controlled foreign companies
  • Equity loans, and
  • Deemed loans

Thin capitalisation

The first significant change was the deletion of the thin capitalisation provisions previously contained in section 31(3), applicable in respect of years of assessment commencing on or after 1 April 2012. The deletion of our thin capitalisation legislation by Act 24 of 2011 does not mean that South African companies forming part of a multi-national group no longer have to ensure that the financial assistance they receive from non-resident shareholders is not excessive. Thin capitalisation is now dealt with under the general provisions of transfer pricing legislation.

The deletion of section 31(3) also meant that practice note 2, which SARS issued to assist taxpayers in complying with the thin capitalisation legislation, ceased to be applicable. In its place, SARS is planning to issue an interpretation note. The interpretation note, despite applying to years of assessment commencing on or after 1 April 2012, is still in draft format.  The draft interpretation note explains how thin capitalisation now falls within the general transfer pricing legislation as follows:

… if the actual terms and conditions of an affected transaction1  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.

While practice note 2 provided safe harbours for both excessive financial assistance and arm’s length interest rates, the draft interpretation note emphasises that a Debt:EBITDA ratio not exceeding 3:1 is not a safe harbour, but a factor to be taken into account by SARS in applying its risk-based audit approach to selecting potential thin capitalisation cases for audit.

The same applies to the interest rates that were previously safe harbours in terms of practice note 2, that is the weighted average of the South African Johannesburg Interbank Agreed Rate plus 2 per cent for rand denominated debt and the weighted average of the base rate of the country of denomination plus 2 per cent for foreign currency denominated debt.

Thus, instead of relying on safe harbours, taxpayers now have to determine appropriate levels of debt by considering the transaction from both the lender’s perspective and the borrower’s perspective. From the lender’s perspective, consideration should be given as to whether the amount borrowed could have been borrowed from an independent entity and from the borrower’s perspective, whether a borrower acting in the best interests of its business would have borrowed the amount.

This places a significant burden on taxpayers. Assessing the loan from an independent lender’s perspective will in essence require more or less the same vetting process as a bank. This generally includes a consideration of quantitative criteria (like diversification, leverage, asset efficiency, debt coverage, earnings coverage and liquidity) and qualitative criteria such as industry stability and outlook, the quality of management, the company’s competitive position, and potential business risks being faced by the company.

But a detailed evaluation of these factors does not appear to be sufficient to support any conclusion reached by the taxpayer. The draft interpretation note warns that “[t]he use of comparable data is important in the context of an arm’s length debt assessment because when considered in conjunction with all the relevant facts and circumstances it should support the position the taxpayer has reached”.

Taxpayers will therefore have to obtain comparable date to support their contention that the level of debt, the interest rate and other conditions agreed upon comply with the arm’s length principle. The draft note suggests financial ratios for comparable taxpayers using third party provided commercial databases or potentially a competitor’s position (if truly comparable).

Compliant South African taxpayers know how difficult, and costly, it is to get access to “truly comparable” information. It seems that SARS has also realised this as the draft interpretation note mentions that SARS is currently “investigating the availability and appropriateness of a third party-provided South African-focussed database” and that “the databases being considered are used in conjunction with credit risk models from a quantitative perspective and scorecard models from a qualitative perspective”.

Access to such a database is likely to be costly, maybe even prohibitively so, especially in a situation where only one or two loans are to be evaluated. It would be most helpful if SARS could make this database available free of charge to South African taxpayers striving to comply with the legislation.

Financial assistance provided by South Africa resident companies to controlled foreign companies2 (CFCs) operating in high taxed jurisdictions

For years of assessment commencing on or after 1 January 2013, section 31(6) provides at least some relief in relation to financial assistance provided to CFCs. In short, the whole of section 31 will not apply in relation to financial assistance provided by a resident to a CFC if:

  • That resident (whether alone or together with any other company forming part of the same group of companies as that resident) owns at least 10 per cent of the equity shares and voting rights in that controlled foreign company
  • That controlled foreign company has a foreign business establishment3 as defined in section 9D (1), and
  • The aggregate amount of tax payable to all spheres of government of any country other than the Republic by that controlled foreign company in respect of any foreign tax year of that controlled foreign company during which that transaction, operation, scheme, agreement or understanding exists is at least 75 per cent of the amount of normal tax that would have been payable in respect of any taxable income of that controlled foreign company had that controlled foreign company been a resident for that foreign tax year.

The aggregate amount of tax so payable by the CFC must be determined after taking into account any applicable agreement for the prevention of double taxation and any credit, rebate or other right of recovery of tax from any sphere of government of any country other than the Republic; and after disregarding any loss in respect of a year other than that foreign tax year or from a company other than that CFC.

At first glance, this seems like significant relief. However, before the exemption can be applied, a complete South African tax computation will have to be done in relation to each CFC receiving financial assistance and the tax so determined has to be compared to the tax payable by the CFC to governments other than that of the RSA.

Apart from the normal complications (such as obtaining sufficient information to perform the South African tax computation, sometimes having to translate the information into English, etc) it is generally only possible to do the South African tax computation and to compare it with the local tax computation, after year end. It may thus happen that a taxpayer assumes that the high tax rule is met, especially if the CFC is subject to a rate in excess of 21 per cent in its country of residence, only to find out after the South African tax computation is completed that the 75 per cent rule is not met owing to unique deductions or allowances or incentives operating in the CFC’s country of residence. This will require the South African taxpayer to make a transfer pricing adjustment in the tax return, which is not always ideal.

In addition, even if the 75 per cent rule is met, the country in which the CFC is resident in all likelihood has transfer pricing legislation and the arm’s length principle will therefore have to be complied with in any event.

Equity loans

After many queries, discussions and disagreements around equity loans, the existence of such loans in groups of companies have finally been recognised by the proposed addition of subsection (7) to section 31 by the draft 2013 Taxation Laws Amendment Bill. In terms of the proposal, which will be effective for years of assessment commencing on or after 1 April 2014 if promulgated, section 31 will not apply where:

  • A resident company grants financial assistance to any foreign company in which that resident company directly or indirectly holds at least 10 per cent of the equity shares and voting rights
  • The foreign company is not obliged to redeem that debt in full within 30 years from the date the debt is granted, and
  • The redemption of the debt in full by

the foreign company:

i              Requires approval from all other persons to which that foreign company owes a debt, or

ii             Is conditional upon the market value of the assets of the foreign company not being less than the liabilities of the foreign company.

The Explanatory Memorandum to the 2013 Draft Taxations Laws Amendment Bill accepts that “this form of ‘capital’ financing is normally undertaken for a variety of reasons unrelated to tax” and explains that “without relief, potential transfer pricing concerns leave the South African shareholder in a compromised tax position vis-à-vis that shareholder’s multinational counterparts”.

This addition to section 31, if promulgated, will come as welcome relief to taxpayers who provided equity loans as funding to foreign entities for a variety of reasons, including exchange and regulatory controls in both South Africa and the country of residence of the borrower. It is advisable to review the loan agreements and disclosure on the financial statements to ensure that the statutory requirements are met.

Deemed loans

Act 24 of 2011 controversially included the concept of a secondary tax adjustment into South Africa’s transfer pricing regime. A secondary adjustment automatically arises from a primary transfer pricing adjustment: if there is a difference between the taxable income arrived at based on arm’s length principles and the actual taxable income, the difference is deemed to be a loan that constitutes an affected transaction.

In terms of the draft interpretation note, “the taxpayer will have to calculate and account for interest income at an arm’s length rate on the deemed loan. The accrued interest on the deemed loan will be capitalised annually for the purposes of calculating the deemed loan outstanding.”

Despite being a deemed loan, the loan will have to carry interest, that is, the South Africa taxpayer will have to include notional interest in its taxable income until it is regarded as having been repaid. According to the draft interpretation note, the loan will be regarded as having been repaid if, for example, the taxpayer is refunded the excessive interest or the other party pays the interest raised on the deemed loan.

The secondary adjustment may in certain circumstances cause practical problems. For example, if the other party to the transaction resides in a country with exchange controls (like Mozambique), approval will have to be obtained before the Mozambican company can pay the deemed loan and interest. It is doubtful whether exchange control approval will be granted in these circumstances. Secondary adjustments may also result in double taxation. It is possible that the tax laws of the other party involved in the transaction that gave rise to the secondary adjustment will not allow a deduction of the notional interest on the constructive loan.

Because of the practical problems around secondary adjustments, many countries have decided against making these adjustments part of their transfer pricing regimes. The only option left to South African taxpayers is therefore to comply with section 31 as far as possible. Since transfer pricing is not an exact science, this is often easier said than done.


As in all transfer pricing issues, the taxpayer is advised to use his best endeavours to arrive at an appropriate level of debt and an arm’s length interest rate taking into account all relevant factors, unless the transaction is specifically excluded from the scope of section 31. It is vitally important to document the facts, the factors considered, the comparables used and the conclusions reached.

While safe harbours no longer exist, it will be wise to test the level of debt against SARS’ 3:1 Debt:EBITDA ratio and the interest expense against the interest rates provided in SARS’ draft, hopefully soon to be final, interpretation note.


1 “Affected transaction” means any transaction, operation, scheme,  agreement or understanding where –

(a) that transaction, operation, scheme, agreement or understanding has been directly or indirectly entered into or effected between or for the benefit of either or both (i) (aa) a person that is a resident; and

(bb) any other person that is not a resident;

(ii) (aa) a person that is not a resident; and

(bb) any other person that is not a resident that has a permanent establishment in the Republic to which the transaction, operation, scheme, agreement or understanding relates;

(iii) (aa) a person that is a resident; and

(bb) any other person that is a resident that has a permanent establishment outside the Republic to which the transaction, operation, scheme, agreement or understanding relates; or

(iv) (aa) a person that is not a resident; and

(bb) any other person that is a controlled foreign company in relation to any resident, and those persons are connected persons in relation to one another.

2  Subject to certain provisions, a “controlled foreign company” means any foreign company where more than 50 per cent of the total participation rights in that foreign company are directly or indirectly held, or more than 50 per cent of the voting rights in that foreign company are directly or indirectly exercisable, by one or more persons that are residents other than persons that are headquarter companies.

3  In short, a foreign business establishment (FBE), in relation to a controlled foreign company, means a fixed place of business located in a country other than the Republic that is used or will continue to be used for the carrying on of the business of that controlled foreign company for a period of not less than one year, where that business is conducted through one or more offices, shops, factories, warehouses or other structures; that fixed place of business is suitably staffed with on-site managerial and operational employees of that controlled foreign company who conduct the primary operations of that business; is suitably equipped for conducting the primary operations of that business; has suitable facilities for conducting the primary operations of that business; and is located outside the Republic solely or mainly for a purpose other than the postponement or reduction of any tax imposed by any sphere of government in the Republic. ❐

Author: Cicelia Potgieter is Head of Tax: Barloworld South Africa (Pty) Limited – Corporate Division

This article is published on behalf of the Tax Suite