Tax treatment of excessive debt financing under review

The reason for this proposal lies in the fact that multinational enterprise groups (MNE groups) with operations in SA often choose to fund their SA entities by way of interest-bearing debt (as opposed to equity), allowing the funded entities to deduct the related interest expenditure when determining their taxable income, provided the relevant requirements have been met. Debt funding can create opportunities for base erosion and profit shifting (BEPS), given that MNE groups can minimise their tax liabilities by placing the majority of interest-bearing debt in countries with higher corporate tax rates relative to others, such as SA.

This is not a new issue for SA. Thin capitalisation rules, providing for a safe harbour of a 3:1 debt-to-equity ratio to determine excessive debt, were already introduced in 1995, in an attempt to curb the use of excessive debt in relation to equity.

There has, however, been heightened interest in the topic since the G20 Finance Ministers called on the Organisation for Economic Co-operation and Development (OECD) to find solutions to BEPS.

Apart from the thin capitalisation rules, SA has introduced several other tax policies over the past 25 years to prevent the erosion of its tax base by way of excessive interest deductions. These include amendments to the transfer pricing anti-avoidance legislation (section 31 of the Income Tax Act), Practice Note 2, a draft interpretation note in 2013, interest withholding tax and other legislation specifically aimed at limiting interest deductions such as sections 23N and 23M of the Income Tax Act.

Inbound interest-bearing debt funding from associated enterprises currently falls within the ambit of the SA transfer pricing rules. Although there has been uncertainty as to whether the thin capitalisation rules continued to apply since the introduction of transfer pricing, the Discussion Document confirms that these rules have in fact been repealed, with only the consideration under section 31 of the Income Tax Act applying from 1 April 2012. This section comes down to whether the terms and conditions of the funding, including the quantum of funding and interest charged, differ from that which independent parties dealing at arm’s length would have agreed upon.

From an African perspective, Botswana has led the way by implementing the OECD’s recommendations through restricting net interest deductions by entities forming part of MNE groups to 30 per cent of EBITDA. Botswana allows interest expenses which cannot be deducted in a particular year to be carried forward for a period of 3 years in the case of general companies, and for a period of 10 years in the case of mining companies.

Where any such difference results or will result in a tax benefit for one of the parties, the necessary transfer pricing adjustment will have to be made.

Section 23M was introduced with effect from 1 January 2015 which serves to limit interest deductions by way of a prescribed formula in instances, including where the related interest is not subject to tax in South Africa, and the existence of a controlling relationship between the creditor and debtor exists.

The OECD/G20 BEPS Project considered the rules which countries have in place to limit excessive debt or interest deductions. It concluded that the best means of addressing tax base erosion is to limit net interest deductions to a fixed percentage of between 10 and 30 per cent of earnings before interest, tax, depreciation and amortisation (EBITDA) and to apply this rule to all entities within a MNE group as a minimum. Most European Union countries have implemented the OECD recommendations already, or are in the process of doing so.

Government consequently proposes to implement the OECD’s recommendations by restricting net interest deductions to 30 per cent of EBITDA for years of assessment commencing on or after 1 January 2021.

In terms of the Discussion Document, it is proposed that the new rules apply to total (external and connected) net interest expenses and equivalent payments to all entities operating in SA that form part of a foreign or SA MNE group. The Discussion Document also proposes that taxpayers be allowed to carry forward disallowed interest deduction amounts for 5 years on an annual first-in-first-out basis. It also tentatively proposes that a de minimis rule be included to exempt entities with net interest expenses between ZAR 2 million and ZAR 5 million from applying the 30% rule.

As an example, a company with an EBITDA of ZAR 20 million and an interest expense of ZAR 10 million in one year, will only be allowed to deduct ZAR 6 million as a tax-deductible expense in that year (being 30% of EBITDA), with the disallowed portion of ZAR 4 million being carried forward to the next year. The ZAR 4 million would again be subject to the 30% rule in the following year. In terms of the proposed de minimus rule, a company with a net interest expense of ZAR 3 million in a particular year would be allowed to deduct the full expense in that year, and would not be subject to the 30% limitation.

The interplay between the existing and the proposed new rules will have to be considered in much more detail before the new rules are implemented, specifically given the proposal by Government that these rules should replace section 23M. The proposal furthermore makes it clear that the new rules will not be replacing the application of the transfer pricing rules in respect of inbound loans, and that the new interest limitation rules will have to be applied to those net interest expenses which have already passed the arm’s length test.

Government also recognises the uncertainty that prevailed regarding the application of previous safe harbour rules, and agrees that a safe harbour is needed to provide taxpayers with certainty in respect of whether the arm’s length principle also has to be applied in respect of the quantum of finance provided.

Government concludes that replacing the existing rules (specifically section 23M) will provide a more uniform approach to all interest payments flowing out of the country, regardless of which country the loan emanates from, which may enhance the level of protection of SA’s tax base. Although this seems to be a noble intention, and although any guidance in this regard is welcomed, the interplay between the new and existing rules, the transitional measures which are to be considered for existing third-party loans when doing away with section 23M and the appropriate safe harbour will have to be properly considered and addressed in order to avoid any further uncertainty on this topic going forward.

Government invites comments in respect of the proposed changes, including views on the appropriate safe harbour to apply in respect of transfer pricing, by 17 April 2020.

Author: MALAN DU TOIT, Tax Consultant: Transfer Pricing malan.dutoit@mazars.co.za