Shall I compare thee to a summer’s day? Intra-group lending becoming ever less lovely and ever more of a minefield.

Following several changes in the South African (“SA”) tax legislation and in OECD guidance, the SA Revenue Service (“SARS”) has finally, just after Valentine’s day, issued a draft interpretation note on the tax around cross-border intra-group loans.  43 pages of poetry it is not, nor does it give much clarity on this complex area, but there are some interesting, and some concerning points, which we discuss below.

Why do we care?

How a business is financed impacts its taxable income, as interest is generally deductible while dividends are not.  Historically, this has created tax optimisation opportunities where intra-group financing was used to create a deduction in a high-tax environment and an income pick-up in a low tax environment.  However, the halcyon days of a double-dip and triple-dip financing structures are long gone, and this note makes it clear what a quagmire intra-group financing can be.

So what does this note say?

Amongst other gems, the interpretation note introduces the concept of “relevant persons” which it defines as “connected persons” or “associated enterprises” as specified in the definition of “affected transaction” in section 31 of the Income Tax Act. This definition was amended in the Act as from 1 January 2022.  This is a significant broadening of the transfer pricing base (see previous article https://reganvanrooy.com/2021/07/09/associated-enterprise/).

The note makes it clear that the pricing of intra-group loans includes consideration of both the quantum and the cost of debt as the arm’s length principle (“ALP”) will not be met if either one or both of these elements are found to be excessive. This means that we have to be able to demonstrate that a third party would lend both the amount of the loan and at the interest and terms provided.  This is important as often businesses focus purely on the interest rate.  If either the quantum or the cost is found to be excessive, a primary transfer pricing adjustment will be made, i.e. the relevant interest found to be excessive (whether the rate is too high or the full interest on a portion of the loan deemed to be excessive) will be added back to the taxpayer’s taxable income. From 2015, a secondary transfer pricing adjustment will also apply, this is essentially a penalty in the form of dividends or donations tax levied on the primary adjustment.

The interpretation note deals with the various scenarios in which indirect funding may be recharacterised and considered to be direct funding between the ultimate lender and ultimate borrower and disregarding all flowthrough transactions in-between. Most importantly, the insertion of an independent party into an indirect funding transaction can be recharacterised as being between relevant persons.

So what is arm’s length?

The interpretation note goes into painful detail on how to accurately delineate intra-group financing transactions and apply the arm’s length principle. In short, the following steps are required:

  • Determining whether the purported loan should be regarded as a loan or some other kind of payment – considering that debt comes in many forms such as straightforward loans, advances, and funding instruments that are economically equivalent to debt (to name a few).

  • Identifying the commercial or financial relations – analysing the factors that affect the performance of the industry that the multinational enterprise (“MNE”) operates in and understanding how a particular MNE responds to those identified industry factors.

  • Comparison of conditions and economically relevant circumstances of the tested transaction with comparable transactions between independent enterprises – considering what other options were realistically available to both the lender and the borrower other than entering into the financing transaction.

As part of the delineation, several economically relevant characteristics of actual intra-group loans must be analysed.

What else does the note say?

The interpretation note tries to clarify some other key issues relating to how transfer pricing or the arm’s length principle is applied in specific instances, including the following:

  • Permanent establishments (“PEs”) – the arm’s length principle would apply when attributing profits to a PE but SARS will not accept notional charges in calculating profits attributable to the PE. This means that the interest expense charged by a head office to a PE will not be deductible, but the interest charged by another party to the head office will be deductible by the head office.

  • Headquarter (“HQ”) companies (as defined in section 9I of the Act) – the arm’s length principle would not be applied to financing provided by an HQ company to a foreign company in which the HQ company directly or indirectly holds at least 10% of the equity shares or voting rights.

  • Ring-fencing of interest expenditure incurred on financial assistance granted by a non-resident to an HQ company – section 20C(2) states that the amount disallowed may be carried forward and deducted in the immediately succeeding YOA of the HQ company.

  • Interaction of sections 23M, 23N, and 31 – transfer pricing principles will apply prior to considering the impact of sections 23M and 23N.

  • Withholding tax (“WHT”) on interest – the application of the arm’s length principle does not alter the amount of interest actually paid or due and payable to the lender, therefore the WHT will still be calculated on that amount.

Essentially, no new concepts were introduced by the interpretation note, but rather SARS clarified its view on existing legislation. It is clear that SARS expects taxpayers to undertake a detailed functional analysis on intra-group financing transactions, much in the same way as is already done for other affected transactions. Furthermore, it is critical that loan benchmarking studies be performed to support both the quantum of debt and interest rates charged, hence complex additional credit rating analyses will be required to be included in the TP documentation.

What now?

Please reach out to us if you need any assistance in understanding how this may affect your business.

Associated enterprises

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.

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