South African companies are often required to provide interest-free, or low interest, loans to its foreign subsidiaries as a result of the commercial realities under which the foreign subsidiary operates. These commercial realities may include being a start-up operation, operating at a loss because of economic circumstances or merely being unable to pay interest as a result of legislative prohibitions or as per the agreement with a joint venture partner. The South African company may decide to rather fund its foreign subsidiary with a loan which is more similar to equity (also known as quasi equity) in that the loan is interest free with no repayment terms seeing that it is easier to get such quasi equity repaid than to return normal share equity.
For similar reasons a South African company may decide to provide the right to use its intellectual property to its foreign subsidiary for no royalty or at a low royalty rate.
In terms of the current South African transfer pricing rules the South African company must include in its taxable income an arm's length interest amount for such low or interest-free loan and an arm's length royalty amount for such low or royalty free use of it intellectual property. The foreign subsidiary will only get a tax deduction for the actual interest or royalty, if any, paid to its South African company.
Proposed amendments to the South Africa transfer pricing provisions seek to eliminate these negative tax implications. These proposed amendments provide that the South African transfer pricing provisions should not apply to cross-border loans or intellectual property transactions where:
- the South African company granting the loan or the right to use the intellectual property is a South African company;
- the loan is received or the intellectual property is used by a foreign subsidiary which is a controlled foreign company ("CFC") of this South African company;
- 10% of the shares in the foreign subsidiary are owned directly by the South African company;
- the foreign subsidiary is taxed at an aggregate effective tax rate of 75% of the South African tax rate of 28%, being 21%; and
- the foreign subsidiary has a foreign business establishment located outside of South Africa.
Although this is a step in the right direction to alleviate the transfer pricing exposure of South African companies, the requirement that the South African company must directly hold at least 10% of the shares in the foreign subsidiary will limit the application of this relief.
For instance, where the South African company uses a central offshore holding company to hold all the shares in its foreign subsidiaries to allow for the offshore pooling of cash and the streamlining of cash generated offshore, the South African company will not hold the required 10% direct interest in the foreign subsidiary and the proposed relief from transfer pricing will thus not apply to any loans or right of use of intellectual property granted to the foreign company by any of the South African group companies.
Where a South African group uses a South African treasury company to provide funding to all its operating subsidiaries, including its offshore operating subsidiaries, the South African treasury company will generally not hold the shares in the offshore operating subsidiaries and any loans granted by the South African treasury company will not qualify for the proposed relief from transfer pricing. This is on the basis that the South African treasury company will not meet the 10% direct shareholding requirement. To qualify for the proposed relief from transfer pricing the South African treasury company must grant the loan to the South African holding company and the South Africa holding company, which must hold at least 10% directly in the foreign subsidiaries, then grants the interest-free loan to the offshore operating subsidiaries.
Where the South African operating companies own their intellectual property and then licence the use thereof to the group's offshore operating subsidiaries, the South African operating companies will generally also not hold the shares of these offshore operating subsidiaries and such licence granted to the offshore operating subsidiaries will again not qualify for the proposed relief from transfer pricing because the South African operating companies will not meet the 10% direct shareholding requirement. To avail of the proposed relief from transfer pricing, the SA operating companies should first grant the right of use of the intellectual property to the South African holding company with the South Africa holding company, which must hold at least 10% directly in the foreign subsidiaries, then granting the licence to use of the intellectual property to the foreign operating subsidiaries.
The requirement that the foreign company receiving the loan or using the intellectual property must be a CFC also limits the relief with regards to the provision of the use of intellectual property by South African companies to offshore joint venture companies. The relief will not apply to a licence charged by a South African company to its offshore joint venture company where the South African company holds 50% or less in the offshore joint venture company seeing that the offshore joint venture company will not be a CFC of such a South African company. However, the South African transfer pricing provisions will still apply to the extent that the South African company holds at least 20% of the shares in the joint venture because the connected person definition with regards to the supply of the use of intellectual property for transfer pricing purposes only requires a 20% shareholding to be a connected person, even if another shareholder holds the majority voting rights of that offshore joint venture.
Based on the above, the proposed relief from the application of the South African transfer pricing rules on loans and the use of intellectual property within a multinational group may only have limited application as it does not recognise the commercial realities with regard to the holding of the shares in offshore subsidiaries, the use of a treasury company, the ownership of intellectual property and the setting up of joint ventures. However, to avail of the relief from the transfer pricing provisions on loans and licence fees, South African multinational companies must carefully:
- consider utilising offshore holding companies to hold the shares of offshore subsidiaries directly;
- use offshore holding companies in tandem with the South African holding company to ensure that the South African holding company holds at least 10% in the offshore subsidiaries with the offshore holding company holding the other 90% of wholly owned subsidiaries;
- consider using treasury companies to provide funding to its offshore subsidiaries;
- ensure that all intellectual property within the group is owned by the holding company and not by the operating companies developing the intellectual property; and
- ensure that the use of intellectual property within the group is legally licensed to the group's South African holding company which will then sub-licence the use to the group's offshore operating companies.
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.