Arm’s length test to impact foreign shareholder loan funding

South African Revenue Service (SARS) is set to adopt the arm’s length test for thin capitalisation purposes as of 1 October 2011. The introduction of the arm’s length test will mean that the current 3-1 debt to equity ratio safe harbour currently provided by SARS will no longer be applicable. Instead, the test in respect of foreign loan funding will be based on the level of funding the borrower could have secured under the terms and conditions proposed, had the foreign shareholder and the local company been independent entities dealing at arm’s length.

According to Karen Miller, Director for International Tax Services at Ernst & Young, is that this will affect the way many organisations which form part of a multinational group are geared in terms of debt and equity. It also means that South African borrowers will need to proactively check whether they will be at risk in terms of the new rules.

“The arm’s length test forms the basis of certain articles within bilateral treaties governing double taxation between member countries within the Organisation for Economic Co-operation and Development (OECD). The new Income Tax measures will be bringing South Africa’s thin capitalisation and transfer pricing regulations in line with the OECD approach and with international precedent,” she says.

“Unfortunately, while the law will become effective as of 1 October, businesses and their advisors alike currently have not received any guidance around this issue. Arms length is defined as how much the borrowing entity could borrow if it were borrowing from an independent third party. Therefore, if the foreign related party loan terms, conditions and amount are substantively similar to the amount the company could borrow under the same terms and conditions from an independent party, it will pass the arm’s length test. Furthermore, the application of the arm’s length test is not restricted to the quantum of the loan but also the price at which the amount is lent.

Miller points out that the new legislation has created some uncertainty in the business world. She suggests that organisations be proactive in analysing intergroup lending arrangements, as the new law places more onus on the borrower. Should your company fail the arm’s length test, she continues, it is best to know about this now, rather than only discovering it in October, when it could already be a major problem.

“Effectively, businesses will need to alter their traditional mindset, and do so quickly. Reliance on the previous views and approaches is a risk that South African companies cannot afford to take. Doing so with thin capitalisation and continuing to think in terms of the 3-1 debt to equity ratio is only going to get you into trouble. You will need to forget that this is the way it was done, and focus on the new arm’s length principle.”

According to Miller, companies will therefore have to look carefully at their borrowing and study their finances in the same way that an independent lender would consider them. She says that this means they will need to be more circumspect about why they want to borrow money.

In deciding whether the arm’s length test is met, South African borrowers must undertake an assessment of the business on a stand-alone basis. The aim of this assessment is to demonstrate that the borrower could (and would) have borrowed to the extent that they have, and that they would have agreed the related interest rates, if they were an independent entity. It will include a qualitative analysis of the business, its particular characteristics and their effect on its borrowing capacity, and a quantitative exercise whereby the overall amount that could be borrowed at arm’s length, and the interest rate at which it is lent, is benchmarked.