Section 31 of the Income Tax Act, No 58 of 1962 (Act) contains South Africa’s transfer pricing provisions which constitutes one of the most contentious areas of tax law not only in South Africa, but around the world. Historically, there has been no judicial precedent in South Africa regarding the application of s31 of the Act and in particular the important “arm’s length” principle. However, in Crookes Brothers Ltd v Commissioner for the South African Revenue Service [2018] ZAGPHC 311 (judgment delivered 8 May 2018) (Crookes Bros) the High Court handed down findings regarding the application of certain provisions contemplated in s31 of the Act.

Background

The taxpayer in Crookes Bros formed part of a group of companies in the commercial agriculture industry operating in Southern Africa (Taxpayer). The Taxpayer had advanced (what purports to be) an ordinary shareholder loan to one of its subsidiaries located in Mozambique (Mozco) to enable it to fund certain costs associated with the establishment of a macadamia nut farm.

In its income tax return for the 2015 year of assessment, the Taxpayer made a transfer pricing adjustment to its taxable income in terms of subsection 31(2) of the Act as well as a “secondary adjustment” in terms of s31(3) of the Act resulting in a deemed dividend in specie being declared and paid to Mozco.

Subsequent to the filing of its income tax return, the Taxpayer realised that the transfer pricing adjustment had been made in error on the basis that the shareholder loan fell outside the application of the transfer pricing provisions in terms of s31(7) of the Act. In an abbreviated manner, s31(7) of the Act states that a debt will not be subject to the s31 transfer pricing provisions to the extent that:

  • the debt is between a resident company and a foreign company in which the resident holds at least 10% of the equity shares and voting rights in the foreign company;
  • the foreign company is not obliged to repay the loan within 30 years of the date the debt is incurred;
  • redemption of the debt is conditional on the value of the assets being greater than the liabilities; and
  • no interest accrued on the debt in the year of assessment.

The Explanatory Memorandum on the Taxation Laws Amendment Bill, 2013 provides context to the introduction of the carve-out contemplated in the s31(7) as follows:

[I]t is proposed that transfer pricing relief should be extended to outbound loans that clearly resemble equity. In effect, taxpayers should not be forced to pay tax on notional interest from a share loan that is in substance nothing more than share capital... A loan that meets the [relevant] criteria is in substance exposed to the same economic risk as equity and thus poses little or no risk to the South African tax base if interest is under-charged (because interest should not be charged at all as an economic matter).

SARS’ contentions

SARS disputed the taxpayer’s reliance on s31(7) of the Act on the basis that clause 7 of the loan agreement was contrary to the requirements of s31(7)(b) and s31(7)(c) of the Act. The matter therefore turned on clause 7 of the agreement, which in simple terms stated that in the event of Mozco being liquidated, going into business rescue or bankruptcy, the loan would be immediately due and payable. SARS was of the view that given that liquidation, business rescue or bankruptcy could occur within 30 years, such clause was indicative of an obligation on the part of Mozco to redeem the debt within 30 years (s31(7)(b) of the Act). Furthermore, that the debt was payable, notwithstanding the fact that the market value of Mozco’s assets may be less than its liabilities (s31(7)(c) of the Act). Lastly, SARS was of the view that a subordination agreement entered into between the parties did not override clause 7 of the loan agreement and that it merely altered the taxpayer’s ranking amongst creditors of Mozco. The conclusion was that the shareholder loan was more akin to debt than equity.

Findings

In respect of whether the shareholder loan fell within the “carve-out” provisions of s31(7) of the Act, Louw J agreed with SARS and held as follows at paragraph 17:

In terms of clause 7 of the loan agreements, the agreements terminate with immediate effect and the loan, or any balance then outstanding, becomes immediately due and payable to the applicant in the event of an application being made for the liquidation of Mozco, or Mozco going into bankruptcy or business rescue or similar type proceedings, or judgment having been taken against Mozco and remaining unsatisfied for a period of 14 days. A situation may therefore arise which obliges the foreign company to repay the loan before expiry of 30 years. It follows that the loan agreements therefore do not comply with the requirement of s31(7)(b) of the Act.

Louw J furthermore agreed with SARS that the subordination of the loan did not override clause 7 and that it simply regulated the subordination of the taxpayer’s claim against Mozco to the claims of other creditors for such time as the liabilities of Mozco exceeded its assets.

Observation in respect of the court’s findings

Clause 7 of the loan agreement appears to be a common clause inserted into most shareholder loan agreements and it is interesting to note that the court was of the view that the happening of an uncertain event (ie liquidation, business rescue or similar) amounted to an obligation on the part of Mozco to redeem the debt within 30 years. In other words, even though one of the eventualities may never occur within 30 years from the date the debt was incurred, the court found that there was nevertheless an obligation to redeem the debt within the stipulated time period. Given the ongoing debate on what constitutes an “obligation to redeem”, it will be interesting to monitor whether the taxpayer may in fact appeal the judgment, particularly when having regard to the intention of the legislature when it introduced the relevant provision.

Development of South Africa’s transfer pricing jurisprudence

Notwithstanding the initial interest that the judgment may have brought relief to the long-standing drought of South African case law dealing with the contentious transfer pricing provisions in s31 of the Act, the judgment unfortunately falls short of providing any in-depth analysis of the key “arm’s length” principle, which forms the crux of any transfer pricing analysis.

That said, it is worth noting that in Chevron Australia Holdings Pty Ltd (CAHPL) v Commissioner of Taxation [2017] FCAFC 62, the Full Federal Court of Australia recently confirmed the findings of the court of first instance and upheld transfer pricing assessments issued by the Australian Tax Office in respect of cross-border interest payments made under intra-group company loans.

It is understood that the taxpayer withdrew its appeal to the High Court of Australia (Australia’s apex court) and the decision thus provides guidance regarding, amongst others, the key transfer pricing issue of what constitutes “arm’s length” terms of cross border loans between intra-group companies.