Tax Alert - Draft IN Thin Cap current version

1 Tax Alert25 March 2013 This Tax Alert is provided by PricewaterhouseCoopers Tax Services (Pty) Ltd for information only, and does not constitute theprovision of professional advice of any kind. The information provided herein should not be used as a substitute for consultation withprofessional advisers. Before making any decision or taking any action, you should consult a professional adviser who has beenprovided with all the pertinent facts relevant to your particular situation. No responsibility for loss occasioned to any person acting orrefraining from acting as a result of using the information in the Tax Alert can be accepted by PricewaterhouseCoopers Tax Services(Pty) Ltd, PricewaterhouseCoopers Inc or any of the directors, partners, employees, sub-contractors or agents ofPricewaterhouseCoopers Tax Services (Pty) Ltd, PricewaterhouseCoopers Inc or any other PwC entity. 2013 PricewaterhouseCoopers ( PwC ), a South African firm, PwC is part of the PricewaterhouseCoopers International Limited( PwCIL ) network that consists of separate and independent legal entities that do not act as agents of PwCIL or any other memberfirm, nor is PwCIL or the separate firms responsible or liable for the acts or omissions of each other in any way.

2 No portion of thisdocument may be reproduced by any process without the written permission of releases Draft interpretation Note on ThinCapitalisation for commentOn 22 March 2013 SARS issued the long awaited updated guidance on the thincapitalisation provisions of the Income Tax Act. The significant features of theInterpretation Note are summarised s length basisThe transfer pricing and thincapitalisation provisions in section 31of the Income Tax Act were amendedwith effect for years of assessmentcommencing on or after 1 April , the thin capitalisationprovision previously contained insection 31(3) was removed and is nowdealt with as a purely transfer pricinganalysis, that is, financial assistance issubject to the arm s length the extent that the financialassistance (in terms of the amount ofthe debt and/or the interest rate) isnot arm s length, a primary transferpricing adjustment, in the form of adisallowance of interest deductions,and secondary adjustment, in theform of a deemed loan, will will require taxpayers toconsider the transaction from theperspective of the lender and theborrower.

3 From the lender, whether theamount could have beenborrowed at arm s length and from the borrower, whether theamount would have beenborrowed at arm s to the Draft interpretationnote, the arm s length amount of thedebt is the lesser of the amount thatcould have been borrowed and theamount that would have beenborrowed in a transaction betweenparties dealing at arm s Note 2 of 1996 (and the 3:1debt to equity safe harbour) areproposed to be withdrawn for years ofassessment commencing on or after1 April analysisA functional analysis will be requiredto support the appropriateness of thetaxpayer s arm s length Draft note lists the followingitems that should be taken intoaccount (the list is not exhaustive): The funding structure andrationale of the funding; The business and plans of theprincipal trading operations; The financial strategy of thebusiness; The companies in the groupstructure which are affected byor involved in the fundingtransactions; current and projected financialposition; Appropriate financial ratios; Indicators of creditworthiness; The availability and quality ofsecurity; Whether the claims aresubordinate to other claims.

4 Terms and conditions of thefunding analysisTaxpayers will also be required toconsider comparable data taking intoaccount the quantitative andqualitative factors that third partylenders would consider when makinglending is currently investigating theavailability of a third-party SouthAfrican focused database to assistwith the assessment of theappropriateness of a taxpayer scomparable data and the arm s lengthamount of equity characterisationSARS considers economic substanceas important in determining the debtor equity nature of an would therefore also includeitems that are economicallyequivalent to debt such as financeleases, certain structured derivativefinancial instruments andcomponents of hybrid of 3 Clarification on the secondaryadjustmentThe application of the secondaryadjustment in section 31(3) is clarifiedto an extent. The secondaryadjustment mechanism operates bydeeming the primary adjustment tobe a deemed loan by the taxpayer tothe connected party.

5 Deemed interesttherefore accrues to the clarification, the note providesthat the deemed interest accrued foreach year of assessment must becapitalised annually for the purposesof calculating the deemed loanoutstanding. The deemed loan andthe interest outstanding on it will bedeemed to be payable until theamount is regarded as being AssessmentRisk-based audit approachSARS adopts a risk-based auditapproach in selecting potential thincapitalisation cases for audit. Inselecting cases, SARS will considertransactions in which theDebt:EBITDA ratio of the SouthAfrican taxpayer exceeds 3:1 to be ofgreater is stressed that this isnota safe will consider a taxpayer to bethinly capitalised if,inter alia, someor all of the following circumstancesexist: The taxpayer is carrying a greaterquantity of interest-bearing debtthan it could sustain on its own; The duration of the lending isgreater than would be the case atarm s length; The repayment or other terms arenot what would have beenentered into or agreed to at arm s length interest rateFrom an audit risk perspective, SARS will consider interest on the followinginbound loans to be of higher risk: Rand denominated debt:A rate exceeding the weightedaverage of the South AfricanJohannesburg Interbank AgreedRate (JIBAR) +2%.

6 Foreign currency denominateddebt:A rate exceeding the weightedaverage of the base rate of thecountry of denomination +2%.Although these are similar to theprevious safe harbour interest rates, itis stressed that these are not guidelinesSARS considers that taxpayers shouldretain the following documentation tosupport their capitalisation position: A description of the fundingstructure, including the dates oftransactions, the source of thefunds, reasons for obtaining thefunds, how the funds are appliedand the repayment terms; A description of the business andthe plans of the principal tradingoperations; Copies of relevant fundingagreements and other relevantdocuments; An analysis of the financialstrategy of the business; A group structure covering allrelevant companies and changesto the structure taking place overthe course of the fundingtransactions; Copies of the financial statementsor management accounts justbefore the point in time thefunding is obtained and after thefunding transactions.

7 A summary of financial forecastswhich are contemporaneous withthe funding transactions inquestion; An analysis supporting theborrower s view of the extent towhich the connected party (orsupported) debt is considered tobe arm s establishmentsAlthough the Draft interpretation notesupports the application of the arm slength basis as per the OECD transferpricing guidelines, and despite SouthAfrica s enhanced engagement statuswith the OECD, South Africa hasreserved the right to use version 7 ofthe OECD Model Tax Convention (theversion that stood immediately priorto the July 2010 update) and thecommentary as it stood at that , when attributing profitsto a permanent establishment,notional charges or expenses will notbe of 3 Deadline for submissionsComment on the draftinterpretation note is due by30 June 2013. PwC will besubmitting comments andproposals to SARS by this date. Ifyou wish to participate in theprocess, please feel free to contactone of the persons more information, pleasecall any of the contacts below:Cape Town:David Lermer + 27 21 529 Espost +27 21 529 Dunne + 27 21 529 Badenhorst +27 11 797 Els + 27 11 287 Ndlovu +27 11 797