South Africa: Foreign Loans To South African Residents - Some Tax Considerations

Last Updated: 17 March 2005

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

Introduction

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)

 

C

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
R500,000

Loans

Shareholder granted loan on 1 April 2004 @ 20% pa
R2,000,000

Interest

Loan

R400,000

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

R500,000

  • debt

R2,000,000

  • debt to equity ratio 4:1

(R2,000,000÷R500,000)

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

R400,000

Less disallowable interest

R100,000
R300,000

Less excessive interest

30,000

Deductible interest

R270,000

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.

Conclusion

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.

To print this article, all you need is to be registered on Mondaq.com.

Click to Login as an existing user or Register so you can print this article.

 
Some comments from our readers…
“The articles are extremely timely and highly applicable”
“I often find critical information not available elsewhere”
“As in-house counsel, Mondaq’s service is of great value”

Related Topics
 
Related Articles
 
Up-coming Events Search
Tools
Print
Font Size:
Translation
Channels
Mondaq on Twitter
 
Register for Access and our Free Biweekly Alert for
This service is completely free. Access 250,000 archived articles from 100+ countries and get a personalised email twice a week covering developments (and yes, our lawyers like to think you’ve read our Disclaimer).
 
Email Address
Company Name
Password
Confirm Password
Position
Mondaq Topics -- Select your Interests
 Accounting
 Anti-trust
 Commercial
 Compliance
 Consumer
 Criminal
 Employment
 Energy
 Environment
 Family
 Finance
 Government
 Healthcare
 Immigration
 Insolvency
 Insurance
 International
 IP
 Law Performance
 Law Practice
 Litigation
 Media & IT
 Privacy
 Real Estate
 Strategy
 Tax
 Technology
 Transport
 Wealth Mgt
Regions
Africa
Asia
Asia Pacific
Australasia
Canada
Caribbean
Europe
European Union
Latin America
Middle East
U.K.
United States
Worldwide Updates
Registration (you must scroll down to set your data preferences)

Mondaq Ltd requires you to register and provide information that personally identifies you, including your content preferences, for three primary purposes (full details of Mondaq’s use of your personal data can be found in our Privacy and Cookies Notice):

  • To allow you to personalize the Mondaq websites you are visiting to show content ("Content") relevant to your interests.
  • To enable features such as password reminder, news alerts, email a colleague, and linking from Mondaq (and its affiliate sites) to your website.
  • To produce demographic feedback for our content providers ("Contributors") who contribute Content for free for your use.

Mondaq hopes that our registered users will support us in maintaining our free to view business model by consenting to our use of your personal data as described below.

Mondaq has a "free to view" business model. Our services are paid for by Contributors in exchange for Mondaq providing them with access to information about who accesses their content. Once personal data is transferred to our Contributors they become a data controller of this personal data. They use it to measure the response that their articles are receiving, as a form of market research. They may also use it to provide Mondaq users with information about their products and services.

Details of each Contributor to which your personal data will be transferred is clearly stated within the Content that you access. For full details of how this Contributor will use your personal data, you should review the Contributor’s own Privacy Notice.

Please indicate your preference below:

Yes, I am happy to support Mondaq in maintaining its free to view business model by agreeing to allow Mondaq to share my personal data with Contributors whose Content I access
No, I do not want Mondaq to share my personal data with Contributors

Also please let us know whether you are happy to receive communications promoting products and services offered by Mondaq:

Yes, I am happy to received promotional communications from Mondaq
No, please do not send me promotional communications from Mondaq
Terms & Conditions

Mondaq.com (the Website) is owned and managed by Mondaq Ltd (Mondaq). Mondaq grants you a non-exclusive, revocable licence to access the Website and associated services, such as the Mondaq News Alerts (Services), subject to and in consideration of your compliance with the following terms and conditions of use (Terms). Your use of the Website and/or Services constitutes your agreement to the Terms. Mondaq may terminate your use of the Website and Services if you are in breach of these Terms or if Mondaq decides to terminate the licence granted hereunder for any reason whatsoever.

Use of www.mondaq.com

To Use Mondaq.com you must be: eighteen (18) years old or over; legally capable of entering into binding contracts; and not in any way prohibited by the applicable law to enter into these Terms in the jurisdiction which you are currently located.

You may use the Website as an unregistered user, however, you are required to register as a user if you wish to read the full text of the Content or to receive the Services.

You may not modify, publish, transmit, transfer or sell, reproduce, create derivative works from, distribute, perform, link, display, or in any way exploit any of the Content, in whole or in part, except as expressly permitted in these Terms or with the prior written consent of Mondaq. You may not use electronic or other means to extract details or information from the Content. Nor shall you extract information about users or Contributors in order to offer them any services or products.

In your use of the Website and/or Services you shall: comply with all applicable laws, regulations, directives and legislations which apply to your Use of the Website and/or Services in whatever country you are physically located including without limitation any and all consumer law, export control laws and regulations; provide to us true, correct and accurate information and promptly inform us in the event that any information that you have provided to us changes or becomes inaccurate; notify Mondaq immediately of any circumstances where you have reason to believe that any Intellectual Property Rights or any other rights of any third party may have been infringed; co-operate with reasonable security or other checks or requests for information made by Mondaq from time to time; and at all times be fully liable for the breach of any of these Terms by a third party using your login details to access the Website and/or Services

however, you shall not: do anything likely to impair, interfere with or damage or cause harm or distress to any persons, or the network; do anything that will infringe any Intellectual Property Rights or other rights of Mondaq or any third party; or use the Website, Services and/or Content otherwise than in accordance with these Terms; use any trade marks or service marks of Mondaq or the Contributors, or do anything which may be seen to take unfair advantage of the reputation and goodwill of Mondaq or the Contributors, or the Website, Services and/or Content.

Mondaq reserves the right, in its sole discretion, to take any action that it deems necessary and appropriate in the event it considers that there is a breach or threatened breach of the Terms.

Mondaq’s Rights and Obligations

Unless otherwise expressly set out to the contrary, nothing in these Terms shall serve to transfer from Mondaq to you, any Intellectual Property Rights owned by and/or licensed to Mondaq and all rights, title and interest in and to such Intellectual Property Rights will remain exclusively with Mondaq and/or its licensors.

Mondaq shall use its reasonable endeavours to make the Website and Services available to you at all times, but we cannot guarantee an uninterrupted and fault free service.

Mondaq reserves the right to make changes to the services and/or the Website or part thereof, from time to time, and we may add, remove, modify and/or vary any elements of features and functionalities of the Website or the services.

Mondaq also reserves the right from time to time to monitor your Use of the Website and/or services.

Disclaimer

The Content is general information only. It is not intended to constitute legal advice or seek to be the complete and comprehensive statement of the law, nor is it intended to address your specific requirements or provide advice on which reliance should be placed. Mondaq and/or its Contributors and other suppliers make no representations about the suitability of the information contained in the Content for any purpose. All Content provided "as is" without warranty of any kind. Mondaq and/or its Contributors and other suppliers hereby exclude and disclaim all representations, warranties or guarantees with regard to the Content, including all implied warranties and conditions of merchantability, fitness for a particular purpose, title and non-infringement. To the maximum extent permitted by law, Mondaq expressly excludes all representations, warranties, obligations, and liabilities arising out of or in connection with all Content. In no event shall Mondaq and/or its respective suppliers be liable for any special, indirect or consequential damages or any damages whatsoever resulting from loss of use, data or profits, whether in an action of contract, negligence or other tortious action, arising out of or in connection with the use of the Content or performance of Mondaq’s Services.

General

Mondaq may alter or amend these Terms by amending them on the Website. By continuing to Use the Services and/or the Website after such amendment, you will be deemed to have accepted any amendment to these Terms.

These Terms shall be governed by and construed in accordance with the laws of England and Wales and you irrevocably submit to the exclusive jurisdiction of the courts of England and Wales to settle any dispute which may arise out of or in connection with these Terms. If you live outside the United Kingdom, English law shall apply only to the extent that English law shall not deprive you of any legal protection accorded in accordance with the law of the place where you are habitually resident ("Local Law"). In the event English law deprives you of any legal protection which is accorded to you under Local Law, then these terms shall be governed by Local Law and any dispute or claim arising out of or in connection with these Terms shall be subject to the non-exclusive jurisdiction of the courts where you are habitually resident.

You may print and keep a copy of these Terms, which form the entire agreement between you and Mondaq and supersede any other communications or advertising in respect of the Service and/or the Website.

No delay in exercising or non-exercise by you and/or Mondaq of any of its rights under or in connection with these Terms shall operate as a waiver or release of each of your or Mondaq’s right. Rather, any such waiver or release must be specifically granted in writing signed by the party granting it.

If any part of these Terms is held unenforceable, that part shall be enforced to the maximum extent permissible so as to give effect to the intent of the parties, and the Terms shall continue in full force and effect.

Mondaq shall not incur any liability to you on account of any loss or damage resulting from any delay or failure to perform all or any part of these Terms if such delay or failure is caused, in whole or in part, by events, occurrences, or causes beyond the control of Mondaq. Such events, occurrences or causes will include, without limitation, acts of God, strikes, lockouts, server and network failure, riots, acts of war, earthquakes, fire and explosions.

By clicking Register you state you have read and agree to our Terms and Conditions