Taming thin capitalisation

Ernest Lai King, director and head of Deneys Reitz Tax Services, navigates South Africa’s thin capitalisation tax laws.

South Africa’s economy expanded by approximately five per cent in the 2005/6 budget year and is expected to grow even further in the period ahead. Revenue collection for the past budget year was an unprecedented R41bn more than expected, resulting in a budget deficit of only 0.5 per cent of gross domestic product. A commonly held opinion is that the South African economy and business confidence, through prudent fiscal and monetary policy, has never been stronger. Foreign direct investment into South Africa is growing, assisted by the country’s extensive double-tax treaty network, and investors are advised to research certain aspects of doing business in South Africa, including the country’s labour laws, exchange control regulations and income tax laws. This article gives a brief overview of the thin capitalisation tax laws applicable to a foreign company (Offco) investing into South Africa via a South African holding company (SAco).

The regulation of international transfer pricing between multinational group companies is a global tax issue and South Africa followed international practice by introducing anti-avoidance measures in 1995 to counter thin capitalisation practices detrimental to its tax base. Two main tax reasons exist for Offco to capitalise SAco with excessive debt as opposed to equity capital. First, the interest payable by SAco to Offco may be deductible for South African tax purposes and, on payment, is not subject to any withholding tax. Second, although South Africa does not have a withholding tax on dividends to foreign shareholders, a corporate tax known as the Secondary Tax on Companies (STC) is levied at a rate of 12.5 per cent on dividends declared by a South African company. So it is clear that Offco would prefer to expatriate profits from South Africa in the form of interest rather than dividends.

The thin capitalisation provisions are contained in section 31(3) of the South African Income Tax Act and apply to “financial assistance”, as defined, granted directly or indirectly by a non-resident to a South African company, where the non-resident investor is entitled to participate in not less than 25 per cent of the dividends, profits or capital or is entitled directly or indirectly to exercise not less than 25 per cent of the votes of the South African company. The thin capitalisation provisions limit the deductibility of interest, for South African tax purposes, where there is an excessively disproportionate ratio between loan capital and equity capital introduced into the South African company. Furthermore, notwithstanding the fact that the debt to equity ratio is acceptable, the provisions will apply to any rate of interest levied on the foreign loan which is deemed excessive.

South Africa’s thin capitalisation rules therefore apply a two-step test. First, they test whether the debt to equity ratio exceeds a certain prescribed ratio and, second, whether the interest levied on the loan exceeds a specified rate. As a general guideline the South African Revenue Service (SARS) will accept a financial assistance to fixed capital ratio of up to 3:1. Fixed capital is determined by the aggregate of a) share capital, b) share premium and c) accumulated profits, and is calculated at the end of the relevant year of assessment. Annual net trading losses, sustained during the current and immediately preceding two years of assessment, may be added back to fixed capital. Deferred tax, as determined for accounting purposes, is excluded from fixed capital.

Where a taxpayer can justify financial assistance in excess of the 3:1 ‘safe harbour’ ratio due to particular or special circumstances, SARS has discretion not to apply the thin capitalisation provisions. Their discretion will generally be applied where the excessive debt to equity ratio is only of a temporary nature and a period is specified within which the 3:1 ratio will be restored. Regarding the interest rate, where a foreign loan is denominated in South African rand, an interest rate not exceeding the weighted average of the South African prime rate plus two percentage points will be accepted as an arm’s length interest rate. Where the loan is denominated in a foreign currency, a rate not exceeding the weighted average of the relevant inter-bank rate plus two percentage points will be an acceptable annual interest rate.

A successful application of the thin capitalisation rules will cause the ‘excessive interest’ to be disallowed for South African income tax purposes and deemed to be a dividend declared by the company, which will be subject to the 12.5 per cent STC. A double penalty is therefore imposed.

Detailed advice is available on this and all other aspects of foreign investment into South Africa’s strong economy and stable political system.