The South African Revenue Service (SARS) released a note which provides guidance on applying a tax rule that ensures adequate tax is paid on loan agreements and various other cross-border transactions entered into by connected parties.
“How a taxpayer is financed is an important consideration when calculating their taxable income,” reads a post from law firm Cliffe Dekker Hofmeyr, explaining the interpretative note SARS released earlier this year.
When two parties with a pre-existing relationship enter into a loan agreement, they may agree to terms that are different from what two parties who don’t know each other would enter into.
For instance, SARS said that a South African taxpayer who is financed by debt from a connected party might result in excessive interest deductions, which reduces tax revenue because of interest exemptions.
This has tax consequences, as SARS stands to levy taxes on transactions where at least one of the parties is a tax resident or has a permanent establishment in the country.
SARS applies the “arm’s length” principle to levy fair taxes on loan agreements that are entered into based on a special agreement between parties with a pre-existing relationship.
The arm’s length principle allows SARS to treat loan agreements and other cross-border transactions entered into between connected persons as if they were entered into by completely independent parties.
Tests need to be applied to compare the transaction between connected parties to the terms agreed to in an agreement made under similar conditions between non-connected parties.
If the principle can correctly be applied, SARS would be able to deduct taxes based on the terms of an agreement entered into by non-connected parties rather than the actual terms of the agreement.
Cliffe Dekker Hofmeyr was clear that this note is not binding legislation but is rather an indicator of how SARS will interpret existing legislation when collecting tax.
They said that transfer pricing cases are sparse in South Africa.