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South Africa: Thin Cap Rules and Back-to-Back Arrangements
By
Adeline Hansen, KPMG Services (Proprietary) Ltd., South Africa
Background
As typically defined in other jurisdictions, thin capitalisation (“thin cap”) refers to the scenario when a South African resident is funded by a foreign investor with a disproportionate degree of debt to equity.
Dividends are usually declared out of post-tax profits, while interest paid is usually tax deductible in the hands of the South African company (therefore not subject to secondary tax on companies or corporate tax). This creates a situation in which it could be more advantageous for foreign investors to make loans to South African subsidiaries, than to inject more capital into the country. The foreign investor would receive interest income that would be exempt from tax in South Africa (provided the exemption requirements are satisfied), while the borrower would receive the tax advantage of the deducibility of the interest.
If left unchecked, this scenario could result in an erosion of the South African tax base.
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Practice Note on Back-to-Back Arrangements
To address the possible erosion of the South African tax base, the thin cap rules were introduced. Section 31(3) of the Income Tax Act No.58 of 1962, which contains the thin cap provisions, applies to financial assistance granted “directly or indirectly” to certain South African tax residents.
The question arises as to what is meant by “indirect financial assistance”. More guidance regarding section 31(3) of the Income Tax Act is provided in paragraph 8 of South African Revenue Service’s Practice Note No 2, which states that indirect financial assistance includes back-to-back arrangements through independent parties or co-investors.
A loan to a South African resident will be regarded as indirect financial assistance when the foreign investor makes a loan to a foreign bank, or any other person, on condition that that bank or person on-lends the funds to the South African resident.
Indirect financial assistance also includes arrangements when the foreign investor provides a guarantee to a nonresident as security for a loan to its resident connected person. Indirect financial assistance specifically excludes the scenario in which a foreign investor provides a guarantee to a South African bank as security for a loan to the resident subsidiary. This is because the foreign investor will not receive any interest, and the lender will be taxed on the interest received from the borrower.
While the scenarios addressed in the Practice Note No 2 seem reasonable, the inclusion of the term “indirect” in the law does result in some uncertainty when a foreign investor owns multiple layers of South African companies and routes all funding via the South African holding company. This is because on a strict reading of section 31(3) of the Income Tax Act, it appears that when a foreign investor (ForeignCo) holds 100% of the shares in a South African resident company (Holdco) which in turn holds 100% of the shares in another South African company (Opco), and ForeignCo lends funds to Holdco on condition that Holdco on-lends those funds to Opco, the loan to Opco could constitute indirect financial assistance in terms of section 31(3) of the Act.
Depicted diagrammatically, this can be explained as follows:
At Holdco level, Holdco would receive an interest deduction for the interest paid to ForeignCo, while ForeignCo would be exempt from tax on the interest received from Holdco (assuming ForeignCo qualifies for the exemption). The thin cap rules would be applied in this case—given that this is the scenario which the thin cap rules have been specifically formulated to address.
At Opco level, Opco would (presumably) deduct the interest paid to Holdco, when Holdco would be taxed on the interest received from Opco. It would therefore appear that at Opco level, there would be no erosion of the South African tax base and therefore the thin cap provisions ought not apply.
KPMG Observation
As discussed above, based on a literal reading of section 31(3) of the Act, the thin cap position at Opco level would also be tested. Officials with the South African Revenue Service informally have indicated that Opco’s thin cap position would be tested.
On the understanding that the intention of introducing the thin cap provisions was to prevent an erosion of the South African tax base, it would appear that these provisions would not apply to the Opco level. Observers believe that more formal guidance and clarity from the tax authorities is warranted on the application of the law. In the absence of further guidance and on a strict reading of the Income Tax Act, many South African resident companies with foreign ultimate holding companies may be thinly capitalised without being aware of it, as the more common understanding is that the tax authorities will look at the thin cap position at Holdco level only, given that this is the level where the erosion of the South African tax base occurs could occur. However, until clarity is provided, prudent South African companies that have received indirect financial assistance from foreign connected persons would test the thin cap position at all levels.
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For more information, contact a KPMG tax professional in South Africa:
Adeline Hansen, +27 11 647 8830, Adeline.hansen@kpmg.co.za
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