Dividends Tax implications of secondary transfer pricing adjustments

The South African Revenue Service (“SARS”) issued Interpretation Note 127 on 17 January 2023.

The note deals with the transfer pricing implications of cross-border intra-group financial assistance (including financial assistance by way of loans).

A matter addressed therein is whether double tax agreements, read with the applicable domestic law provisions relating to dividends tax, afford relief from dividends tax for resident companies (in respect of secondary transfer pricing adjustments).

Transfer pricing adjustments arise, for example, in circumstances where a South African resident company reduces its South African taxable income by incurring non-arm’s length/excessive interest in favour of a non-resident related party.

The primary transfer pricing adjustment affected, in order to prevent the income tax deduction benefit to the South African resident company, is the denial of the excessive/non-arm’s length interest amount as a deduction (in the hands of the resident company).

In such circumstances, the South African resident borrower’s non-arm’s length/excessive interest incurred is also treated as a dividend in specie (declared and paid by it in favour of the non-resident related lender). This is known as the secondary transfer pricing adjustment.

SARS’ view is that dividends tax on a deemed dividend in specie will result.

The following is stated in this regard[1]

“Under section 31(2), if there is a difference between the arm’s length amount that is taken into account in calculating taxable income or the amount that, but for section 31(2), would have been taken into account (that is, the actual amount) the difference is subject to a secondary adjustment and constitutes a deemed dividend in specie for dividends tax purposes …. For the reasons set out in the paragraphs below, a resident company will not qualify for an exemption from dividends tax under section 64FA(1) or a reduced rate of dividends tax under section 64FA(2) on a deemed dividend in specie which arises under section 31(3)(i). Accordingly, the deemed dividend will be subject to dividends tax at a rate of 20%.

For section 64FA(1) or section 64FA(2) to apply, the beneficial owner must submit the declaration and written undertaking referred to in that section to the company that is deemed to have declared and paid the deemed dividend in specie. The Act defines “beneficial owner” in section 64D as ”the person entitled to the benefit of the dividend attaching to a share.” A recipient of a deemed dividend in specie under s 31(3)(i) is not entitled to the benefit of the dividend because there is no benefit. There is no benefit because the deemed dividend in specie, which results from a difference determined between two taxable income calculations, is a figure calculated for tax purposes only which has resulting dividends tax implications. An actual benefit arises for the other party to an affected transaction (the recipient) when an expense is overpriced or income is understated, but this actual benefit is different to and distinct from the dividend which is deemed to arise under section 31(3)(i). The actual benefit arises before and irrespective of whether the Act deems a dividend to arise under section 31(3). Neither section 31(2) nor section 31(3) re-characterises the underlying expense or income to be a dividend; the deemed dividend under section 31(3)(i) arises over and above the underlying transaction. In addition, even if one assumes there is a benefit, that benefit would not be considered to be “attaching to a share”. The benefit attaches to the “affected transaction” that gave rise to the application of section 31(2) and section 31(3)(i) and not to a share. There is no direct link or cause between the benefit and a share. The immediate cause of the adjustment in section 31(2) is the underlying transaction which was not conducted on an arms’ length basis. Accordingly, the deemed recipient is not a “beneficial owner”.

In the absence of a “beneficial owner,” as defined in section 64D, the requirements of section 64FA(1) and section 64FA(2) cannot be met. Further, in the absence of a “beneficial owner,” it is irrelevant whether the specific requirements in a potentially applicable tax treaty, referred to in section 64FA(2)(a) and which would otherwise need to be met, are met. The requirements include, for example, the tax treaty definition of a dividend and the possible requirement for a specific holding in the capital or voting rights of a company.

In addition to the absence of a beneficial owner, for completeness, it is noted that an affected transaction falling within the ambit of section 31 is a transaction which is unlikely to meet the requirements in section 64F as referred to in section 64FA(1)(a).”

(words in bold reflect our emphasis)

It is prudent to seek tax advice in respect of cross-border intra-group financial assistance at the time of obtaining such assistance and at least annually thereafter to ensure appropriate income tax and dividends tax treatment. Careful regard should also be had to the relevant provisions of the applicable double tax agreement.

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[1] At pp 32 thereof