TRANSFER PRICING: INTEREST ON SHAREHOLDER LOANS AND RELATED MATTERS
This is a recording that was delivered on TRM Hivemind by Mr Renier van Rensburg.
Below find the video as well as a summary of the discussion:
Transfer pricing is a critical aspect of international taxation, and one area that often raises concerns is the treatment of interest on shareholder loans and related matters. This blog post aims to provide a comprehensive overview of this topic, drawing insights from a document published on the Tax Risk Management website and a complementary video resource.
Understanding Shareholder Loans
Shareholder loans are financial arrangements where a company receives funds from its shareholders, typically in the form of debt. These loans can have significant tax implications, particularly when they involve cross-border transactions between related parties.
Transfer Pricing Considerations
Transfer pricing refers to the pricing of transactions between related parties, such as a parent company and its subsidiaries or between two subsidiaries of the same parent company. When it comes to shareholder loans, transfer pricing rules dictate that the interest rate charged on these loans should be at arm’s length, meaning it should be consistent with the rate that would be charged between unrelated parties in similar circumstances.
Arm’s Length Principle
The arm’s length principle is a fundamental concept in transfer pricing. It ensures that transactions between related parties are priced as if they were conducted between independent entities, preventing the artificial shifting of profits to low-tax jurisdictions. Failure to comply with the arm’s length principle can result in tax adjustments and potential penalties.
Determining Arm’s Length Interest Rates
Determining the appropriate arm’s length interest rate for shareholder loans can be a complex process. It involves considering various factors, such as the creditworthiness of the borrower, the currency of the loan, the term of the loan, and the prevailing market conditions. Tax authorities often provide guidance on acceptable methods for determining arm’s length interest rates, such as the use of comparable uncontrolled prices (CUPs) or the application of credit rating models.
Thin Capitalization Rules
In addition to transfer pricing considerations, many countries have implemented thin capitalization rules to limit the deductibility of interest expenses on shareholder loans. These rules aim to prevent excessive debt financing and ensure that companies maintain an appropriate debt-to-equity ratio. Failure to comply with thin capitalization rules can result in the disallowance of interest deductions, leading to increased tax liabilities.
Documentation and Compliance
Proper documentation and compliance with transfer pricing regulations are crucial when it comes to shareholder loans. Companies must maintain comprehensive records and be prepared to justify the arm’s length nature of their interest rates and related transactions. This may involve conducting benchmarking studies, preparing transfer pricing reports, and maintaining contemporaneous documentation.
Practical Considerations from the Video Resource
The video resource provided by Tax Risk Management offers additional insights and practical considerations regarding transfer pricing interest on shareholder loans. It highlights the importance of proactive tax planning, regular monitoring of transfer pricing policies, and the potential consequences of non-compliance, such as double taxation and penalties.
How Tax Risk Management Can Assist
Prof Dr Daniel N Erasmus and his team at Tax Risk Management are well-equipped to assist companies in navigating the complexities of transfer pricing interest on shareholder loans and related matters. With their extensive expertise in international taxation and transfer pricing, they can provide tailored solutions, conduct thorough analyses, and ensure compliance with relevant regulations.
TRANSCRIPT OF RECORDING
This is a short recording on transfer pricing and interest on shield loans and related matters, with a specific focus on Africa. The idea of this discussion is to raise a few points on certain issues that have come up in recent matters and tax inquiries from revenue authorities in certain parts of Africa. This discussion is not South African-related; it specifically concerns other African countries. The reason for this is that South Africa has a sophisticated level of tax regulation, specifically focusing on transfer pricing. However, many other countries in Africa are starting to catch up and get up to speed with certain principles laid out in the OECD transfer pricing guidelines.
I thought it appropriate to start with one or two specific issues that have come up over the years. Firstly, I would like to refer to the January 2022 OECD transfer pricing guidelines for multinational enterprises and tax administrations. A new section has been introduced, Chapter Ten (Chapter X), which addresses transfer pricing aspects of financial transactions. In that section, under paragraph B, there is a specific reference to the interaction with the guidance in Section D1 of Chapter One, which deals with some basic principles of transfer pricing. It discusses the determination of whether a purported loan should be regarded as a loan. Then, it goes into B2, identifying the commercial or financial relations, and B3, which covers the economically relevant characteristics of financial transactions.
Under Section B3, there are a few headings. I’ll read the introductory part and mention one or two specific headings. Paragraph 10.21 emphasizes that the economically relevant characteristics should be considered to inform an analysis of the terms and conditions of a financial transaction as part of accurately delineating the actual transaction or seeking to price the accurately delineated actual transaction. The first characteristic mentioned is the contractual terms. This is important because it ensures that the agreed terms between Party A and Party B are commercial. In transfer pricing, the transaction should be stated, delineated, and priced as it would be between two unrelated or unconnected parties.
The second point is the functional analysis. The OECD guidelines go into detail about what needs to be done in a functional analysis. It’s crucial to understand these various points, as referenced in sections C11 and C112, which deal with credit ratings, the borrower’s economic circumstances, and the lender’s economic circumstances. Paragraph B33 discusses the characteristics of financial instruments, which also need to be understood, along with the economic circumstances under which the loans are entered into. It rounds off with a reference to business strategies, a recurring theme in the guidelines. All these aspects form an important part of understanding the transfer pricing of financial transactions.
Now, back to the topic at hand, where we refer to one or two aspects of shield loans. Over the last few years, I have been involved in matters in several countries. In one case, the revenue authority questioned the interest rate levied on a shield loan, claiming it was not at arm’s length, even though it was between two related parties. During the administrative and technical analysis, the matter ended up in court. The revenue authority could not defend its position, and the court found that the client’s interest rate was satisfactory. The court focused on the process followed rather than the merits of the rate itself. This emphasizes the importance of adhering to the OECD transfer pricing guidelines in dealing with shield loans.
In a separate matter, which started from a capital gains assessment, the revenue authority later questioned the interest rate. The client produced evidence, including government bond rates and secure debt positions with non-related parties, which the revenue authority is still considering.
Both cases highlight that revenue authorities question interest rates and the actual interest levied. Indirect taxes, like withholding tax, also play a role in how interest is allocated and calculated. Therefore, it’s crucial to address these issues comprehensively.
In studying and dealing with these matters, certain preventative measures should be considered when entering transactions, especially within group entities. Firstly, documentation and archiving are vital. One case involved going back four years, and another nearly five years, emphasizing the need for thorough documentation to support transactions.
Secondly, don’t assume anything when it comes to transfer pricing. Always break down the transaction and explain it thoroughly in all paperwork, objections, or appeals. This is crucial because many African revenue authorities lack strong technical transfer pricing units and may not follow acceptable practices.
Understanding the administrative process is also important, ensuring all necessary filings and evidence are properly documented over time.
In conclusion, I hope these points assist people, companies, and clients in setting up structures and handling related party transactions. Additionally, I suggest that companies, especially multinational groups, consider creating a tax risk committee (click here to download our free eBook on helping you set up a Tax Risk Steering Committee) to help manage future matters effectively. Good luck with your transfer pricing audits on shield loans in Africa.
