A company is typically financed (or capitalised) through debt and/or equity. Thin capitalisation refers to the situation in which a company is financed through a relatively high level of debt compared to equity levels. Thin capitalisation occurs where a business/ entity/ company has been funded to an extent where the debt is not in proportion to the equity of the business/entity/company, to the extent to that its debt far exceeds its equity with the result that such business/ entity/ company is referred to as a “thinly capitalised company”.
Usually debt generates deductible interest for tax purposes, which if excessive could erode a tax base of a country. Thin capitalisation provisions in a tax regime usually target schemes to prevent the abuse of interest deductions (for tax purposes) where a taxpayer gains a tax benefit by funding its business and/or company with debt as opposed to equity, with the result that any tax excessive interest may not be deducted, as well as any interest on amounts of debt that may be regarded as unnecessary and/or excessive.
What is equity?
Equity can include share capital, capital contributions, retained profits, interest-free loans or revaluation reserves.
The purpose of thin capitalisation provisions
Thin capitalisation provisions are in place as an anti-avoidance measure, as a means to ensure that a cross-border transaction is based on “arms-length” principle to avoid a profit shift that may occur, that would not have normally occurred had the parties transacted at arms-length (in layman's terms, to avoid deliberate and aggressive tax planning which results in a loss to the tax regime of a country). The result of such a profit shift is that the profits can be shifted to a low-tax jurisdiction, and/or an interest deductibility permitted in the other tax jurisdiction, with the result that the taxable income of such a party is reduced and less tax is collected and payable in the other tax jurisdiction.
Thin capitalisation in South Africa
Section 31 of the Income Tax Act 58 of 1962 (the “Act”) currently sets out provisions which are aimed at the prevention of the erosion of the tax base of South Africa through transactions which are not conducted at arms-length, which results in a tax benefit to one and/or both of the parties, with a resulting prejudice to the South African fiscus. Section 31 currently deals with transfer pricing, which is now worded to encompass thin capitalisation provisions, on the basis that if the parties would have transacted at arm’s length, then the interest charged would be an arm’s length amount.
History of thin capitalisation in South Africa
Section 31 was initially introduced into the Act on 19 July 1995 and Practice Note 2 was issued by the South African Revenue Services. Prior to 1 April 2012, the Commissioner of SARS had the discretion of whether to adjust the price and/or interest paid between connected parties in terms of the previous section 31(3) of the Act (now replaced). This is no longer the case and the onus is on the taxpayer to adjust the price and/or interest paid, where applicable. As a result, connected parties could previously charge excessive interest, with the risk that it would only be adjusted if queried by the Commissioner or in the event of an audit. Naturally, this led to a depletion in revenue collection due to the process of interest stripping, i.e. where a borrower would deduct from its taxable income excessive interest, and pay less tax.
In April 2012, section 31 of the Act incorporated transfer pricing provisions and thin capitalisation provisions into the same section, to mimic article 9 of the OECD Model Tax Convention treaty. This is, in the view of the writer, the correct step, as the failure to previously do so may have inadvertently created tax loopholes, as similar provisions to the OECD's will bring South Africa's treatment of transfer pricing and thin capitalisation in conformity to most other countries who are members of the OECD.
Thin capitalisation provisions in South Africa
In South Africa, where there is an “affected transaction” as defined in section 31 of the Act between connected persons, the price of goods or services between the connected persons, as well as the price/interest paid or charged must be adjusted by the taxpayer to reflect the arms-length position. Whether a transaction reflects an “arms-length” price is a factual enquiry and not one of law. An arm’s length transaction means a transaction where the parties are not closely connected (i.e. they are able to exercise their independence and make independent commercial decisions).
What is an “affected transaction”?
An affected transaction is defined in section 31 of the Act as“any transaction, 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; and
(b) any term or condition of that transaction, operation, scheme, agreement or understanding is different from any term or condition that would have existed had those persons been independent persons dealing at arm’s length.
It is necessary to note that in terms of section 31, a “connected person” means a connected person as defined in section 1, provided that the expression “and no holder of shares holds the majority voting rights in the company” in paragraph (d)(v) of that definition must be disregarded.
Accordingly, the definition of an affected transaction is quite wide, and could be any kind of an agreement or agreement between connected persons as defined in section 31(1).
In terms of section 31(2)(b), the taxable income/ tax payable of the taxpayer must be adjusted where, in respect of any affected transaction which is “different from any term or condition that would have existed had those persons been independent persons dealing at arm’s length, a tax benefitwhich is or will be enjoyed by a person who is a party to the affected transaction results. This is known as the primary adjustment.
Therefore, in order for the pricing and/or interest to be adjusted, then there must be an affected transaction between connected persons (i.e. not at arm’s length) and there must be a tax benefit as defined in section 1 of the Act. The questions to be asked are whether the factual terms and conditions of the agreement/ transaction differ from the terms and conditions that would have existed if the parties had not been connected persons, and if the terms do indeed differ from what would be considered arms-length, has it resulted in a tax benefit? If in the affirmative, then the interest charged would need to be adjusted.
Section 31 of the Act must be applied to any transaction, including interest charged on loans, between connected persons. It is important to bear this in mind when planning cross-border transactions, as failure to plan correctly may lead to additional tax assessments imposed by SARS, penalties and/or interest. If you need any assistance in this field, or cross-border structuring, we can assist.
Please note that this is a brief summary prepared by the writer, Natalie Macdonald-Spence, which may contain errors and/or omissions, and should not be regarded as legal advice.
SARS Draft Interpretation Note: Thin Capitalisation
Section 1 of the Act: Tax benefit includes any avoidance, postponement or reduction of any liability for tax.
Silke, South African Income Tax, page 627