Intra-group funding is where South African transfer pricing often bites hardest. On 17 January 2023 SARS published Interpretation Note 127, “Determination of the taxable income of certain persons from international transactions: intra-group loans”. It sets out how SARS applies section 31 of the Income Tax Act to cross-border loans between connected persons, and it replaced years of uncertainty after the old safe harbours in Practice Note 2 were withdrawn.
Key points
- IN 127 applies to loans advanced in years of assessment starting on or after 1 April 2012.
- A loan is incorrectly priced if the amount of debt, the cost of the debt, or both, exceed what is arm’s length.
- There are no safe harbour debt-to-equity ratios or interest rates.
- Excessive interest is disallowed, and the adjustment triggers a secondary adjustment taxed as a deemed dividend at 20%.
- Groups need evidence for both the quantum of debt and the interest rate.
What IN 127 covers
The note deals with financial assistance between a South African taxpayer and connected persons abroad, including direct loans and some indirect funding, such as back-to-back arrangements and loans guaranteed by group companies. It explains how SARS will test whether the amount borrowed and the interest charged are consistent with what independent parties would agree. You can read Interpretation Note 127 on the SARS website.
Test 1: Is the amount of debt arm’s length?
SARS asks whether an independent lender would have lent this amount to the borrower on these terms, and whether the borrower would have wanted to borrow it. The analysis looks at the borrower’s business, its cash flows, its ability to service the debt from its own resources and the purpose of the loan. Debt beyond what the borrower could raise independently is treated as excessive, and the interest on the excess is not deductible.
Test 2: Is the interest rate arm’s length?
Once the arm’s length amount is established, the interest rate must reflect the borrower’s credit standing and the loan’s terms: currency, term, security, ranking and repayment profile. IN 127 discusses several pricing approaches, including:
- The comparable uncontrolled price (CUP) method, using comparable loans or bonds
- Credit rating approaches that estimate the borrower’s stand-alone creditworthiness
- Credit default swap spreads to estimate a risk premium
- Economic modelling approaches used in some industries
Pricing a loan this way is a form of benchmarking. Our guide to benchmarking studies explains how loan benchmarks are documented.
Consequences of getting it wrong
- Primary adjustment: interest on excessive debt, or excessive interest on arm’s length debt, is disallowed.
- Secondary adjustment: for a company, the adjustment is treated as a deemed dividend in specie subject to dividends tax at 20%. SARS’s view is that treaty relief and the usual dividends tax exemptions do not reduce this.
- Penalties and interest: understatement penalties may apply under the Tax Administration Act.
Other rules that interact with IN 127
- Interest limitation: section 23M may further limit interest deductions on debt owed to certain connected non-residents. Transfer pricing is applied first.
- Interest-free loans to foreign subsidiaries: section 31(7) can exclude certain loans by a South African company to a controlled foreign company from the transfer pricing rules, if the conditions are met.
- Exchange control: inward loans from non-residents generally require exchange control approval, and the approved terms should match the transfer pricing analysis.
Practical steps for South African borrowers
- Prepare a debt capacity analysis when the loan is advanced, not after an audit starts.
- Support the interest rate with a credit rating analysis and market data.
- Put a written intercompany loan agreement in place that reflects the real terms.
- Review existing loans annually, especially when interest rates or the borrower’s results change.
- Disclose financial assistance correctly in the ITR14.
Intra-group financing is also a common source of wider risk, as we explain in our guide to management fees and intra-group services, which covers the other charge SARS most often questions. If you would like your group’s funding reviewed, Impact can help design a defensible financing policy and supporting documentation.
Frequently asked questions
Is there still a safe harbour debt-to-equity ratio?
No. IN 127 does not provide safe harbours. Each loan must be supported by its own analysis of debt capacity and pricing.
Is an interpretation note binding?
An interpretation note sets out SARS’s view of the law. It is not binding on the courts, but it shows how SARS will approach an audit, so it should be followed or departures carefully justified.
Does IN 127 apply to guarantee fees?
IN 127 focuses on intra-group loans, but guarantees affect the analysis of indirect funding and should also be priced at arm’s length.
