Internationally, intra-group financing arrangements have been under scrutiny for a number of years and have been the subject of some of the most significant transfer pricing disputes. Base erosion through excessive interest expenses was, in fact, the specific focus of Action 4 of the Organisation for Economic Cooperation and Development's ("OECD") Base Erosion and Profit Shifting ("BEPS") project.

While certain of the BEPS reports were released in 2016, BEPS Action 4, and the OECD's approach to intra-group financial transactions generally, have proved more difficult to finalise. The OECD's guidance on intra-group financial transactions was only finalised in 2020, and now forms part of the Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations. 

In South Africa, the transfer pricing rules in terms of section 31 of the Income Tax Act, 58 of 1962 have been of particular importance in respect of cross-border, intra-group financing arrangements since April 2012 when thin capitalisation rules based on specific debt to equity ratios were withdrawn. Since that date, both the amount of debt assumed as well as the interest rate have, instead, been subject to the transfer pricing rules and have been required to be consistent with the arm's length principle.

In 2013, the South African Revenue Service ("SARS") issued a draft interpretation note on the application of section 31 to thinly capitalised entities. The draft, however, has never been finalised and, aside from minor updates to reflect changes to legislation, guidance from SARS in this regard has not been forthcoming. We understand that this has, in part, been due to the fact that SARS itself has been awaiting the finalisation of the OECD's guidance on financial transactions. SARS has, for some years, been promising to issue updated guidance.

With the finalisation of the OECD guidance in 2020 , SARS has now issued a new draft interpretation note on the application of section 31 to intra-group loans ("2022 Draft Note") for public comment.

The 2022 Draft Note is broadly aligned with Chapter X of the OECD Guidelines. It emphasises the continued importance of the arm's length principle in the context of intra-group loans on a basis that takes into account all economically relevant circumstances. In this regard, the 2022 Draft Note validates the approach which we typically take to analysing and documenting intra-group arrangements for our clients and is to be welcomed.

On an initial high-level review, the key takeaways from the 2022 Draft Note are as follows:

  • Section 31 requires consideration of both the amount of debt (i.e. thin capitalisation) and the cost of debt in terms of the arm's length principle.
  • No safe harbours or capital structure ratio guidelines exist.
  • Transactions potentially in scope include "indirect" financial assistance, such as back-to-back loans involving the interposition of an independent financial institution, and the provision of intra-group guarantees in respect of third party debt.
  • In applying the arm's length principle to intra-group finance arrangements, SARS may characterise debt and equity according to economic substance. This is over and above the specific provisions relating to hybrid instruments such as section 8F and 8FA.
  • An analysis of an intra-group financing arrangement in terms of the arm's length principle requires that the arrangement be considered both from the borrower's perspective and from the lender's perspective.
  • Bank opinions or quotations as to an applicable interest rate do not constitute evidence of arm's length terms and conditions.
  • Credit ratings, economic modelling and credit default swaps are all potentially relevant in determining the economically relevant circumstances relating to intra-group finance arrangements.
  • Public Notice 1334 of 28 October 2016 contains specific requirements for documenting intra-group finance arrangements. These requirements continue to apply.
  • Sections 23M and 23N of the Act contain specific provisions which limit interest deductions under certain circumstances. These provisions are intended to be applied after the application of section 31.
  • The application of section 31(2) may result in the borrower being denied deductions in respect of amounts of interest actually paid. This does not, in SARS' view, mean that interest withholding tax applies to the reduced (i.e. arm's length) amount of interest. Section 31(2) simply requires that taxable income be calculated on an arm's length basis. It does not deem the actual transaction to have taken place on adjusted terms.

Comments on the 22 Draft Note are due by 22 April 2022. Find a copy here.

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.