SARS’ APPROACH TO PRICING INTRA – GROUP LOANS

The capital structure of a company consists of equity and debt which is used for the capital and operating costs of the company. The ratio of equity and debt is typically influenced by the investment and operational requirements of the company. However tax planning has bearing on capital structure considerations, as equity and debt enjoy different treatment under our tax laws. Interest payments that are made to service the debt of a company are usually deductible from the income of a company whereas benefits derived from capital appreciation are subject to taxes. Therefore, it is common for debt to be used as means of reducing the taxable income of a company.

Section 1(1) of the Income Tax Act (“the Act”) defines a group of companies as two or more companies in which one company directly or indirectly holds shares in at least one other company, to the extent that (a) at least 70 percent of the equity shares in each controlled group company are directly held by the controlling group company, one or more other controlled group companies or any combination thereof; and (b) the controlling group company directly holds at least 70 percent of the equity shares in at least one controlled group company. It is common for a group of companies to provide financing and/or financial assistance to one another in the form of intra-group loans. Intra-group loans are typically used as a tool to reduce the taxable income of companies whereby a foreign-based group company in a low-tax jurisdiction provides large amounts of debt to a resident group company.

This results in interest payments being made to the foreign group company to service the debt and the resident company deducting such interest payments from its taxable income resulting in the South African fiscus being robbed of potential taxes which could be used for the provision of goods and services to South African citizens (“transfer pricing”). SARS recently released an interpretation note on determining the taxable income of parties in the case of international intra-group loans. The note provides clarity on how SARS intends to determine arms-length pricing for the purpose of intra-group loans.

Section 31 of the Act sets out the provisions which deal with the transfer pricing rules. In terms of the Act, the transfer rules are applicable to any transaction, operation, scheme, agreement or understanding where (1) that transaction is an affected transaction as defined in the Act, and (2) results in a tax benefit being derived by a person that is a party to the affected transaction. Section 31(1) of the Act defines an affected transaction as “any transaction, operation, scheme, agreement or understanding which has been directly or indirectly entered into or effected between or for the benefit of either or both, inter alia, a resident or non-resident which are connected persons in respect to each other and where any of the terms or conditions of agreed upon are not of an arms-length nature”.

Parties to an affected transaction are required to calculate their taxable income as if that transaction had been entered into on terms and conditions that would have existed had those parties been independent persons dealing at arm’s length. The interpretation note provides that a taxpayer’s debt will usually be deemed to be non-arm’s length if the following circumstances exist:

• The taxpayer is carrying a greater quantity of debt than it could sustain on its own (that is, it is thinly capitalised).
• The duration of the lending is greater than would be the case at arm’s length.
• The repayment, interest rate or other terms are not what would have been entered into or agreed to at arm’s length.

When determining whether the pricing of an intra-group loan (amount and cost) is arm’s length, SARS will heed the application of and adherence to the arm’s length principle in the Organisation for Economic Co-operation and Development (OECD) Guidelines.

It is important to note that the transfer pricing rules set out in Section 31 require taxpayers to also apply the arm’s length principle to “financial assistance” provided by group companies in the same manner the principle is applied to affected transactions. Therefore, it is essential that groups that fall within the ambit of Section 31 of the Act ensure that they have an approved transfer policy and that their intra-group loans comply and are implemented in accordance with the arm’s length principle as set out in the Act and the interpretation note.

SARS’ interpretation notes are not law, but provide insight into the predominant practice of SARS and guidance on SARS’ views on the applications of tax provisions.