Thin capitalisation and transfer pricing

Transactions across international borders are complex. Adding the tax effects of such transactions into the mix can turn them into a mine field. The domestic tax laws of each of the contracting states have to be considered, as well as the implications of a double tax agreement between the two states, if applicable.

With the increased interest from foreign companies to establish businesses in South Africa, the rules pertaining to transfer pricing and thin capitalisation are now more pertinent than ever.

A transfer price, as contemplated by the Income Tax Act, is merely the price at which goods or services are exchanged between connected persons. When one of these connected persons is a South African tax resident and the other a non-resident, the price at which the goods or services are exchanged becomes an area of scrutiny for the South African Revenue Services (SARS).

SARS is especially interested in prices which are not at an arm’s length, and where this deviation from an arm’s length price creates and undue tax advantage for either one of the parties. Section 31 of the Income Tax Act provides that the revenue authorities in both contracting states must calculate the taxable income of the taxpayer in its jurisdiction as if the prices were determined on the basis of an arm’s length.

Adding insult to injury, the amount of adjustment in prices will be deemed a dividend and will be subject to dividends tax (according to section 64C of the Income Tax Act).

To avoid this kind of outcome, sufficient time needs to be spent in determining transfer prices. It may also be necessary to consult SARS Practice Notes in this regard.

Thin capitalisation

Foreign shareholders of South African companies often provide financial assistance to their South African subsidiaries. The nature of the financial assistance needs to be considered carefully, as an incorrect treatment thereof might lead to nasty surprises.

Section 31 of the Income Tax Act has the effect that, in cases where a foreign shareholder provides financial assistance to a South African subsidiary and the financial assistance is considered “excessive” in relation to the equity contributed by that shareholder, the interest deductible by the South African company on such loan is limited to an arm’s length amount. Section 64 C will again have the effect of deeming the excessive amount of interest a dividend, causing dividends tax to become payable.

The Act does not define “excessive”. However, according to SARS Practice Notes a ratio of 3:1 (loans to equity) is acceptable. Where the ratio exceeds 3:1, the provisions of section 31 will be applicable.

Foreign companies who consider establishing a presence in South Africa, have to be aware of a number of potential pitfalls. These can be avoided by careful and timeous planning.

For more information, contact Jaco Odendaal of Exceed Tax & Management Services on tel. 021 882 8140 or e-mail jaco@exceed.co.za