Abstract

Keywords

Arm's length; compatibility; legislative design; OECD Model Tax Convention; OECD Transfer Pricing Guidelines; safe harbour rules; thin capitalisation.

……………………………………………………….

1 Introduction

Companies have the option to make use of debt or equity to finance their capital requirements. Many companies tend to make use of debt as opposed to equity, as the interest on debt may be allowed as a tax-deductible expense. 1

* Lize Goosen. CA(SA) MTax (Stell). Lecturer, School of Accountancy, Stellenbosch University, South Africa. E-mail: lgoosen@sun.ac.za. ORCiD: https://orcid.org/0000-0002-9661-6808. This research was conducted by Lize Goosen as part of her master's thesis, under the supervision of Cecileen Greeff.

** Cecileen Greeff. CA(SA) MCom (Stell). Senior Lecturer, School of Accountancy, Stellenbosch University, South Africa. E-mail: cgreeff@sun.ac.za. ORCiD: https://orcid.org/0000-0002-4591-3124.

1 DTC 2016 https://www.taxcom.org.za/docs/New_Folder3/6%20BEPS%20Final

%20Report%20-%20Action%204.pdf 8.

Thin capitalisation can result in a loss to the fiscus through base erosion when a resident company is funded by a non-resident company, especially when these companies form part of the same group of companies 3

3 Section 1 of the Income Tax Act 58 of 1962 (hereafter the Act) defines "group of companies" as "two or more companies in which one company (hereinafter referred to as the 'controlling group company') directly or indirectly holds shares in at least one other company (hereinafter referred to as the 'controlled group company'), to the extent that (a) at least 70% of the equity shares in each controlled group company are directly held by the controlling group company, one or more other controlled group companies or any combination thereof; and (b) the controlling group company directly holds at least 70% of the equity shares in at least one controlled group company."

In order to limit base erosion in South Africa, transfer pricing provisions were introduced into the Income Tax Act 58 of 1962 (hereafter the Act) of

South Africa in 1995. 6

6 SARS 1999 https://www.sars.gov.za/wp-content/uploads/Legal/Notes/LAPD-IntR-PrN-2012-11-Income-Tax-Practice-Note-7-of-1999.pdf 6.

The Davis Tax Committee compared current South African legislation to limit base erosion due to excessive interest deductions to the recommendations made by the Organisation for Economic Co-operation and Development (hereafter the OECD) in the report titled Limiting Base Erosion Involving Interest Deductions and Other Financial Payments, Action 4 - 2016 Update: Inclusive Framework on BEPS 9

9 OECD 2016 https://www.oecd-ilibrary.org/docserver/9789264268333-en.pdf? expires=1618222878&id=id&accname=guest&checksum=7B862F70AEB47E98966AB6C6BCB65C88.

capitalisation safe harbour rules should be investigated for introduction into South African legislation.

Thin capitalisation safe harbour rules are transfer pricing provisions that may relieve eligible taxpayers from certain requirements, for example arm's length price adjustments, which may be imposed by a country's transfer pricing legislation. 16

16 OECD 2022 https://read.oecd-ilibrary.org/taxation/oecd-transfer-pricing-guidelines-for-multinational-enterprises-and-tax-administrations-2022_0e655865-en#page211 204.

The OECD directs that countries that do make use of safe harbour rules should take into consideration that the design of safe harbour rules requires careful attention. 20

20 OECD 2022 https://read.oecd-ilibrary.org/taxation/oecd-transfer-pricing-guidelines-for-multinational-enterprises-and-tax-administrations-2022_0e655865-en#page211 207-211.

Article 9(1) of the OECD MTC. 23

23 De Wet Seeking Deviations 8.

This article's focus is on debt (i.e. non-complex inbound financial assistance transactions) and the resulting interest on debt transactions between associated enterprises, 25

25 An "associated enterprise" is defined in s 31 of the Act as "an associated enterprise as contemplated in Article 9 of the Model Tax Convention on Income and on Capital of the Organisation for Economic Co-operation and Development". Article 9 of the OECD Model Tax Convention on Income and on Capital: Condensed Version (2017) (the OECD MTC) states that two enterprises are associated enterprises "where an enterprise of a Contracting State participates directly or indirectly in the management, control or capital of an enterprise of the other Contracting State; or the same persons participate directly or indirectly in the management, control or capital of an enterprise of a Contracting State and an enterprise of the other Contracting State, …".

To this end, section 2 of the article discusses the arm's length principle, current South African domestic legislation relating to thin capitalisation, together with the applicable articles in existing South African tax treaties, to determine compatibility with the arm's length principle and to provide the legislative framework required to determine the features of thin capitalisation safe harbour rules that are essential for compatibility. Section 3 of the article examines the legislative design of thin capitalisation safe harbour rules of Australia, New Zealand, and Canada. 27

27 Although there are African countries with thin capitalisation safe harbour rules, the focus of this article is on developed countries due inter alia to the general issues in obtaining comparables, benchmarking and general tax authority capacity in Africa. Additionally, developed countries have been at the forefront of addressing BEPS

countries have advanced transfer pricing legislation in place that includes thin capitalisation safe harbour rules, with substantial literature available on the topic. Based on sections 2 and 3, section 4 of the article proposes a legislative design for the introduction of thin capitalisation safe harbour rules into South African legislation. The article then ends with section 5 as the conclusion and also provides further recommendations.

2 Theoretical overview

2.1 Arm's length in the context of thin capitalisation safe harbour rules

Article 9(1) of the OECD MTC 28

28 The OECD MTC provides a uniform standard for member countries on the taxing rights and obligations to be negotiated between countries.

The tax treaty negotiated between contracting states is therefore important, as it will determine if the arm's length principle forms the basis for negotiation between these contracting states. It is also important to understand what constitutes arm's length in the context of debt. In the Commentary on Article 9 of the OECD MTC, 35

35 OECD Model Tax Convention 226 para 3(b).

The OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations 2022 (hereafter the OECD Transfer Pricing Guidelines) contains the internationally agreed upon principles on the determination of arm's length prices as directed in the OECD Commentary to Article 9. 40

40 OECD 2022 https://read.oecd-ilibrary.org/taxation/oecd-transfer-pricing-guidelines-for-multinational-enterprises-and-tax-administrations-2022_0e655865-en#page211.

interest rate and country risk differences, compounding the complexity of determining appropriate arm's length prices. 43

43 Oguttu 2020 INTERTAX 83.

The Thin Capitalisation Report was the first OECD report that specifically discussed the factors to consider in the context of thin capitalisation as well as the varying international approaches followed to counter base erosion due to thin capitalisation. 45

45 OECD Thin Capitalisation.

The Thin Capitalisation Report accordingly provided the first indication of the importance of arm's length, both in respect of the interest rate and the amount of debt, and it reiterated that should thin capitalisation rules, either earnings stripping or safe harbour rules, be applied, the adjusted profit should approximate arm's length. Despite the principles provided for the use of safe harbour rules in the Thin Capitalisation Report, the OECD initially had a negative view of the use of safe harbour rules. 48

48 Picciotto 2018 https://opendocs.ids.ac.uk/opendocs/bitstream/handle/20.500. 12413/14117/ICTD_WP86.pdf?sequence=1&isAllowed=y 28.

basis for determining transfer prices. 49

49 OECD 1995 https://www.oecd-ilibrary.org/docserver/g2g7fa2a-en.pdf?expires=

1725969931&id=id&accname=guest&checksum=14DA2775FF3FD4D59C6EF7D336C4EF2B IV-40.

A provision that applies to a defined category of taxpayers or transactions and that relieves eligible taxpayers from certain obligations otherwise imposed by a country's general transfer pricing rules. A safe harbour substitutes simpler obligations for those under the general transfer pricing regime. 52

52 OECD 2022 https://read.oecd-ilibrary.org/taxation/oecd-transfer-pricing-guidelines-for-multinational-enterprises-and-tax-administrations-2022_0e655865-en#page211 204.

Safe harbour rules are typically used to restrict the amount of debt on which tax-deductible interest should be calculated, generally by defining an acceptable debt-to-equity ratio. 53

53 Arnold 2019 BFIT.

accordance with the safe harbour rules to be representative of the arm's length principle. 57

57 OECD Thin Capitalisation 37.

OECD member countries have debated the question of whether thin capitalisation safe harbour rules should be restricted by the arm's length principle as contained within Article 9(1) of the OECD MTC, as this could influence whether or not rules of this type should be utilised by a country in its legislative design. 58

58 Arnold 2019 Can Tax J 1072.

2.2 South African legislation pertaining to the limitation of interest

South Africa's transfer pricing legislation initially included thin capitalisation safe harbour rules in section 31(3) of the Act that applied to interest-bearing financial assistance granted by a non-resident to a resident who was a "connected persons" as defined in the Act. 61

61 SARS 1996 https://www.sars.gov.za/wp-content/uploads/Legal/Notes/LAPD-IntR-PrN-Arc-2019-01-Arc-01-Income-Tax-Practice-Note-2-of-1996-withdrawn-5-August-2019-with-effect-from-1-April-2012.pdf 3, 9.

which at that stage did not include any guidance on safe harbour rules and recommended an arm's length approach. 64

64 Taxation Laws Amendment Act 7 of 2010.

The draft Interpretation Note 65

65 SARS 2013 https://www.sars.gov.za/wp-content/uploads/Legal/Drafts/LAPD-LPrep-Draft-2013-10-Draft-IN-Determination-Taxable-Income-International-Transactions-Thin-Capitalisation.pdf.

Currently no thin capitalisation safe harbour rules are included in South African tax legislation, and debt transactions form part of the general definition of "affected transactions" in section 31(1) of the Act. Debt transactions are, therefore, subject to the arm's length principle in respect of both the amount of debt and the interest rate charged. 70

70 SARS 2013 https://www.sars.gov.za/wp-content/uploads/Legal/Drafts/LAPD-LPrep-Draft-2013-10-Draft-IN-Determination-Taxable-Income-International-Transactions-Thin-Capitalisation.pdf 9.

transfer pricing policies. 71

71 OECD 2021 https://www.oecd.org/global-relations/keypartners/south-africa-and-oecd.htm#:~:text=In%202007%20the%20OECD%20Council,a%20sustained%20and%20comprehensive%20manner.

Up until 2012 section 31 of the Act was the only section in the Act dealing specifically with thin capitalisation, by way of limiting interest deductions where it was determined that the terms on which transactions were concluded did not meet arm's length requirements. 74

74 DTC 2016 https://www.taxcom.org.za/docs/New_Folder3/6%20BEPS%20Final% 20Report%20-%20Action%204.pdf 29.

2.2.1 Section 31 of the Act

Section 31 of the Act serves as an anti-avoidance provision that aims to address "affected transactions" 76

76 "Affected transactions" encompass any transactions, operations, arrangements, agreements or understandings that are either directly or indirectly undertaken between or for the advantage of specific parties, who are either connected persons or, starting from the 1st of January 2023, associated enterprises. These transactions involve terms or conditions that deviate from those that would be present if the parties involved were independent entities conducting transactions at arm's length.

account. 79

79 SARS 2023 https://www.sars.gov.za/wp-content/uploads/Legal/Notes/Legal-IN-127-Determination-of-the-taxable-income-of-certain-persons-from-international-transactions-Intra-group-loans.pdf 6.

The burden of proof falls on the South African taxpayer to demonstrate, as per section 31 of the Act, 83

83 If the SARS determines that the taxpayer did not transact at arm's length in accordance with s 31(2), s 31(3) of the Act requires the SARS to impose the primary and secondary adjustments based on what the SARS perceives to be arm's length, together with penalties. Any amount of excessive interest deducted (that is interest that relates to a non-arm's length debt amount or interest on arm's length debt amount which is calculated at a non-arm's length interest rate) will be added back to a taxpayer's taxable income as the primary adjustment in terms of s 31(2) of the Act. S 31(3) of the Act reclassifies the amount of the primary adjustment to be a dividend in the form of a distribution in specie declared and paid by the resident, for which a secondary adjustment will be required, subject to dividends tax, which is currently at 20 per cent.

Article 9(1) of the OECD MTC. However, section 31 of the Act cannot be evaluated in isolation, as section 23M of the Act and its interaction with section 31 should also be examined to determine its compatibility with the arm's length principle.

2.2.2 Section 23M of the Act

Section 23M was introduced into the Act in 2013 (effective from 1 January 2015). The objective of this section is to restrict the deductible interest 87

87 For years of assessment ending on or after 31 March 2023, the definition of "interest" for this purposes of s 23M of the Act is expanded to include not only s 24J interest, but also payments that are economically equal to interest or incurred for raising finance.

Report. 95

95 OECD 2016 https://www.oecd-ilibrary.org/docserver/9789264268333-en.pdf? expires=1618222878&id=id&accname=guest&checksum=7B862F70AEB47E98966AB6C6BCB65C88 2, 3.

Section 23M of the Act, being a fixed ratio limitation provision, bears similarities to the recommended earnings stripping rules of the OECD, in so far as it limits interest deductions based on a fixed formula. 96

96 National Treasury 2020 http://www.treasury.gov.za/public%20comments/ Reviewing%20the%20Tax%20Treatment%20of%20Excessive%20Debt%20Financing,%20Interest%20Deductions%20and%20Other%20Financial%20Payments.pdf 47.

Section 23M of the Act does not refer to the arm's length principle in any way and was based on an arbitrary percentage deduced from financial accounting information supplied by Statistics SA as long ago as 2014, initially, and is currently based on the OECD's best practice recommendation to apply a 30 per cent interest limitation ratio. 99

99 National Treasury and SARS 2014 http://www.treasury.gov.za/ legislation/bills/2014/TLAB-TALAB/2014%20October%2016%20-%20Response%20document%20TLAB%20and%20TALAB.pdf 14.

2.2.3 The interaction between sections 31 and 23M of the Act

In some instances both the transfer pricing provisions in section 31 of the Act and the interest limitation provisions of section 23M of the Act may be applicable to the same transaction, which could also influence the compatibility of these sections with the arm's length principle. To illustrate, if a foreign holding company offers financial support to its South African subsidiary and does not pay tax on the interest income received, both sections 31 and 23M of the Act may apply. Although different views on the order of application of sections 31 and 23M of the Act remain, 101

101 Neuhaus Limitation of the Deduction of Interest 47.

3 The legislative design and features of thin capitalisation safe harbour rules

3.1 Domestic legislation relevant to thin capitalisation safe harbour rules

Tax authorities can address the risk of base erosion through the introduction of legislation that limits the deductible amount of interest in the calculation of taxable profit. 103

103 OECD 2012 https://web-archive.oecd.org/2013-01-08/221764-5.%20Thin_ Capitalization_Background.pdf 7.

Neither Article 9 of the OECD MTC nor the OECD Transfer Pricing Guidelines prohibits a country from implementing its own domestic thin capitalisation rules, provided that its rules do not result in profit adjustments in excess of arm's length interest. 105

105 OECD Thin Capitalisation 39.

The OECD draft paper Thin Capitalisation Legislation: A Background Paper for Country Tax Administrations 108

108 OECD 2012 https://web-archive.oecd.org/2013-01-08/221764-5.%20Thin_

Capitalization_Background.pdf.

to disagreement between countries on what constitutes arm's length profits. 111

111 OECD 2012 https://web-archive.oecd.org/2013-01-08/221764-5.%20Thin_ Capitalization_Background.pdf 12.

It is further stated in the mentioned OECD draft paper that countries have the choice, depending on their legal system, on the manner of inclusion of their thin capitalisation safe harbour rules into their legislation. 112

112 OECD 2012 https://web-archive.oecd.org/2013-01-08/221764-5.%20Thin_ Capitalization_Background.pdf 21.

3.2 Tax treaties

Depending on the type of safe harbour rules employed in a country, there may consequently be concerns regarding the compatibility of these safe harbour rules with the arm's length principle in terms of Article 9(1) of the OECD MTC and existing tax treaties. It is, therefore, important that any thin capitalisation safe harbour rules included in domestic legislation should approximate the arm's length principle. Alternatively, should a country's domestic legislation limit interest in a way that does not conform to the arm's length principle, a country may negotiate tax treaties that deviate from the OECD MTC, by including or amending tax treaty provisions to specifically allow the application of thin capitalisation rules. 115

115 Fross 2013 European Taxation.

3.2.1 Australia, New Zealand and Canada

Despite the OECD's Action 4 Report recommendation, Australia 116

116 Income Tax Act 27 of 1997 (Australia).

harbour rules in its legislation. All three countries are OECD members and are therefore committed to following the recommendations and guidelines as provided by the OECD in accordance with the OECD MTC and OECD Transfer Pricing Guidelines. 119

119 Duff "Interest Deductibility and International Taxation" 23:15.

By comparing the three selected countries' standard tax treaties with the OECD MTC, it was established that all three countries use the OECD MTC as the basis for their tax treaties and include a corresponding article in their tax treaties based upon the standard Article 9 of the OECD MTC with some minor exceptions. By comparing the selected countries' corresponding articles with one another and Article 9 of the OECD MTC, it was determined that the articles corresponding to Article 9 of the OECD MTC do not deviate significantly in any of the three selected countries and can be considered compatible with Article 9 of the OECD MTC.

3.2.1.1 Australia

Australia recently amended their thin capitalisation rules to be more aligned to the OECD's recommended earnings stripping approach. 120

120 For income years commencing on or after 1 July 2023, Australia's thin capitalisation safe harbour rules were amended, which amendment is applicable to most multinational businesses operating in Australia with at least $2 million in debt deductions. The three new tests apply to "general class entities", which includes most multinational businesses. The first test is a fixed ratio test which limits interest deductions to 30% of EBITDA. The second test is a group ratio test which limits net debt deductions by applying a ratio of the worldwide group's net interest expense to the group's EBITDA. The third test is a third-party debt test that disallows all debt deductions not attributable to third-party debt. The current safe harbour test and worldwide gearing ratio test remain in place for entities classified as financial entities and authorised deposit-taking institutions (ADIs). The existing arm's length debt test is retained for ADIs. Financial entities that are not ADIs may opt for the new third-party debt test, while the existing arm's length debt test for non-ADIs has been repealed. See Australian Government, Australian Taxation Office 2024 https://www.ato.gov.au/about-ato/new-legislation/in-detail/businesses/multinational-tax-integrity-package-thin-capitalisation-rules.

i) a safe harbour debt amount, whereby the maximum allowable debt was determined by way of a debt-to-equity ratio (prescribed as 1.5 to 1 for general entities, and 15 to 1 for financial entities); 125

125 PwC 2021 https://taxsummaries.pwc.com/australia/corporate/group-taxation.

ii) a worldwide global gearing test, in terms of which an entity is allowed to gear up its Australian operations to the same level of gearing as its global group in certain circumstances (this accordingly allowed businesses to obtain more debt than would be allowable under the safe harbour debt amount, if the global group maintains a higher debt-to-equity ratio than the Australian business); 126

126 PwC 2021 https://taxsummaries.pwc.com/australia/corporate/group-taxation.

iii) an arm's length debt test, in terms of which the maximum allowable debt amount that would have been negotiated between an independent lending entity and a borrower transacting at arm's length had to be established. 127

127 PwC 2021 https://taxsummaries.pwc.com/australia/corporate/group-taxation.

Although the debt-to-equity safe harbour debt amount based on a fixed ratio may not have been considered to adhere to the arm's length principle, there was flexibility in terms of the worldwide gearing test and the arm's length debt test that was available to taxpayers as alternatives. 128

128 Australian Government, Board of Taxation 2014 https://taxboard.gov.au/ sites/taxboard.gov.au/files/migrated/2015/07/discussion_paper.pdf.

principle. 129

129 Australian Government, Board of Taxation 2014 https://taxboard.gov.au/ sites/taxboard.gov.au/files/migrated/2015/07/discussion_paper.pdf 12.

3.2.1.2 New Zealand

By comparing the New Zealand transfer pricing and thin capitalisation provisions in the Income Tax Act (New Zealand) 97 of 2007 to the OECD Transfer Pricing Guidelines, it was determined that New Zealand deviates from these guidelines in the following respects:

Although the Inland Revenue Department is of the view that the current New Zealand restricted transfer pricing rules and thin capitalisation rules are consistent with international arm's length standards, it was concluded that some countries may not view the safe harbour rules as compatible with the arm's length principle, mainly as a result of prescribed ratios that may not be considered arm's length approximations, in addition to the inflexibility of the rules, with no arm's length alternative available to taxpayers. 138

138 New Zealand Inland Revenue Department 2017 https://taxpolicy.ird. govt.nz/en/publications/2017/2017-other-beps/16-ria-interest-limitation.

3.2.1.3 Canada

The Canadian transfer pricing and thin capitalisation provisions in the Income Tax Act RSC (Canada) 1985 139

139 Section 247 of Income Tax Act RSC 1985 c 1 (5th Supp) (Canada).

The authors of this article concluded that the Canadian transfer pricing provisions and thin capitalisation rules may be considered incompatible with the arm's length principle by countries with rigid arm's length requirements.

4 A proposed legislative design

4.1 Transfer pricing provisions

It is recommended that the sections in the Act determining what constitutes arm's length price – therefore interest rates – and what constitutes arm's length debt amounts – therefore whether a taxpayer is thinly capitalised – should be separated, as recommended by the Davis Tax Committee 144

144 DTC 2016 https://www.taxcom.org.za/docs/New_Folder3/6%20BEPS%20Final%

20Report%20-%20Action%204.pdf 54.

It is proposed that section 31 of the Act should be amended to apply to the pricing of debt only, in terms of which taxpayers have to adjust their taxable income to reflect arm's length interest in terms of only interest rates and not debt amounts. Accordingly, interest rates in relation to transactions that fall within the ambit of section 31 of the Act must reflect arm's length rates, or interest in excess of arm's length would be denied as a deduction. In order to provide certainty for taxpayers, simplification measures could be added in secondary legislation in terms of which National Treasury could publish indicative interest rates for loans below a specific value in the Government Gazette, as in the New Zealand approach, that provides indicative interest rates for loans up to NZD 10 million. 145

145 New Zealand Inland Revenue Department 2021 https://www.ird.govt.nz/ international-tax/business/transfer-pricing/simplification-measures.

4.2 Thin capitalisation safe harbour rules

It is proposed that a standalone thin capitalisation section should be included in the Act to determine when a taxpayer will be viewed to be thinly capitalised. In terms of this thin capitalisation section, taxpayers' interest deductions will be limited should they exceed either a prescribed safe harbour ratio or a second worldwide gearing ratio. The previous thin capitalisation safe harbour debt-to-equity ratio of 3 to 1 146

146 SARS 1996 https://www.sars.gov.za/wp-content/uploads/Legal/Notes/LAPD-IntR-PrN-Arc-2019-01-Arc-01-Income-Tax-Practice-Note-2-of-1996-withdrawn-5-August-2019-with-effect-from-1-April-2012.pdf 3.

National Treasury, in conjunction with the SARS, should determine an acceptable fixed ratio such as a debt-to-equity or debt-to-assets ratio similar to that used by Australia (previously a debt-to-equity ratio prescribed as 1.5 to 1 for general entities and 15 to 1 for financial entities) and New Zealand (currently a debt-to-assets ratio prescribed as 60 per cent {in respect of inbound investment} or 75 per cent {in respect of outbound investment}; and 110 per cent of the worldwide group's debt percentage). This ratio should provide a simple measure to indicate excessive debt in a company's capital structure and detail the interest limitation consequences for exceeding the prescribed safe harbour ratio. It may also be beneficial, in terms of both the thin capitalisation safe harbour ratio and indicative interest rates, to establish through benchmarking whether different prescribed ratios or interest rate thresholds would be required for different industries to better reflect market conditions. The determination of which items should be included in the debt and asset values applied in the ratios should also be clearly defined in the guidance provided by the SARS or appointed body to the National Treasury, to be published as and when required.

Should a taxpayer exceed the prescribed safe harbour ratio the second ratio, namely the worldwide gearing ratio, that is linked to the capital structure of a taxpayer's worldwide group, would be beneficial in allowing a taxpayer to borrow at the same level as the rest of its group. The group gearing ratio should provide a rudimentary arm's length proxy for the taxpayer's group. This could be similar to the worldwide gearing test previously applied in Australia, in that it would enable a taxpayer to borrow up to the level of its group even if it exceeds the prescribed safe harbour ratio in specific circumstances.

It is also recommended that a de minimis threshold that exempts taxpayers with interest expenses below a specific amount should be included in the thin capitalisation rules. The current and previous Australian thin

capitalisation rules are applicable only should an entity's total interest deductions exceed AUD 2 million in any tax year. 147

147 Division 820: 820-835 of Income Tax Act 27 of 1997 (Australia).

The OECD recommends in its Transfer Pricing Guidelines 148

148 OECD 2022 https://read.oecd-ilibrary.org/taxation/oecd-transfer-pricing-guidelines-for-multinational-enterprises-and-tax-administrations-2022_0e655865-en#page211 208.

It is important that any potential thin capitalisation rules approximate the arm's length principle to be compatible with existing South African tax treaties. It is recommended that a safe harbour should not discriminate against specific taxpayers but treat all taxpayers similarly. However, if the proposed safe harbour rules to be introduced are flexible enough and approximate the arm's length principle, discrimination should not be applicable. Should a state not consider the South African safe harbour rules to reflect the arm's length principle, it is important that the South African legislation allows the taxpayers the option to demonstrate arm's length amounts.

Where two jurisdictions can agree upon bilateral safe harbours, it could provide relief to taxpayers without resulting in double taxation. 149

149 Ezenagu 2019 https://opendocs.ids.ac.uk/opendocs/bitstream/handle/20.500. 12413/14620/ICTD_WP100.pdf?sequence=1.

negotiated on a continental or regional level. 150

150 Ezenagu 2019 https://opendocs.ids.ac.uk/opendocs/bitstream/handle/20.500. 12413/14620/ICTD_WP100.pdf?sequence=1 24.

It may be beneficial not only to describe the eligibility requirements and requirements of the safe harbour ratio or monetary thresholds in the Act, but to publish the prescribed ratios and specific thresholds as well as the interpretation and application of the safe harbour rules in the Government Gazette. The ratios and thresholds could be periodically updated as market indicators change. Primary legislation cannot be easily amended, whilst National Treasury in conjunction with the SARS can update prescribed maximum interest rates or applicable ratios and de minimis thresholds more regularly in the Government Gazette. Sufficient administrative guidance should be provided by the SARS by way of updated interpretation notes on the application and calculation of any thin capitalisation rules, with clarity as to the hierarchy in the application of the different interest limitation rules and the proposed thin capitalisation safe harbour rules.

4.3 Earnings stripping rules

The existing section 23M of the Act may not be deemed in alignment with the arm's length principle since it relies on a fixed formula. The OECD states in its Action 4 Report 154

154 OECD 2016 https://www.oecd-ilibrary.org/docserver/9789264268333-en.pdf?

expires=1618222878&id=id&accname=guest&checksum=7B862F70AEB47E98966AB6C6BCB65C88 62.

Luxembourg 157

157 Ernst & Young 2021 https://www.ey.com/en_lu/tax/luxembourg-tax-authorities-issue-guidance-on-the--equity-escape-.

It is accordingly proposed that section 23M of the Act be amended with the inclusion of an "equity escape" rule, in terms of which section 23M will not apply if the taxpayer is subject to the thin capitalisation safe harbour rules. In terms of the proposed "equity escape" rule that exempts a taxpayer from applying section 23M, there should consequently no longer be a concern that the application of section 23M could result in non-arm's length adjustments, provided that the thin capitalisation rules do approximate arm's length amounts. As an alternative, a de minimis threshold in respect of the total interest expense of a taxpayer could be included in section 23M of the Act. Potentially section 23M could be abandoned if section 31 and the standalone thin capitalisation rules to be included in the Act could be formulated in such a way as to cover the section 23M debt transactions as well.

5 Conclusion and recommendations

This article has examined the legislative design and features required of thin capitalisation safe harbour rules that should achieve compatibility with the arm's length principle with the aim of proposing a legislative design for the introduction of thin capitalisation safe harbour rules into South African legislation for non-complex inbound financial assistance transactions. It has been established that the determination of arm's length, with specific reference to debt transactions, is viewed as a resource intensive and complex process. Thin capitalisation safe harbour rules do provide a country with a method of simplifying transfer pricing requirements. Nevertheless, it is crucial that the legislative design and features of thin capitalisation safe harbour rules are consistent with the arm's length principle to prevent the potential for double taxation when implementing these regulations.

Section 3 of the article considered the different legislative approaches followed internationally, and specifically examined the thin capitalisation safe harbour rules utilised by Australia, New Zealand and Canada. Section 4 of the article proposed a legislative design for South Africa with recommendations for amendments to existing legislation in relation to transfer pricing provisions (section 31), and proposed thin capitalisation rules and earnings stripping rules (section 23M). It is submitted that the proposed legislative design for the introduction of thin capitalisation safe harbour rules into South African legislation should provide the necessary certainty and simplification measures to South African taxpayers and the SARS alike to establish what constitutes arm's length in terms of debt

amounts and interest for non-complex inbound financial assistance transactions. The proposed design should also still achieve compatibility with the arm's length principle contained within existing South African tax treaties, thereby reducing the risk of double taxation.

Further research is required to determine which financial ratios would best determine when a taxpayer should be viewed to be thinly capitalised. Further research that provides detailed benchmarking for the chosen financial ratio is also required to establish what the prescribed thresholds should be and whether different thresholds should apply for different industries. The same is applicable for other simplification measures, including indicative interest rates, as well as potential de minimis thresholds.

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De Wet M Seeking Deviations from South Africa's Tax Treaty Policy with Respect to Treaties in Africa: Evidence from the Treaty Practice (MComm-dissertation University of Cape Town 2019)

Duff "Interest Deductibility and International Taxation"

Duff DG "Interest Deductibility and International Taxation in Canada After BEPS Action 4" in Canadian Tax Foundation Report of the Proceedings of the Seventieth Tax Conference: 2018 Conference Report (Canadian Tax Foundation Toronto 2019) 23:1-26

Elliffe 2013 ATF

Elliffe C "Trans-Tasman Thin Capitalisation Rules and Treaties: Implications for New Zealand and Australia on Tighter Thin Capitalisation Ratios" 2013 ATF 605-640

Fernandes 2017 Revista Direito Tributário Internacional Atual

Fernandes S "Arm's Length Principle and the Issue of Thin Capitalization" 2017 Revista Direito Tributário Internacional Atual 209-237

Fross 2013 European Taxation

Fross A "Earnings Stripping and Thin Cap Rules: Maintaining an Arm's Length Distance" 2013 European Taxation 507-516

Neuhaus Limitation of the Deduction of Interest

Neuhaus TA The Limitation of the Deduction of Interest in Order to Combat Base Erosion and Profit Shifting in Light of Thin Capitalization and Transfer Pricing (LLM-dissertation University of Johannesburg 2016)

OECD Model Tax Convention

Organisation for Economic Co-operation and Development Model Tax Convention on Income and on Capital: Condensed Version (OECD Paris 2017)

OECD Thin Capitalisation

Organisation for Economic Co-operation and Development Thin Capitalisation: Taxation of Entertainers, Artistes and Sportsmen (OECD Paris 1987)

Oguttu 2020 INTERTAX

Oguttu AW "Challenges of Applying the Comparability Analysis in Curtailing Transfer Pricing: Evaluating the Suitability of Some Alternative Approaches in Africa" 2020 INTERTAX 74-102

Oguttu 2022 CILSA

Oguttu AW "Transfer Pricing Adjustments: The Different Types, Practical Challenges and Recommended Approaches—A South African Perspective" 2022 CILSA 1-49

Saurez 2019 Tax Notes International

Saurez S "Transfer Pricing in Canada" 2019 Tax Notes International 781-813

West 2017 International Taxation in China

West C "Status Quo of South African Tax Treaty Policy" 2017 International Taxation in China [no page numbering]

Legislation

Income Tax Act 27 of 1997 (Australia)

Income Tax Act 58 of 1962 (South Africa)

Income Tax Act 97 of 2007 (New Zealand)

Income Tax Act RSC 1985 c 1 (5th Supp) (Canada)

Taxation Laws Amendment Act 7 of 2010

Taxation Laws Amendment Act 31 of 2013

International instruments

OECD Model Tax Convention on Income and on Capital: Condensed Version (2017)

Internet sources

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List of Abbreviations