Prior to 1 April 2012, the South African rules on thin capitalization provided a safe harbour ratio of 3:1 for debt-to-equity. Thereafter, the thin capitalization rules were subsumed by the current transfer pricing legislation. Section 31 of the Income Tax Act 58 of 1962 (“the Act”) essentially provides for cross border transactions between connected parties to be at arm's length. Therefore SARS may, for example, disallow the interest deductions pertaining to interest on that 'thinly capitalized' amount (i.e.: on that excessive amount). According to the Draft Interpretation Note on section 31, the arm’s length nature of the loan agreement must be assessed from the perspective of the borrower as well as the lender.

Although South Africa no longer has a safe harbour rule, this does not mean that one will be entitled to deduct all interest paid on a loan. One will only be entitled to do so if one can show that the capital amounts obtained from the loan are of an arm’s length nature (i.e.: that the company would have been able to obtain a loan of such size from an unconnected person). This means that SARS can deny deductions for interest that would not have existed had the South African entity not been thinly capitalised with excessive debt.

As an example:

A South African subsidiary borrows R60 million from its foreign holding company. In an arm’s length arrangement between independent parties, however, a lender would have been prepared to lend and a borrower would have been prepared to borrow R40 million. The result of this is that no deduction must be claimed for the interest on the excessive debt of R20 million.

The gist of the South African position is that there is no quantitative rule of thumb, but instead one will be required to embark on a traditional transfer pricing analysis taking into account the specific facts and circumstances of each entity.

The rationale for debt financing and indicators of the company’s creditworthiness will therefore play a big role in determining the extent to which the debt funding will be acceptable to ensure an interest deduction.

The practical effect of the transfer pricing provisions in South Africa is that the connected parties must determine what amount they would have been able to borrow and loan had the transaction been concluded in an open market. The lending capacity of the borrower therefore has to be determined by considering the terms and conditions which would have been applicable between unconnected persons.

We note that, although no safe harbour rule exists in South Africa, SARS has previously suggested that it will consider transactions where the debt-to-EBITDA (earnings before interest, taxes, depreciation, and amortization) ratio exceeds 3:1 to be of greater risk when it comes to selecting cases for audit.

One must bear in mind, however, that the SARS Draft Interpretation Note on Section 31 of the Income Tax Act provides that the ratio may not be indicative of what constitutes an arm’s length position for a particular taxpayer. The ratio is merely used as a potential risk identifier. The ratio therefore does not preclude SARS from auditing a taxpayer who is within the range of the ratio.

Taxpayers with group financing into South Africa are advised to ensure that they can justify the arm’s length nature of the capital sum of any connected party loans to withstand any possible scrutiny from SARS.