Thin capitalisation: out with the old

2011-05-26 00:00

THIN capitalisation relates to the funding of a company with a disproportionate amount of debt as opposed to equity.

This provides the foreign investor with interest income, while providing a deduction of interest for the company paying the interest on the debt.

The current thin capitalisation rules are applied to limit the deductibility of interest on the excessive debt funds to protect the South African economy against highly geared foreign investments in South African resident companies.

The current thin capitalisation provisions apply a debt-to-equity ratio of 3:1 when a non-resident grants interest-bearing financial assistance to any connected person who is a tax resident. When the South African Revenue Service (SARS) believes that the value of the aggregate value of financial assistance is excessive in relation to the fixed capital (share capital, share premium and accumulated profits), a portion of the interest will be disallowed as a deduction for income tax purposes.

Furthermore, the amount disallowed will be deemed to be a dividend subject to secondary tax on companies (STC).

With effect from years of assessment commencing on or after October 1, 2011, SARS is to adopt a new arm’s-length test for the purposes of thin capitalisation.

This means that the current 3:1 debt to equity ratio safe harbour will fall away and will be replaced with the arm’s-length test.

In terms of the new regime, the test, with regard to foreign loan funding, will be based on the level of finance the borrower could have secured under the same terms and conditions had the borrower (the local company) and the lender (the foreign company) been independent parties dealing at arm’s length, and, whether as a result of the transaction, a tax benefit is derived by the parties to the transaction.

The intent is to limit the deductible interest incurred in a transaction between independent parties dealing at arm’s length.

Furthermore, the new test does not make reference to the value of the financial assistance being excessive in relation to the fixed capital.

While the change has benefits, SARS has provided little guidance in its application. In the absence of guidance the following principles may be applied to test whether the company is thinly capitalised:

•Determine the amount the company would have been able to borrow from an independent lender.

•Compare this to the amounts actually borrowed from the foreign connected party.

•Compare the interest payable on the actual debt to the interest that would have been paid under a third-party arrangement.

The allowable deduction would be the interest payable under the third party arrangement.

Companies should be proactive in analysing intra-group lending arrangements, especially since the new law places a greater responsibility on the borrower.

Borrowing companies are warned to study their borrowings and finances carefully in the same way that they would if the funds had been borrowed from an independent third party.

For more information, call ­KPMG at 033 347 7600. - Giselle Nursoo, Tax Consultant

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