Introduction
Normally, loans between a South African company and its foreign group companies would be subject to the transfer pricing rules that require the terms of the loan to be arms-length. There is, however, an exclusion from the rules in relation to certain inter-company debt. But multinationals relying on this transfer pricing exclusion should review the terms of the loans considering a recent High Court decision.
Broadly, the rule (contained in section 31(7) of the Income Tax Act) applies where the companies form part of the same group and the foreign company is not obliged to redeem the debt in full within 30 years from the date it is incurred. Such redemption is conditional upon the market value of the assets not being less that the liabilities and no interest accruing during the relevant year of assessment.
In the matter before the court, the loan agreements contained a clause that the loans would be cancelled and the outstanding amounts would become immediately payable in the event of an application for liquidation, bankruptcy, etc.
According to the judgement, the effect of such a clause is that it could result in the redemption of the debt within 30 years resulting in the requirements of section 31(7) not being met.
Context: Crookes Brothers Ltd vs. Commissioner for the South African Revenue Service
In Crookes Brothers Ltd vs. Commissioner for the South African Revenue Service [2018] ZAGPHC 311, the applicant Crookes Brothers Limited (CBL) owned 99% of the shares in a subsidiary company, MML, which was incorporated in Mozambique.
CBL approved loans to MML with the key provisions being:
· MML would not be obliged to repay the loan amount in full within 30 years;
· Any repayment would not take place if the market value of the assets of MML were less than the market value of its liabilities as of the date of the payment; and
· No interest would accrue or be payable.
Importantly, clause 7 provided that, in the event of an application being made for the liquidation of MML, or MML going into bankruptcy, business rescue or similar, or judgment having been taken against MML and remaining unsatisfied for a period of 14 days, the agreement would terminate with immediate effect without the necessity of notice, and the loan amount, or any balance then outstanding, would immediately become due and payable to CBL.
MML also entered into a subordination agreement with CBL in terms of which:
· CBL subordinated for the benefit of the other creditors of MML, so much as would enable the claims of other creditors to be paid in full;
· Claims of the creditors of MML would rank preferentially to the subordinated claim;
· The subordination would remain in force so long only as the liabilities of MML exceeded its assets; and
· Until the assets of MML, fairly valued, exceeded its liabilities, it would not be entitled to demand or sue for or accept repayment of the whole or any part of the amount subordinated.
At the time of submitting its income tax return for 2015, CBL made an adjustment to its taxable income in terms of section 31(2) and (3) on the basis that an arms-length interest rate should apply and that a deemed dividend arose. CBL was assessed by SARS on this basis.
Subsequent to this, CML submitted a request to SARS for a reduced assessment on the basis that the loan met the requirements for the exclusion in contained in section 31(7).
SARS rejected the request for a reduced assessment on the basis that the loans did not meet the requirements of section 31(7), more particularly, section 31(7)(a) and (b), which stipulate:
· That foreign company is not obliged to redeem that debt in full within 30 years from the date the debt is incurred; and
· The redemption of the debt in full by the foreign company is conditional upon the market value of the assets of the foreign company not being less than the market value of the liabilities of the foreign company.
CML applied to the High Court to review and set aside the decisions taken by SARS.
The Court agreed with SARS, that the effect of clause 7 was that if the relevant events occurred, the loans would become immediately due and payable and therefore the requirements of section 31(7) were not met.
The Court was also of the view that the subordination agreement merely changed CBL’s ranking amongst the creditors of MML, and did not detract from the above conclusion.
What this means for multinationals with inter-company agreements
Many loan agreements provide for events of default, such as an application for liquidation etc. Typically, the provisions only come into effect once the relevant event takes place. It is debatable whether this would result in the requirements of section 31(7) not being met, since the application of the provision would be conditional upon the event of default actually occurring.
Notwithstanding this, it would be wise to review any inter-company agreements in respect of which the exclusion in section 31(7) is claimed.
Justin Liebenberg is an independent tax specialist; Michael Hewson is a director of Graphene Economics™.
