Since the withdrawal of Practice Note 2 (“PN 2”), confusion has reigned as to the manner in which the SARS would apply the newly amended transfer pricing provisions in section 31 of the Income Tax Act, 58 of 1962 (the “ITA”) to intra-group loans. The only indication of the SARS view on this subject was a draft interpretation note which remained in such form since 2013.
On 17 January 2023 the SARS finally published Interpretation Note 127 headed Determination of the Taxable Income of Certain Persons from International Transactions: Intra-Group Loans (“IN 127”), providing official guidance as the manner in which the SARS will apply the provisions of section 31 in respect of transfer pricing and thin capitalization.IN 127 provides guidance on the application of the arm’s length principle in the context of the pricing of intra group loans and covers several aspects of section 31 including the scope of its application, transactions which qualify as affected transactions, who qualifies as connected persons and associated enterprises as well as the factors which the SARS will consider to determine whether the arm’s length principle has been complied with.
Some noteworthy points raised in IN 127 are set out below.
No more safe harbours
Unlike PN 2 and previous drafts of the interpretation note, no more “safe harbours” are provided.
Direct and Indirect Funding
The wording of section 31 is wide and applies to ‘transactions, operations, schemes, agreements and understandings that have been directly or indirectly entered into or effected between or for the benefit of either or both of the parties specified in the definition. The section is therefore far wider than a loan between two of the parties specified in paragraph (a) of the definition of an “affected transaction” and takes into account the chain of borrowing entities including the ultimate borrower’.
Indirect financial assistance is then included, which would include guarantees provided by a party to support a borrower’s credit. A lender would need to evaluate a guarantor in a similar way as the borrower to ensure the terms of the transaction is arm’s length.
Determining the commercial and financial relations
The SARS takes a very broad view of the manner in which the actual transaction is to be delineated and states in respect of determining the contractual terms:
[h]owever, between relevant parties the contractual arrangements may not always provide information in sufficient detail or may be inconsistent with the actual conduct of the parties or other facts and circumstances. It is therefore necessary to look to other documents, the actual conduct of the parties – notwithstanding that such consideration may ultimately result in the conclusion that the contractual form and actual conduct are in alignment – and the economic principles that generally govern relationships between independent enterprises in comparable circumstances
Considering both sides of a transaction
In applying the arm’s length principal the SARS requires taxpayers to consider a transaction from the perspective of the borrower and the lender. Accordingly an arm’s length amount of debt for a borrower with a healthy balance sheet and excess cash reserves may be nil and such a loan will fall within section 31 if the borrower cannot show a business need or reason or commercial benefit for obtaining the relevant loan.
Loan fees and charges
If loan fees and charges are seen in a loan between relevant parties, such fees will also be subject to an arm’s length analysis.
A bankability opinion will not suffice on its own to demonstrate an arm’s length amount of debt or interest as it is the view of SARS that such an opinion does not represent an actual offer to lend.
In order to determine whether a term loan will fall within the provisions of section 31 an analysis must not only be done prior to implementation but also during the term of the loan to reassess the appropriateness of the level and cost of the debt. The interval of such reassessment will depend on the facts and circumstances of the loan. Practically, annual assessments may be sufficient.
Deemed dividend or donation
In terms of section 31(1), the difference between the arm’s length amount that is taken into account in calculating taxable income or the amount that would have been taken into account, but for section 31(2), is subject to the secondary adjustment and constitutes a deemed dividend in specie or a deemed donation.
As there is no beneficial owner of such dividend any exemption from dividends tax or treaty relief will not be applicable.
Public notice 1334 issued by the SARS provides specific requirements as to the records to be kept for transfer pricing purposes.
Advanced Pricing agreement
Although an advanced pricing agreement process is not yet in place, the SARS is considering such a process for the future.
In conclusion, although the publication of IN 127 is a positive development and provides helpful guidance to taxpayers, it must be remembered that an interpretation note is not binding on a court and its provisions are merely the SARS’s view of the correct interpretation of section 31 of the ITA.