Certainty in setting an acceptable level of debt
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.