New Draft Interpretation Note on Intra-group Financial Transactions brings welcome clarity

​SARS has released a new draft interpretation note that will help to clarify issues around intra-group loans, but several key issues still need to be addressed.

Debt is an important source of financing for investment. However, intra-group financial assistance can create opportunities for base erosion and profit shifting. Base erosion profit shifting (BEPS) refers to tax planning strategies used by multinational enterprises to "shift" profits from a higher-tax to a lower-tax jurisdiction, which results in loss for the tax base of the higher-tax jurisdiction.

This can be achieved by, inter alia.:

  • multinationals placing higher levels of third-party debt in high tax jurisdictions;
  • multinationals using related party financing to fund the generation of tax-exempt interest income; and
  • multinationals using related party loans to generate interest deductions in excess of the multinational's third-party interest expense.

BEPS has been a key area of interest for National Treasury and SARS, more so in recent years due to South Africa's slow economic growth and poor tax revenue collections. Before 2012, it was addressed through the thin capitalization rules in section 31(3) of the Income Tax Act.

In terms of these rules, a South African resident company in receipt of debt financing from a connected person would not be thinly capitalized, provided the total amount of connected party interest-bearing debt per investor did not exceed three times the level of fixed capital pertaining to that investor. In addition, the interest rate applied would not contravene the transfer pricing rules if the effective rate (after eliminating any excess loan funding) did not exceed the rates provided in Practice Note 2.

From 1 April 2012, section 31 was overhauled, resulting in section 31(3) and Practice Note 2 (i.e. the previous South African thin capitalisation provisions), being repealed. Under the new rules, any debt financing received by a South African resident taxpayer from a foreign connected party constitutes a transaction that is subject to the general transfer pricing rules. This involves a two-step analysis of the funding transaction concerned: Firstly, that the quantum of the debt should adhere to the arm’s length principle; and secondly, that the interest rate applied should also adhere to the arm’s length principle.

In 2013, a draft interpretation note was released by SARS providing guidance on how it would expect a South African taxpayer to confirm the arm's length nature of an intra-group financial transaction. In testing the arm's length nature of the debt and the interest rate, the 2013 draft interpretation note advocated a Debt to EBITDA ratio of 3:1 and a risk harbour rate not exceeding JIBAR plus 2% for ZAR denominated debt, or for foreign debt, the weighted average of the base rate of the country of denomination plus 2%, respectively.

SARS advised that its guidance on the application of the transfer pricing rules to inbound debt, both in terms of the quantum and the interest rate, would not be finalised until the Organisation for Economic Cooperation and Development (OECD)'s working group on the transfer pricing of financial transactions was released. The resulting uncertainty placed an undue compliance burden on taxpayers.

The OECD released its transfer pricing guidance on financial transactions in 2020 and incorporated them in its Transfer Pricing Guidelines for Multinational Enterprises and Tax Administration in January 2022 (the OECD Guidelines).

National Treasury released its discussion paper entitled 'Reviewing the Tax Treatment of Excessive Debt Financing, Interest Deductions and Other Financial Payments' on 26 February 2020. In this paper, it recognised that South Africa has a high corporate income tax rate in comparison to the global average and that taxpayers may engage in schemes or arrangements that will minimise their tax liabilities by placing most of their debt funding in high-tax jurisdictions (such as South Africa) to get the interest deduction. Consequently, after receiving comments on National Treasury's paper, government proposes to expand the scope of the current interest limitation rules and to limit the net interest expense deductions to 30% of earnings in respect of intra-group debt.

Considering this, on 11 February 2022, SARS released for comment its new Draft Interpretation Note on the Determination of the Taxable Income of Certain Person from International Transactions: Intra-Group Loans. In terms of the new draft interpretation note, SARS has confirmed that the pricing of an intra-group loan will be considered arm's length if it adheres to the arm's length principle in the OECD Guidelines. The OECD Guidelines requires a comparison of the conditions in a controlled transaction with the conditions that would have been laid down if the parties been independent and had undertaken a comparable transaction under comparable circumstances from both a lender's and borrower's perspective. It also clarifies that the impact of the section 23M and section 23N limitations on the deductibility of interest may only be considered after the transfer pricing rules have been applied in testing the arm's length nature of the intra-group financial transaction.

Other key takeaways from the 2022 draft interpretation note are that it:

  • Discusses the application of the transfer pricing rules to a broad range of both direct and indirect funding arrangements, including back-to-back financial arrangements with banks and other financial institutions and guarantees.
  • Gives some welcome context on how SARS will apply the "associated enterprise" definition.
  • Confirms that, in assessing whether a taxpayer's debt is arm's length, SARS will not only consider the quantum of the debt and the rate of interest, but also the duration of the debt arrangement.
  • Revisits the substantive nature of the arrangement and provides guidance on when a purported loan is regarded as a loan, as opposed to a contribution to equity capital.
  • Addresses key commercial and financial comparability factors, such as the groups' funding strategy and factors affecting the performance of businesses in the relevant industry sectors and the financial resources that are realistically available to the parties.
  • Gives guidance on approaching the comparability analysis, including the use of credit ratings, and the use of publicly available information to determine credit ratings, factors impacting credit ratings such as incidental benefits of being part of a group, covenants and guarantees in existence.
  • Gives guidance on the issue of loan fees and charges.
  • Gives alternatives on how to apply the arm's length principle in the absence of comparable uncontrolled transactions.
  • Discusses the methodology for determining risk-free and risk-adjusted rates of return.
  • Summarises the tax consequences of the level and cost of an intra-group debt not being arm's length.
  • Reiterates the importance of retaining appropriate documents that support the taxpayer's view that the intra-group debt is arm's length.
  • Confirms that SARS will apply the arm's length principle to affected transactions involving permanent establishments as if they are separate enterprises.
  • Discusses the headquarter company exclusions and the limitation on interest deductions by a headquarter company on financial assistance granted to it by a non-resident.
  • Notes that SARS is considering the use of advance pricing agreements on intra-group cross-border debt.
  • Confirms that the withholding tax on interest calculation will not be affected by any transfer pricing adjustments.

Key issues identified:

  • ​Most notable is that the 2022 draft interpretation note has removed all safe harbour and risk harbour provisions. And has instead placed the main burden on proving that the arrangement is arm's length. Without a de minimus rule, this will not only create an undue compliance burden for taxpayers, but also a difficult administrative task for SARS' auditors.
  • The 2022 draft interpretation note states that bank opinions or quotes do not form comparable support. The reasons presented are: (i) the approach represents a departure from an arm's length approach based on comparability because it is not based on comparison of actual transactions; and (ii) term sheets do not constitute formal loan offers. Although we understand SARS' concerns, we maintain there is merit in using such data as term sheets attest to a third-party lender's willingness to provide a certain level of debt under the same terms and conditions as the funding arrangement concerned. It therefore serves as proof of what an independent party would be willing to accept and should accordingly be considered comparable to satisfy the arm's length principle.
  • The 2022 draft interpretation note requires the transfer pricing analysis of the intra-group debt to be done at the time that the debt is given, which was expected. But then also requires the appropriateness of the level and cost of the debt to be re-assessed from "time to time". No standardised frequency of time is given for the reassessment. All that the draft states is that the frequency and timing will depend on the nature of the taxpayer's business and the amount of change and variability that it experiences. We agree that the ongoing assessment is in line with the principle of arm's length testing. However, the OECD advocates for a reassessment to be done every three years – would this be acceptable? For debt akin to an overdraft, the draft interpretation note suggests a reassessment several times a year – is this practical?? For financial assistance that is available for draw-down over time, the draft interpretation note states that the amount actually drawn down and the amount which may still be drawn down are equally important — is SARS suggesting an assessment at each draw down? – If so, this will create an insensible and unbusinesslike burden for taxpayers.

In our view, the 2022 draft interpretation note on intra-group financial transactions provides clearer guidance to South African taxpayers on how to determine and demonstrate the arm's length nature of inbound debt (which notably, effectively aligns with the OECD's global guidance and principles) and the deductibility of interest payments in respect thereof. However, several key issues need to be addressed before finalising the interpretation note.

Comments on the new draft interpretation note are due by 29 April 2022.


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Webber Wentzel > News > New Draft Interpretation Note on Intra-group Financial Transactions brings welcome clarity
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