Thin Capitalisation and secondary adjustments

Thin Capitalisation in relation to transfer pricing (“thin cap”) has been a hot topic for quite some time. A company is said to be thinly capitalised when its capital structure has an excessive high ratio of debt to equity. What this excessive high ratio is deemed to be varies from tax jurisdiction to tax jurisdiction.

Some tax jurisdictions may provide a fix debt to equity ratio such as a 3:1 (3 times debt to 1 times equity) and anything over that is deemed to be excessive whereas other tax jurisdictions state that the company must behave at arm’s length including its capital structuring. The latter raises many concerns as to how a company would determine whether it is at arm’s length in relation to its capital structure or not. In theory an arm’s length thin cap analysis seems easy, one must analyse what a company could borrow and how much it would borrow taking into account its capital structure, the purpose for the loan and other relevant factors (i.e. other alternatives etc.). In practice, however, this is much more difficult. Probably the biggest issue is to find relevant and reliable data on which a company can base its conclusion that the amount it has borrowed is at arm’s length (i.e. it could borrow and would borrow the amount). This post is not trying to discuss the different ways of determining an arm’s length loan arrangement and/or an arm’s length interest charge, however, should you want to discuss this please let me know and I am happy to write something about that too.

If you are not too familiar with thin cap from a transfer pricing perspective you may ask yourself why does it matter if a company is thinly capitalised or not. The problem is that if a company is thinly capitalised the excess portion of the debt that the company pays interest on is usually disallowed as a tax deduction. Further, some tax authorities may implement a secondary adjustment. The purpose of a secondary adjustment is to tax the allocated profits from the primary transaction according to its form. In other words, a secondary adjustment is taxing the excessive transferred profits from the primary transaction either as a dividend, equity contribution or loan. This may result in additional tax such as withholding taxes. For example, where a company is deemed to be paying excess interest on a loan the excess amount may be deemed to be a dividend which means the excess portion is not allowable as an interest deduction and secondly the excess amount will attract dividend withholding taxes. Some tax jurisdictions may deem the excessive portion paid as a deemed loan which in turn will attract interest payable on the outstanding amount. Without going into too much detail, the issue with secondary adjustments is that they may result in double taxation as the other tax jurisdiction may not provide for a credit, further, some countries reject secondary adjustments all together due to the practical difficulties they may present.

South Africa released its Draft Interpretation Note on thin cap (available on the SARS website). As some may be aware the new transfer pricing legislation in South Africa is primarily based on that in the UK. The same is true for the thin cap provision which is now part of the normal transfer pricing provisions. Ernst & Young summarised the Draft Interpretation Note here. The Draft Interpretation Note has been in the public forum for quite some time and has caused some concerns. Through public correspondence with SARS it is the general feeling that SARS may release an amendend Interpretation Note on thin cap soon. 

I am hoping that we will get clarity on the proposed secondary adjustments. Currenlty SARS is proposing a secondary adjustment in the form of a deemed loan. Which is likely to change if the latest budget speech is anything to go by. 

This comment may be applicable in other tax jurisdictions that have a similar approach (i.e. deemed loans as a secondary adjustment). Obviously should the secondary adjustment change the below comments are no longer applicable.

Section 6.2 of SARS’ Draft Interpretation Note states:

“This means that in addition to the primary adjustment, the amount of the disallowed deduction is deemed to be a loan by the taxpayer that constitutes an affected transaction. As a result the taxpayer will have to calculate and account for interest income at an arm’s length rate on the deemed loan. The accrued interest on the deemed loan will be capitalised annually for the purpose of calculating the deemed loan outstanding.”

Should the secondary adjustment work as described above, my concern is that a taxpayer will have to calculate and account for interest income at an arm’s length rate on the deemed loan. My question is – how can you calculate an arm’s length interest rate on a loan which was deemed to be a loan because of a primary adjustment to a loan which was excessive (i.e. deemed to be not at arm’s length)? In other words, the Draft Interpretation Note wants the taxpayer to calculate an arm’s length interest rate on a loan that is not arm’s length. Surely this is not possible? As discussed secondary adjustments are usually done to account for other taxes that would have been due and payable if the taxpayer had structured its tax affairs in a compliant manner. A possible solution to this conundrum could be to implement a fixed and fair interest rate rather than an arm’s length interest rate.

There are other issues from a South African perspective (which may be similar in other African countries with Exchnage Controls) in relation to the secondary adjustment, such as Exchange Control approvals for payments of the deemed loan. The question here is what happens to a taxpayer’s taxable position if the Exchange Control does not allow the money to leave the country? As the accrued interest is capitalised annually and there is no way of repaying the debt, the interest expense will increase every year which at some stage may render a company bankrupt!

Let me know what you think about the Draft Interpretation Note and if you have any comments. Should there be any update from SARS on this topic I will keep you posted.