The OECD guidelines for thin capitalisation – Should we be worried?
10 Jul 2017
Companies are funded in two ways, namely through debt and equity. In certain instances interest payments incurred in the production of income are deductible for tax purposes, while distributions are not tax deductible. The way in which a company is structured therefore raises tax concerns regarding the balance between debt and equity. Thin capitalization is governed by the general transfer pricing provisions of the Income Tax Act. The Organisation for Economic Co-operation and Development (OECD) has clear guidelines on thin capitalization.
In terms of –the transfer pricing rules taxpayers must determine an acceptable amount of debt on an arms-length basis. The taxpayer are therefore required to-
- Determine whether the actual terms and conditions of the transaction differ from the terms and conditions that would have existed if the parties had been independent persons dealing at arms-length; and
- If there is a difference which resulted in a tax benefit for one of the parties to the transaction.
How would an arms-length amount of debt be determined?
SARS requires taxpayers to consider the transaction from both the lender’s and the borrower’s perspective. In other words from the lender’s perspective whether the amount borrowed could have been borrowed at arms-length. Once the arms-length amount of debt was determined a test must also be performed whether the interest rate charged represent a rate the taxpayer would have paid had the transaction been concluded through an independent party.
Based on the two tests performed, if it is found that a portion of debt in a company is capitalised on a non-arms-length basis then an adjustment must be made therefore. For example, in the case of a loan made by a non-resident company to a South African company the portion of interest that is considered excessive will be disallowed as a tax deduction and in addition to the disallowed deduction, from 1 January 2015, the secondary adjustment deems the difference to be dividend (in the case of the lender being a company) and a donation (in the case of the lender not being a company) payable 6 months after year end.
What is SARS’s view on thin capitalisation?
SARS have stated in their interpretation note that a risk-based approach is used in selecting potential thin capitalisation cases for audit. Furthermore the revised income tax return for companies will provide additional information which SARS will use to identify these types of transactions and effectively reduce the risk of base erosion and profit shifting (BEPS).
We are here to help
If you require any guidance on this matter or any other transfer pricing matters please feel free to contact any one of our national offices.