Draft Interpretation Note on Intra-group Financial Arrangements

Shazia Raviduth and I wrote the below article based on our comments which we submitted to SARS. What are your thoughts on this Interpretation Note?

On 11 February 2022, the South African Revenue Service (SARS) released a new Draft Interpretation Note (Draft IN) on Intra-Group Financial Transactions for public comment. This Draft IN was welcomed by the South African transfer pricing community, including BDO, as intra-group financial arrangements have been a contentious issue for a number of years. The release of the Draft IN also reinforces that this is an area which SARS will actively be placing under scrutiny. Intra-group financing arrangements have been known to create opportunities for base erosion and profit shifting (BEPS).

During 2013, SARS released a Draft Interpretation Note which provided guidance on how SARS would expect a South African resident taxpayer to support the arm’s length nature of all its cross border intra-group financial arrangements entered into. Since then, SARS has maintained that firm guidance in respect of inbound financial assistance will be provided only once the Organisation for Economic Co-operation and Development (OECD) releases the final version of the transfer pricing implications on financial transactions.

Having regard to this, the Draft IN has now been aligned with Chapter X of the OECD Guidelines, issued in January 2022. As anticipated, continuous emphasis was placed on the significance of the arm’s length principle, which should ideally consider all economically relevant circumstances in respect of intra-group financing arrangements.

Key takeaways of the Draft IN are:

  • Transfer pricing rules and how this is applicable to both direct and indirect funding, and that this is inclusive of back-to-back funding and guarantee arrangements.
  • That SARS will consider the quantum of debt, the duration of the intra-group financing arrangement and other terms such as the interest rate, repayment terms etc. in determining whether the intra-group financing arrangement does in fact satisfy the arm’s length principle.
  • That there are no safe harbours with regard to ratio analyses.
  • The importance of distinguishing what constitutes debt and equity.
  • The substantive nature of an intra-group financing arrangement and whether a purported loan should be regarded as a loan as opposed to a contribution to equity capital.
  • The key commercial and financial relations in order to accurately delineate the intra-group 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 comparability analysis which involves the use of credit ratings, factors which 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 intra-group financing arrangements.
  • Guidance provided 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 to be faced by the South African resident taxpayer in the event that the level and cost of the intra-group debt is not at arm’s length i.e. primary, and secondary adjustments.
  • The importance of preparing and retaining the appropriate transfer pricing documentation which supports the taxpayer’s position regarding the arm’s length nature of the intra-group financing arrangement.
  • How SARS would treat this in relation to permanent establishments.  
  • The headquarter company exclusions and the ring-fencing of interest expenditure incurred on inbound intra-group financial arrangements.
  • Advance pricing agreements and that SARS may potentially make use of this on intra-group financial arrangements.
  • Withholding tax on interest and that this will not be affected by transfer pricing adjustments. 

Even though the Draft IN is welcomed and does in fact provide more clarity around intra-group financial arrangements, there are several key issues which still need to be addressed. The key issues identified are:

  • Debt and interest have not been defined.
  • All safe harbours in relation to intra-group financing arrangements have been removed which places an additional burden on the taxpayer with regard to support of the arm’s length nature of the intra-group financial arrangement.
  • The Draft IN seems to be moving 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 PE, 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 to ensure that an acceptable loan from an arm’s length perspective is not further limited.  
  • The Draft IN only refers to the OECD Guidelines. Even though the UN TP Model is aligned to the OECD Guidelines, there are some minor differences. It would be useful to understand if the taxpayer can make use the UN TP Model for additional support/analyses.

Overall, the Draft IN on intra-group financial arrangements does provide guidance to South African taxpayers, especially considering that this is now aligned with global guidance i.e. the OECD Guidelines. However, as mentioned, a number of key issues need to be addressed prior to the finalisation of this Draft IN, and we look forward to the feedback on our above concerns and recommended approaches, which SARS is yet to provide.

It can be complex to determine an arm’s length consideration for loans and interest. We recommend that taxpayers with such transactions seek professional advice to not fall foul of the transfer pricing rules that come into play for such transactions.

What are your thoughts?

This site uses Akismet to reduce spam. Learn how your comment data is processed.