Cer­tainty in set­ting an ac­cept­able level of debt

Business Day - Business Law and Tax Review - - BUSINESS LAW & TAX REVIEW - Peter Dachs & Bernard du Plessis

THE con­cept of base ero­sion and profit shift­ing has been much dis­cussed at var­i­ous in­ter­na­tional fo­rums, but in­creas­ingly also in SA. It was a hot topic at the G20 fi­nance min­is­ters and cen­tral bank gov­er­nors meet­ing in July 2013 in Moscow as well as the G20 heads of state meet­ing in Septem­ber 2013.

From a South African per­spec­tive, the Davis Tax Com­mit­tee has been set up, among oth­ers, in or­der to ad­dress the is­sue of base ero­sion and profit shift­ing in a South African con­text. The com­mit­tee re­leased its in­terim re­port in De­cem­ber. This re­port in­cludes an an­nex­ure deal­ing with debt/eq­uity is­sues.

In SA the gen­eral rule is that in­ter­est is de­ductible for tax pur­poses while div­i­dends are not. This ap­plies even in cir­cum­stances where the div­i­dends are in the form of in­ter­est­type pay­ments on re­deemable pref­er­ence shares, which them­selves es­sen­tially repli­cate debt.

The is­sue of debt ver­sus eq­uity and the tax de­ductibil­ity of in­ter­est ver­sus div­i­dends has con­sumed much of the leg­is­la­ture’s time in re­cent years. The con­cern is that high lev­els of debt, par­tic­u­larly in a cross-bor­der con­text, may lead to an ero­sion of the South African tax base.

Thin cap­i­tal­i­sa­tion refers to the sit­u­a­tion in which a com­pany is fi­nanced through a rel­a­tively high level of debt com­pared to eq­uity. Do­mes­tic rules typ­i­cally al­low a de­duc­tion for in­ter­est. The higher the level of debt in a com­pany and con­se­quently the greater amount of in­ter­est it pays, the lower will be its tax­able prof­its. In re­gards to fi­nance, debt can there­fore be seen as more tax ef­fi­cient than eq­uity.

The de­ductibil­ity of in­ter­est can give rise to dou­ble non-tax­a­tion in both in­bound and out­bound in­vest­ment sce­nar­ios.

With in­bound in­vest­ment, the con­cern is mostly with loans from a re­lated en­tity in a low-tax regime, cre­at­ing in­ter­est de­duc­tions for the bor­rower with­out a cor­re­spond­ing in­ter­est in­come in­clu­sion by the lender. The re­sult is that the in­ter­est pay­ments are de­ducted against the tax­able prof­its of the bor­rower while the in­ter­est in­come is taxed favourably or not at all.

For out­bound in­vest­ment, a com­pany may use debt to fi­nance the pro­duc­tion of ex­empt or de­ferred in­come, claim­ing a de­duc­tion for in­ter­est ex­pense while de­fer­ring or ex­empt­ing the re­lated in­come.

Do­mes­tic tax au­thor­i­ties of­ten in­tro­duce rules that place a limit on the amount of in­ter­est that can be de­ducted in cal­cu­lat­ing the mea­sure of a com­pany’s profit for tax pur­poses. From a pol­icy per­spec­tive, fail­ure to tackle ex­ces­sive in­ter­est pay­ments to as­so­ci­ated en­ter­prises gives multi­na­tional en­ter­prises an ad­van­tage over purely do­mes­tic busi­nesses that are un­able to gain such tax ad­van­tages.

SA in­tro­duced thin cap­i­tal­i­sa­tion rules in 1995. From 1 April 2012, thin cap­i­tal­i­sa­tion is gov­erned by the gen­eral trans­fer pric­ing pro­vi­sions of subsec­tion 31(2) of the In­come Tax Act. Tax­pay­ers must now de­ter­mine the ac­cept­able amount of debt on an arm’s length ba­sis.

There­fore, to the ex­tent that the ac­tual terms and con­di­tions of an af­fected trans­ac­tion dif­fer from those that would have been agreed if the lender and bor­rower had been trans­act­ing at arm’s length and this dif­fer­ence re­sults in a tax ben­e­fit, the in­ter­est, fi­nance charges and other con­sid­er­a­tion re­lat­ing to the ex­ces­sive por­tion of the debt will be dis­al­lowed as a de­duc­tion.

With the in­tro­duc­tion of the new trans­fer pric­ing rules, the is­sue of thin cap­i­tal­i­sa­tion has be­come part of the trans­fer pric­ing man­date. Thus, the old thin cap­i­tal­i­sa­tion rules have been deleted. With this dele­tion, the pre­vi­ous 3:1 debt-to-eq­uity ra­tio safe har­bour also no longer ap­plies.

In­stead, the new rules, which have been in­tro­duced with ef­fect from 1 April 2012, ap­ply­ing to all years of as­sess­ment start­ing on or af­ter that date, re­quire that the arm’s length prin­ci­ple be ap­plied to fi­nan­cial as­sis­tance in the same way as it is ap­plied to any other trans­ac­tion, op­er­a­tion, scheme agree­ment or un­der­stand­ing. Thus the tax­payer will have to de­ter­mine what amounts it would have been able to bor­row in the open mar­ket (that is, its lend­ing ca­pac­ity), on what over­all terms and con­di­tions, and at what price.

SARS has in­di­cated in its Draft In­ter­pre­ta­tion Note on sec­tion 31 of the In­come Tax Act that, in or­der to con­sider what is an ap­pro­pri­ate amount of debt for thin cap­i­tal­i­sa­tion pur­poses and in ap­ply­ing the arm’s length prin­ci­ple to fund­ing ar­range­ments, a tax­payer should con­sider the trans­ac­tion from both the lender’s per­spec­tive and the bor­rower’s per­spec­tive.

From the lender’s per­spec­tive, that is whether the amount bor­rowed could have been bor­rowed at arm’s length (ie, what a lender would have been pre­pared to lend and there­fore what a bor­rower could have bor­rowed) and from the bor­rower’s per­spec­tive, whether the amount would have been bor­rowed at arm’s length (ie, what a bor­rower act­ing in the best in­ter­ests of its busi­ness would have bor­rowed).

In analysing a fund­ing trans­ac­tion on this ba­sis, SARS pro­poses that a tax­payer per­form a func­tional anal­y­sis to sup­port the ap­pro­pri­ate­ness of their arm’s length debt as­sess­ment. In per­form­ing such an anal­y­sis of the trans­ac­tion, SARS has in­di­cated that the fol­low­ing types of fac­tors and or in­for­ma­tion could be rel­e­vant in sup­port of a tax­payer’s fund­ing ar­range­ments:

The fund­ing struc­ture which has been or is in the process of be­ing put in place, in­clud­ing the dates of trans­ac­tions, the source of the funds, rea­sons for ob­tain­ing the funds, the pur­pose of the fund­ing, the re­pay­ment and other terms and con­di­tions;

The busi­ness of the tax­payer, in­clud­ing de­tails of the in­dus­try in which it op­er­ates;

The fi­nan­cial and busi­ness strate­gies of the busi­ness;

De­tails of the prin­ci­pal cash flows and the sources for re­pay­ment of the debt;

The tax­payer’s cur­rent and pro­jected fi­nan­cial po­si­tion for an ap­pro­pri­ate pe­riod of time, in­clud­ing the as­sump­tions un­der­ly­ing the pro­jec­tions and cash flows;

Ap­pro­pri­ate fi­nan­cial ra­tios (cur­rent and pro­jected), for ex­am­ple: Debt: EBITDA ra­tio; In­ter­est cover ra­tio; Debt: eq­uity ra­tio; and Other in­di­ca­tors of the cred­it­wor­thi­ness of the tax­payer, in­clud­ing, if avail­able, any rat­ings by in­de­pen­dent rat­ings agen­cies.

SARS has fur­ther in­di­cated that it will con­sider trans­ac­tions in which the debt: EBITDA ra­tio of the South African tax­payer ex­ceeds 3:1 to be of greater risk when it comes to se­lect­ing cases for au­dit. This should, how­ever, not be con­strued as a safe har­bour and each case will be con­sid­ered on its in­di­vid­ual mer­its based on the fac­tors set out above.

When the much an­tic­i­pated trans­fer pric­ing prac­tice note is re­leased it will likely con­tain amend­ments to cer­tain ap­proaches set out in the Draft In­ter­pre­ta­tion Note. It is hoped that ad­vance pric­ing agree­ments as well as a safe har­bour in re­spect of thin cap­i­tal­i­sa­tion is­sues will as­sist to pro­vide cer­tainty on ac­cept­able lev­els of debt which may be pro­vided by a for­eign par­ent to its South African sub­sidiary.

Is­sue of debt ver­sus eq­uity and the tax de­ductibil­ity of in­ter­est ver­sus div­i­dends has con­sumed much of the leg­is­la­ture’s time

Peter Dachs and Bernard du Plessis are di­rec­tors and joint heads of ENSafrica’s tax depart­ment.

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