Transfer Pricing News Issue 39 - June 2022

Draft interpretation note on intragroup financial arrangements issued for public comment

The South African Revenue Service (SARS) on 11 February 2022 released a new Draft Interpretation Note (Draft IN) on Intra-Group Financial Transactions for public comment. The South African transfer pricing community, including BDO, welcomed the draft IN, as intragroup financial arrangements have been a contentious issue for a number of years. The release of the Draft IN also confirmed that this is an area the SARS is likely to scrutinize closely. Intragroup financing arrangements have been known to create opportunities for base erosion and profit shifting (BEPS).

In 2013, SARS released a Draft Interpretation Note that provided guidance on how SARS would expect South African resident taxpayers to support the arm’s length nature of cross-border intragroup financial arrangements they entered into. Since then, SARS took the position that firm guidance in respect of inbound financial assistance would be provided only once the Organisation for Economic Co-operation and Development (OECD) released the final version of the guidance on the transfer pricing implications of financial transactions.

The OECD released its guidance on the transfer pricing aspects of financial transactions in 2020. That guidance has been incorporated in the 2022 version of the Transfer Pricing Guidelines for Multinational Enterprises and Tax Administration as Chapter X.

The Draft IN has now been aligned with Chapter X of the OECD transfer pricing guidelines. As anticipated, the Draft IN places continued emphasis on the significance of the arm’s length principle, which should ideally consider all economically relevant circumstances in respect of intragroup financing arrangements.

Key Takeaways

The Draft IN discusses the following topics:

  • The transfer pricing rules and their application to both direct and indirect funding, including back-to-back funding and guarantee arrangements. 
  • SARS will consider the quantum of debt, the duration of the intragroup financing arrangement and other terms such as the interest rate and repayment terms to determine whether the intragroup financing arrangement does in fact satisfy the arm’s length principle. 
  • There are no safe harbours with regard to ratio analyses.  
  • The importance of distinguishing what constitutes debt and equity.  
  • The substantive nature of an intragroup financing arrangement and whether a purported loan should be regarded as a loan or as a contribution to equity capital. 
  • The key commercial and financial relations to accurately delineate the intragroup financial arrangement. This is inclusive of an analysis with regard to the options realistically available to all parties involved in the arrangement. 
  • Guidance provided on a comparability analysis, which involves the use of credit ratings, factors that could potentially affect the credit rating of an entity, covenants and guarantees. 
  • The use of the comparable uncontrolled price (CUP) method to determine the arm’s length interest rate/s to be applied to intragroup financing arrangements. 
  • Guidance on loan fees and charges.  
  • The cost of funds as an alternate approach in the absence of comparable uncontrolled transactions.  
  • Risk-free and risk-adjusted rates of return and the methodologies to be used in this regard. 
  • The consequences South African resident taxpayers would face in the event that the level and cost of the intragroup debt is not at arm’s length, i.e., primary and secondary adjustments. 
  • The importance of preparing and retaining appropriate transfer pricing documentation that supports the taxpayer’s position regarding the arm’s length nature of the intragroup financing arrangement.  
  • How SARS would treat this in relation to transactions involving permanent establishments.   
  • The headquarters company exclusions and the ring-fencing of interest expenditure incurred on inbound intragroup financial arrangements. 
  • Advance pricing agreements (APAs) and the possibility that SARS may use APAs on intragroup financial arrangements. 
  • Withholding tax on interest, confirming that this calculation will not be affected by transfer pricing adjustments. 

Pending Issues

Even though the Draft IN is welcomed and does in fact provide more clarity regarding intragroup financial arrangements, there are several key issues that still need to be addressed. The key issues identified are:

  • Debt and interest have not been defined.  
  • All safe harbours in relation to intragroup financing arrangements have been removed, which places an additional burden on taxpayers trying to support the arm’s length nature of the intragroup financial arrangement. 
  • The Draft IN seems to move away from a ratio-type analysis and is purely focused on an arm’s length debt test. Such a test may still include a ratio analysis but may require additional analyses, which can be time-consuming and subjective. 
  • The Draft IN seems to indicate that SARS may not accept interest charges between a head office and its South African permanent establishment, as it deems this to be a notional charge with the exception of an external link to an actual charge. 
  • The Draft IN mentions that the underlying transaction is not adjusted through a transfer pricing adjustment and therefore the amount of interest paid or due and payable to the lender remains the same. As such, the adjustment does not have an impact on the calculation of withholding tax on interest, which means double tax may arise on that portion of the adjustment as both potential interest withholding tax and the secondary adjustment are applicable.  
  • The South African Reserve Bank (SARB) also places certain limitations on interest rates that can be charged into South Africa from a cross-border related-party. It would be very useful if these limitations were aligned to Section 31 of the Income Tax Act to ensure that an acceptable loan from an arm’s length perspective is not further limited.   
  • The Draft IN refers only to the OECD transfer pricing guidelines. Even though the UN’s Practical Manual on Transfer Pricing is aligned with the OECD transfer pricing guidelines, there are some minor differences between the two. It would be useful to understand whether taxpayers can use the UN manual for additional support/analyses.  

Overall, the Draft IN on intragroup financial arrangements does provide guidance to South African taxpayers, especially considering that this is now aligned with the guidance provided by the OECD transfer pricing guidelines. However, as mentioned above, a number of key issues need to be addressed before finalisation of the Draft IN.

Determining an arm’s length consideration for loans and interest can be a complex exercise. We recommend that taxpayers with such transactions seek professional advice to avoid running afoul of the transfer pricing rules that come into play for such transactions.

Marcus Stelloh
[email protected]

Shazia Raviduth
[email protected]