By Prof Peter Surtees (Special Tax Consultant) and Suné Millard (Associate)


South Africa's return to the international community in 1994 has seen an increase in the number of foreign investors investing in South African companies. Such inward investment requires a balance between equity on the one hand and debt on the other. An important consideration in this balancing act is that the interest earned by a non-resident lender who does not carry on a business in South Africa is exempt from tax in South Africa in terms of section 10(hA) of the Income Tax Act, 1962 ("the Act") but would be deductible by the borrower if it was incurred in the production of income. Therefore, it might suit an investor to maximise debt rather than equity, especially as dividends paid would not be deductible from income, and to impose as high an interest rate as possible. However, two factors operate to limit the benefits a foreign investor may obtain in this way. These factors require that, in making these loans, consideration be given to:

  • the rate of interest that can be charged by a foreign lender (see transfer pricing below); and
  • the South African company's debt to equity ratio (see thin capitalisation below).

Transfer pricing

In South Africa, intra group financial assistance, (comprising loans by a foreign lender to a South African company where the lender has an interest of not less than 25% or loans by a foreign lender to a connected person in South Africa) falls within the ambit of section 31 of the Act. This section governs both transfer pricing and thin capitalisation. The South African Revenue Service ("SARS") has issued two practice notes in respect of section 31, Practice Note 2 which was issued on 14 May 1996 and later amended by an addendum on 17 May 2002, and Practice Note 7 which was issued on 6 August 1999. Whilst Practice Note 2 is of more general application, Practice Note 7 makes provision for guidelines setting out the procedures to be followed in determining arm's length prices within the South African business environment. It also sets out the Commissioner's views on documentation and other practical issues relevant to the analysis of international agreements.

Transfer pricing is aimed at eliminating tax benefits from transactions where artificial prices are placed on goods or services between connected persons as a means of effectively transferring income, or expenditure, from one jurisdiction to another for the purpose of obtaining tax benefits. Thin capitalisation on the other hand, limits the deductibility of interest where there is a disproportionate ratio between loan capital and equity employed in a company.

For purposes of transfer pricing, section 31(2) of the Act provides, to the extent here relevant:

"(2) Where any goods or services are supplied or acquired in terms of an international agreement and--

(a) the acquiror is a connected person in relation to the supplier; and

(b) the goods or services are supplied or acquired at a price which is either--

(i) less than the price which such goods or services might have been expected to fetch if the parties to the transaction had been independent persons dealing at arm's length (such price being the arm's length price); or

(ii) greater than the arm's length price,

then, for the purposes of this Act in relation to either the acquiror or supplier, the Commissioner may, in the determination of the taxable income of either the acquiror or supplier, adjust the consideration in respect of the transaction to reflect an arm's length price for the goods or services." (emphasis added)

Section 31(1) defines an international agreement as a transaction between a resident and a non-resident, and includes inter alia the granting of financial assistance, including a loan, advance or debt, and the provision of any security or guarantee.

A "connected person" is defined in section 1 of the Act, to the extent here relevant, as:

"(d) in relation to a company-

(i) its holding company ….;

(ii) its subsidiary so defined;

(iii) any other company where both such companies are subsidiaries of the same holding company;

iv) any person other than company as defined in section 1 of the Companies Act, 1973 (Act No 61 of 1973), who individually or jointly with any connected person in relation to himself, holds, directly or indirectly, at least 20 per cent of the company's equity share capital, or voting rights"

Accordingly, where a loan is provided by a non-resident to a resident and the parties are connected persons, and the interest paid by the resident to the non-resident is not at arm's length, the interest, to the extent that it exceeds an arm's length rate, will be regarded as being excessive. Paragraph 2.2 of Practice Note 2 indicates that SARS will then, in the determination of the taxable income of the resident, adjust the deductible portion of interest in the hands of the resident in relation to the financial assistance granted.

Practice Note 2 goes further to provide that for purposes of transfer pricing, where a loan is denominated in Rand, a rate of interest not exceeding the weighted average of the South African prime rate plus 2 percentage points will be acceptable. Where the loan is denominated in foreign currency, a rate of interest not exceeding the weighted average of the relevant inter bank rate plus 2 percentage points will be an acceptable nominal annual interest rate. In the event that the interest rate changes during the year, a weighted average of the rates will be used.

Therefore, interest that exceeds the weighted average of the relevant rate plus 2 percent may be regarded by SARS as being excessive. Should this happen, section 64C(2)(e) of the Act (that dealing with deemed dividends) provides, to the extent here relevant, that:

"that amount represents additional taxable income or reduced assessed loss of that company by virtue of any transaction with the shareholder or connected person in relation to such a shareholder, the consideration of which is adjusted in accordance with the provisions of section 31;"

The effect of applying section 64C(2)(e) is that where the non resident shareholder benefits by means of transfer pricing (by receiving an excessive rate of interest), the amount which is deemed to be excessive will be treated as a dividend and be subject to the secondary tax on companies ("STC") of 12½% of the deemed dividend.

Furthermore, the local borrower will be precluded from claiming a deduction for tax purposes of the excessive interest, because it is treated as a dividend.

Thin capitalisation

Thin capitalisation is a term used to refer to loans, made to local companies by foreign investors, which are disproportionately large in relation to the company's equity. That is, a company will be thinly capitalised when its equity component is disproportionately low in comparison with its overall capitalisation. The temptation to capitalise a company primarily with debt financing stems from the fact that interest is generally tax deductible by the debtor and exempt from tax in South Africa in the hands of a non-resident lender. Dividends on the other hand are not tax deductible.

Section 31(3) of the Act deals with the issue of thin capitalisation and disallowable interest, and provides to the extent here relevant that:

"(3) (a) Where any person who is not a resident (hereinafter referred to as the investor) has granted financial assistance contemplated in paragraph (c) of the definition of "services" in subsection (1), whether directly or indirectly, to---

(i) any connected person in relation to the investor who is a resident; or

(ii) any other person (in whom he has a direct or indirect interest) other than a natural person, which is a resident…and, by virtue of such interest, is entitled to participate in not less than 25 per cent of the dividends, profits or capital…or is entitled, directly or indirectly, to exercise not less than 25 per cent of the votes of the recipient;

and the Commissioner is, having regard to the circumstances of the case, of the opinion that the value of the aggregate of all such financial assistance is excessive in relation to the fixed capital (being share capital, share premium, accumulated profits, whether of a capital nature or not, or any other permanent owners' capital, other than permanent capital in the form of financial assistance as so contemplated) of such connected person or recipient, any interest, finance charge or other consideration payable for or in relation to or in respect of the financial assistance shall, to the extent to which it relates to the amount which is excessive as contemplated in this paragraph, be disallowed as a deduction for the purposes of this Act." (emphasis added)

Practice Note 2 of the Act also provides guidance as to the application of the thin capitalisation principles and determines that a 'safe haven' ratio in South Africa is 3:1. Therefore, provided the debt portion is not more than 75% of the total financing, it is acceptable to the Commissioner.

According to Practice Note 2, excessive interest in terms of the thin capitalisation rule is determined by using the following formula:

A =

B X (C – D)



A =

the disallowable interest

B =

the total interest incurred during the year in respect of all financial assistance existing during the year.

C =

the weighted average of all interest-bearing financial assistance granted prior to 19 July 1995 which existed during the year.

D =

represents the greater of –

  • three times the fixed capital of the resident or recipient as at the end of the relevant year of assessment; and
  • the weighted average of all interest-bearing financial assistance granted prior to 19 July 1995, which existed during such year.

When section 31(3) is found to be applicable, any interest and/or finance charge payable for the foreign loan, to the extent that it relates to an amount that is found to be excessive, will be disallowed as a deduction. According to the Commissioner's practice, the adjustment arising out of applying the thin capitalisation provision is called 'disallowable' interest, and the adjustment arising out of applying the transfer pricing provision is called 'excessive' interest.

Accordingly, if it is found that a South African borrower ("SA Co") is 'thinly' capitalised then, to the extent that it has been so 'thinly' capitalised, SA Co will be disallowed a deduction for the pro rata portion of the interest which is excessive.

The need for a transfer pricing policy document

Despite having introduced section 31 as well as the two practice notes SARS has, until recently, been slow to enforce the transfer pricing provisions. It is, however, clear that these times have passed since SARS has published new disclosure requirements for companies relating to transfer pricing activities. Since the 2002 tax year, the Company tax return form brochure (IT14B) has required that a company that has entered into an international transaction with a connected person is obliged to furnish the following information:

  • a copy of the agreement entered into;

  • a copy of the company's transfer pricing policy document;

  • original cost price of the asset to the connected person and current market value; and

  • Income Tax value to the connected person on the date of transaction.

The problem we are facing is that nowhere in the Act, the Practice Notes and/or SARS' Information on Income Tax brochure do we find any reference to what constitutes a transfer pricing policy document. Olivier et al in their book International Tax: A South African Perspective recommend that a transfer pricing policy document should include information relating to:

  • an identification of the relevant transactions in terms of international agreements with connected parties, and the extent of any other commercial or financial relations with connected persons within the scope of section 31;

  • copies of the international agreements entered into with connected parties;

  • a description of the nature and terms, including prices, of all relevant transactions,

including a series of transactions and any off-setting transactions;

  • the method that has been used to arrive at the nature and terms of the relevant transaction and to the particular circumstances;
  • an explanation of the process used to select and apply the method used, to establish the transfer prices, and the reason why it is considered to provide the result that is consistent with the arm's length principle;
  • information relied upon in arriving at the arm's length terms such as commercial agreements with third parties, financial information, budgets and forecasts; and
  • details of any circumstances that may have influenced the prices that have been set.

Companies do not have a choice in submitting its transfer pricing policy document; it is compulsory.

Section 65 of the Act provides:

"All forms of returns and other forms required for the administration of this Act shall be in such form and be submitted at such place as may be prescribed by the Commissioner from time to time"

Section 74A in turn, provides that:

"The Commissioner or any other officer may, for the purposes of the administration of this Act in relation to any taxpayer, require such taxpayer or any other person to furnish such information (whether orally or in writing), documents or things as the Commissioner or such officer may require"

Should the company fail to provide such information then section 75, which deals with penalties and default in the Act, determines to the extent here relevant:

"(1) Any person who-

(a) fails or neglects to furnish, file or submit any return or document as and when required by or under this Act; or..

shall be guilty of an offence and liable on conviction to a fine or to imprisonment for a period not exceeding 24 months."

Therefore, from a corporate governance perspective it is essential that companies ensure that when they enter into international transactions, they comply with the disclosure requirements.

Application of section 31 in practice and SARS' treatment thereof

To summarise, thin capitalisation is aimed at interest bearing financial assistance between a non-resident and a resident. In this regard, Section 31(3) enables SARS to determine the acceptable debt to equity ratio i.e. 3:1. The interest that relates to the excessive portion of the loan capital will be disallowed as a deduction. That being said, once section 31(3) has been applied, it must be determined with reference to section 31(2) (the transfer pricing provision) whether interest calculated on the allowable portion of the financial assistance falls within an arm's length price.

Accordingly, when you have an international agreement between two parties your first step should be to determine whether financial assistance has been granted. If so, you are obliged to determine whether the financial assistance falls within the 3:1 debt to equity ratio. Only thereafter do you determine whether the interest that relates to the financial assistance is at arm's length.

This can be explained with reference to the following example:

Mr X, a non-resident, invested in South Africa by purchasing a holiday home. He structured the transaction by ceding his right to purchase the property to a South African company ("SA Co"), which was incorporated specifically for this purpose. He capitalises SA Co with R500,000 and lends the balance of the purchase price of R2,000,000 to SA Co via a loan agreement.

SA Co's financial year ends on 31 March. During the financial year the weighted average of the South African prime rate of interest was 16%.

The following information is relevant:

Fixed Capital



Shareholder granted loan on 1 April 2004 @ 20% pa




Application of section 31

Step 1

Because it is financial assistance section 31(3) i.e. 3:1 debt to equity ratio must first be considered:

  • equity


  • debt


  • debt to equity ratio 4:1


Therefore, interest on R1,500,000 will be acceptable but the interest on R500,000 will be regarded as being disallowable interest.

Disallowable interest portion R100,000 (500,000x20%)

Step 2

With reference to section 31(2) it must be determined whether the interest rate is excessive. During the financial year the weighted average of the South African prime rate of interest was 16%. According to the Practice Note 2, prime rate plus 2 percentage points will be acceptable. Accordingly, SARS will accept 18% (16%+2%).

The excessive interest portion R30,000 (R1,5000,000x2%)

The overall position is as follows:

Interest incurred


Less disallowable interest


Less excessive interest


Deductible interest


The result of applying section 31 is that SA Co has suffered adverse consequences, in relation to both normal tax and STC, of R130,000 (R100,000+R30,000). This amount would not be deductible, and would be subject to STC.


In view of the doubly adverse consequences of falling foul of the provisions of section 31, it behoves a taxpayer to be alert when setting up cross-border financial or commercial arrangements. This is particularly important in view of the fact that SARS is actively pursuing the application of section 31 at present.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.