South Africa: Interest-Free Shareholder's Loans At Arm's Length?

Last Updated: 26 April 2012
Article by Okkie Kellerman

Most Read Contributor in South Africa, September 2018

Where foreign subsidiaries find themselves in financial distress, the interest rate on the shareholder loans from a South African shareholder may be reduced to zero percent as the foreign subsidiary is unable to pay any interest due to the fact that it may be insolvent.

However, in terms of the transfer pricing provisions in section 31(2) of the Income Tax Act, Act 58 of 1962, as amended, all shareholder's loans granted by South African shareholders to foreign subsidiaries should bear an arm's length interest rate. The question therefore remains whether a zero interest rate on a shareholder's loan will be seen as an arm's length interest rate for South African transfer pricing purposes.

Arm's length price

Based on case law, dealing at arm's length implies that each party is independent of the other and that each party will ensure that it receives the best result for itself out of the transaction with the other party.

The Organisation for Economic Co-operation and Development ("OECD") acknowledges, in its Transfer Pricing Guidelines, that there is a practical difficulty in applying the arm's length principle in that connected persons may enter into transactions with each other which independent parties would not have entered into. These transactions are commercially justifiable as group companies may face different commercial circumstances when dealing with each other.

When applying the arm's length principle, it is important to compare the conditions of a transaction between connected parties with the conditions of a transaction between independent parties. Such a comparison can only be of use if the economically relevant characteristics of these two situations are also comparable. In other words, none of the differences between the two situations should have a material effect on the price that is charged for the transaction, or that an adjustment could be made to the price to neutralise the effect of such differences. To determine the comparability it is important to understand how independent companies evaluate a potential transaction.

Independent companies will compare a proposed transaction with other options available to them and will only enter into the proposed transaction if there is not a more attractive alternative available to it. In this comparison, any economically relevant differences between the various options will be considered. It is therefore only fair that tax administrations should also consider these differences when comparing two situations in the determination of an arm's length price.

Therefore, to determine the comparability of two transactions to determine the arm's length conditions it is necessary to compare the attributes of both the transactions and the companies which may affect conditions in an arm's length transaction. These attributes may include the characteristics of the service provided, the assets applied by each party, the risks assumed by each party, the contractual terms, the business strategies of the parties and the economic circumstances of the parties.

Zero interest rate

Practice Note 7, issued by SARS, deals with "Interest-free loans to non-residents" and states that the Commissioner will consider various issues before exercising his discretion to adjust the interest rate in respect of loans granted by residents to non-residents. Even in practice, it appears that SARS will consider the merits of each individual shareholder's loan before making any adjustments to the interest rate of a shareholder's loan in terms of the transfer pricing provisions.

In terms of international case law, it seems that the setting of an interest rate on a shareholder's loan by reference to interest rates used in respect of other borrowings is risky unless a proper economic analysis has been done to ensure that the conditions are comparable between the shareholder's loan and the other borrowings.

In the case of a shareholder's loan, the terms and conditions of the loan provide the crucial information required for a comparison with third party debt to determine an arm's length interest rate. One should also consider the purpose of the loan, the credit worthiness of the offshore subsidiary, its credit history and the industry in which it operates.

Based on this, there may be circumstances where the levying of a zero interest rate on shareholders' loans is, indeed, at arm's length.

This applies especially to shareholders' loans as one can argue that a shareholder's loan is unique compared to any other funding provided to a company, especially where the shareholder's loan is subordinated and subject to the provisions of a shareholder's agreement. To consider the interest rate that might have been levied on a loan from a non-shareholder does not make sense seeing that the parties to a shareholder's loan are neither independent nor dealing at arm's length.

It is, therefore, clear that the interest rate levied on a shareholder's loan will depend largely on the circumstances under which the loan is granted. Therefore, a zero interest rate should be treated as being concluded on an arm's length basis for a shareholder's loan to a foreign subsidiary which:

  • Is realising continued losses as a result of its poor operational performance;
  • Is unable to pay any interest on the shareholder's loan due to its lack of free cash flow;
  • Is unable to make any repayments on the shareholder's loan due to its lack of free cash flow;
  • Is unable to obtain a bank loan or only third party funding as a result of its lack of creditworthiness; and
  • Can only obtain funding from its shareholder because the shareholder is the only one who will risk further capital based on the capital it has already contributed to the company.

Depending on the circumstances, an interest-free shareholder's loan can indeed be an arm's length transaction.

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.

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