Companies are funded (“capitalised”) in two ways, namely through a mixture of debt and equity. In certain instances, interest payments incurred in the production of income are deductible for tax purposes, while distributions in the form of dividends are not tax deductible. The way in which a company is structured, ie the company’s debt to equity ratio, can therefore raise tax concerns from the South African Revenue Services’ (“SARS”) point of view. The effect of this is that SARS may contend that too much interest is being claimed as an income deduction.
Thin capitalisation refers to situations wherein a company is financed through a relatively high level of debt compared to equity. Thinly capitalised companies are perhaps more often referred to as being “highly leveraged” or “highly geared”.
The way in which a company is capitalised will often have a significant impact on the amount of profit the company reports for tax purposes. Countries’ tax rules typically allow for a deduction for interest paid or payable, in arriving at the tax measure of profit. The higher the level of debt in a company, and thus amount of interest it pays, the lower its taxable profit will be. It is for this particular reason that debt, rather than equity, is often the more tax efficient method of finance.
Multinational entities are often able to structure their financing arrangements to such an extent that these entities can maximise the benefits of profit erosion, thereby reducing the overall tax liability. Not only are these multinational entities able to establish a tax-efficient mixture of debt and equity in borrowing countries, they are also able to influence the tax treatment of the lender which receives the interest. For example, the arrangement may be structured in such a way that allows the interest to be received in a jurisdiction that either does not tax the interest income, or which subjects such interest to a comparatively low tax rate.
In terms of the South African Income Tax Act No. 58 of 1962 transfer pricing rules, taxpayers must determine an acceptable amount of debt on an arms-length basis. Taxpayers are therefore required to determine whether the actual terms and conditions of the transaction differ from the terms and conditions that would have existed if the parties had been independent persons dealing at arms-length.
Based on the tests performed, if it is found that a portion of debt in a company is capitalised on a non-arms-length basis then an adjustment must be made. For example, a primary adjustment would see the disallowance of interest on both the excessive portion of any funding as well as interest rates in excess of an arm’s length rate. Non-arms-length interest is not deductible and is subject to secondary tax treatment as deemed dividends.
Taxpayers must be able to substantiate their view of the extent to which the connected party debt is considered to be arm’s length and accordingly must retain appropriate documentation.