Transfer Pricing
June 2012

Transfer pricing and thin capitalisation rules in terms of section 31 of Income Tax Act No. 58 of 1962 (ITA) have significantly changed for years of assessment commencing on or after 1 April 2012 under the Taxation Laws Amendment Act No 24 of 2011. In brief, any cross-border transaction between a resident and a non-resident who are connected persons in relation to each other, must pass the arm’s length test. As will be apparent from these comments, the consequences of not doing so are, at first blush, less severe than was the case under the previous version of section 31.

The two significant changes comprise-

1. the removal of the differentiation between transfer pricing and thin capitalisation in terms of the former sections 31(2) and 31(3) of the ITA and their respective Practice Notes 7 and 2.  Thin capitalisation is no longer mentioned as such in section 31; it is treated as a form of transfer pricing.;
2. the introduction of a new two part definition of “affected transaction”.  

Firstly, it is a transaction, operation, scheme, agreement or understanding that has been directly or indirectly entered into or effected between or for the benefit of either or both- 

1. a person that is a resident and any other person that is not a resident;
2. a person that is not a resident and any other person that is not a resident that has a permanent establishment in South Africa;
3. a person that is a resident and any other person that is a resident that has a permanent establishment outside South Africa; or 
4. a person that is not a resident and any other person that is a controlled foreign company in relation to any resident, and those persons are connected persons in relation to one another.

Secondly any term or condition of the transaction is different from a term or condition that would have existed had the parties been independent persons dealing at arm’s length.

Where a transaction qualifies as “affected”, it is vulnerable to adjustment by the Commissioner: SARS, but only if it results in a tax benefit for a party to the transaction. 

Where there is a tax benefit, then, to the extent that there is a difference between the amount charged between the parties and the arm’s length price, the amount of that difference is now deemed to be a loan which attracts a market-related interest.  This contrasts with the previous application of section 31 where the difference was treated as a deemed dividend. 

The definition of “connected person” has been expanded for purposes of section 31.  Normally, a company is a connected person in relation to another company if it holds at least 20% of the equity shares or voting rights in that company and no shareholder holds the majority voting rights in the company.  In applying section 31 the majority voting right leg of the test does not apply. 

The transfer pricing rules have been relaxed in certain circumstances for transactions involving headquarter companies.  Where a non-resident, which must of course be a connected person in relation to the headquarter company, provides financial assistance to the headquarter company, section 31 will not apply to the extent that the headquarter company applies the financial assistance to any foreign company in which the headquarter company directly or indirectly holds at least 10% of the equity shares and voting rights.  By the same token, section 31 will not apply to the second leg of the transaction, the onward financial assistance by the headquarter company to the other company. 

We expect guidance from SARS in the form of an Interpretation Note on various aspects of these changes to section 31.  Our expectations include clarifying:

• the meaning and implications of a tax benefit in the application of section 31; the implications and nature of the deemed loan representing the difference between the actual  price between the connected persons and an arm’s length price, especially regarding repayment of the deemed loan; 
• that a tax benefit only relates to the ITA and not to value-added tax or customs and excise duty, and what the implications are for a benefit that arises under the Value-Added Tax Act or the Customs and Excise Act; 
• and whether SARS will issue any so-called safe-harbour guide for the thin-capitalisation element of transfer pricing or acceptable interest coverage ratios or debt/EBITDA ratios to determine the arm’s length principle of debt to equity for financial assistance.

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