South Africa: Base erosion and profit shifting – Debt:equity

Peter Dachs

The concept of base erosion and profit shifting (BEPS) has been much discussed at various international fora.

From a South African perspective, the Davis Tax Committee has been set up, inter alia, to address the issue of BEPS in a South African context.

In South Africa the general rule is that interest is deductible for tax purposes while dividends are not. This applies even in circumstances where the dividends are in the form of interest-type payments on redeemable preference shares, which themselves essentially replicate debt.

The issue of debt versus equity and the tax deductibility of interest versus dividends has consumed much of the legislature's time in recent years. The concern is that high levels of debt, particularly in a cross-border context, may lead to an erosion of the South African tax base.

Thin capitalisation refers to the situation in which a company is financed through a relatively high level of debt compared to equity. Domestic rules typically allow a deduction for interest. The higher the level of debt in a company and consequently the greater amount of interest it pays, the lower will be its taxable profits. In regards to finance, debt can therefore be seen as more tax efficient than equity.

With the introduction of the new transfer pricing rules, the issue of thin capitalisation has become part of the transfer pricing mandate. Accordingly, the old thin capitalisation rules have been deleted. With the deletion of these rules, the previous 3:1 debt-to-equity ratio safe harbour also no longer applies.

When the much anticipated transfer pricing practice note is released it will likely contain amendments to some of the approaches set out in the Draft Interpretation Note. It is hoped that advance pricing agreements (APAs) as well as a safe harbour in respect of thin capitalisation issues will help to provide certainty on acceptable levels of debt which may be provided, inter alia, by a foreign parent to its South African subsidiary.

Many derivative amounts exist which do not fall into the definition of interest and will therefore not be subject to the interest withholding tax when introduced. An example is "manufactured interest" payments in respect of share lending agreements.

In addition provisions are expected for amounts payable on forward exchange contracts and cross currency swap contracts where there are no initial exchanges. This economically represents interest, but does not fall into the definition thereof.

South Africa has a general anti-avoidance provision which is contained in sections 80A-L of the Income Tax Act. These anti-avoidance provisions may be used in the appropriate circumstances.

If a non-resident enters into a derivative arrangement instead of advancing a loan to a South African resident then this has the effect of sidestepping an anticipated tax liability in respect of interest withholding tax for the non-resident entity. A 'tax benefit' will therefore arise for the non-resident. To avoid the application of the anti-avoidance provisions, such non-resident then bears the onus of proving that its "sole or main purpose" was not to achieve such tax benefit.

Peter Dachs (pdachs@ensafrica.com)
ENSafrica – Taxand Africa
Tel: +27 21 410 2500
Website: www.ensafrica.com

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