As if the connected person definition wasn’t hard enough, it’s about to get worse…
SA’s new associated enterprise rules
Nowadays international tax and transfer pricing (“TP”) are largely synonymous terms, as the key tax focus is on what should be taxed where and why, i.e., how revenues are allocated between group entities. Which of course is the whole focus of the Pillar I of the Organisation for Economic Co-operation and Development (“OECD”) initiatives (see our previous newsletter – BEPS 2.0 Inclusive Framework announced).
All TP says is that cross-border (although sometimes also domestic) transactions must be on arm’s length terms. Simple enough in theory, yes. But what does arm’s length mean, and what are connected persons? Today we will focus on the latter question from the South African (“SA”) perspective. We often say that the connected person definition in Section 1 of the SA Income Tax Act is very simple to understand 99% of the time, but in complex situations, it can seem the trickiest section of the entire legislation. And now it’s getting worse…
In simple terms, for an individual a connected person is any individual related, by marriage or by blood, to the third degree of consanguinity, which includes parents, children, grandparents, great-grandparents, siblings, nephews, nieces, uncles and aunts, and any trust of which the person, or anyone connected to him, is a beneficiary.
In respect of companies, two companies will be connected when they are part of the same group of companies as defined in the SA Income Tax Act, except the shareholding requirement in the definition of a group of companies drops from 70% to 50%. So, the first step is to determine the appropriate definition of a “group of companies”, and then to apply the 50% exception to that definition to determine whether or not one complies with the first test of the “connected person” definition.
The second test for a company in relation to another company is that company will be a connected person if at least 20% of the equity shares in the company are held by that other company, and no shareholder holds the majority voting rights in the organisation. This seems straightforward to determine but, again, there are exceptions.
In terms of Section 31 of the SA Income Tax Act, for TP purposes, and transactions relating to intellectual property or financial assistance, the phrase “and no shareholder holds the majority voting rights in the company”, should be disregarded. This has the effect of lowering the threshold of a connected person for purposes of specified TP provisions.
These two tests apply in circumstances where there is a direct shareholding.
The tricky part comes in when we look at options other than direct shareholding. Two companies will be connected to each other if both are managed or controlled by the same person. Or, if two connected persons control separate companies, those two companies will be connected. In practice, this requires careful analysis.
The final twist in this complicated situation is that the connected person test must be applied in converse. Therefore, if company B is a connected person in respect of company A, company A will automatically be a connected person in relation to company B. Sounds simple and logical, but quite different and difficult to test in complicated corporate transactions.
Are you still with us? Well hold on to your hat, as with effect from 1 January 2022 “associated enterprises” will also fall within the scope of connected persons.
What is an associated enterprise?
The definition of “associated enterprises” in Section 31 of the SA Income Tax Act (“ITA”) refers back to the definition from the OECD Model Tax Convention (“MTC”). The MTC is the basis from which most of SA’s tax treaties are based and contains the OECD’s interpretation of the application thereof. Article 9 of the MTC defines an associated enterprise as follows:
a) an enterprise of a Contracting State participates directly or indirectly in the management, control, or capital of an enterprise of the other Contracting State,
b) the same persons participate directly or indirectly in the management, control or capital of an enterprise of a Contracting State and an enterprise of the other Contracting State.”
The commentary on the articles of the MTC, states the following:
“This Article deals with adjustments to profits that may be made for tax purposes where transactions have been entered into between associated enterprises (parent and subsidiary companies and companies under common control) on other than arm’s length terms”
The 2017 OECD TP Guidelines confirm that two entities will be associated if one of the enterprises meets the conditions of Article 9(1)(a) or 9(1)(b) of the OECD Model Tax Convention with respect to the other enterprise.
Under these conditions, two enterprises are associated if one of the enterprises participates directly or indirectly in the management, control, or capital of the other or if “the same persons participate directly or indirectly in the management, control, or capital” of both enterprises (i.e., if both enterprises are under common control).
How to apply the definition
This is a simultaneously broad, yet vague definition, which in addition to the connected party definition brings many entities into the TP net. Essentially though, the common control element is what is critical. There is further confusion arising in that the MTC commentary does not mention participation in capital, merely common control. Therefore, in the absence of any further commentary in any of the relied upon guidance, it is possible for tax authorities to argue that the breadth of cover is there in terms of an amount of capital being held to create an associated enterprise.
Perhaps you are asking yourself – if I hold shares in two companies in different countries – does that make both companies associated enterprises? Presumably, where there are minority holdings and, in particular, a dominant large shareholder, it would be assumed that the minority holder has minimal influence on the pricing, i.e., there would be less of a risk that the two companies would be associated enterprises. However, if that shareholder has influence over the majority shareholder in any way this may change that risk profile.
To summarise, from the beginning of 2022, SA TP regulations will apply equally to associated enterprises as to connected persons.
This means that you need to be aware of the tax consequences, and more specifically TP consequences of holding capital or controlling companies across a few jurisdictions. If you are concerned that this applies to your business, please contact us to assist.
How can we help?
How you structure your business is a critical question as you expand globally. The right structure will protect your assets, improve your currency position, support your business operations, facilitate future business expansion and changes, and optimise your overall tax rate. Trying to unscramble a sub-optimal structure entered into in haste or without full consideration of relevant facts is complex and expensive, so it’s important to plan upfront.
Structuring an international business is both a science and an art – this is our specialist area of expertise. Regan van Rooy is an international tax and structuring advisory firm focussing on Africa. We have offices in South Africa, Mauritius and Ireland and we can help you with any international tax or structuring query.