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Mauritius: Supreme Court upholds the applications of arm’s length test on domestic companies and deemed interest on interest free loans

24 March 2023
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The Supreme Court of Mauritius recently dismissed the appeal made by Innodis Ltd (Innodis) against the Assessment Review Committee’s (ARC’s) finding of 26 May 2016 with respect to the applications of the arm’s length test on domestic companies and deemed interest on interest free loans. 

The case provides interesting insights on the application of arm’s length principle. A summary of the case, as well as our key take-aways to consider when pricing intragroup debt, follows.

The facts

Innodis granted loans to five wholly-owned subsidiaries from 2002 to 2004. The loans were unsecured, interest free and had a respite period of one year. The subsidiaries that were given the loans were either start-up companies with no assets or companies facing financial difficulties. 

The Mauritius Revenue Authority (MRA) considered that the granting of the loans without interest was not at arm’s length as required by section 75 of the Income Tax Act 1995 (ITA) and was clearly a preferential treatment to the subsidiaries.

The MRA took the view that an interest rate of 13% should have been applied to the loans. This rate was based on the market interest rate charged by the MCB and SBM on loans granted to Innodis for another purpose around the same period.

Innodis contended that section 75 of the ITA does not apply to the present case given that it is under the part of the ITA that deals with international aspects of income tax. Innodis and the subsidiaries are domestic companies, their businesses are run mainly in Mauritius and there was no cross-border issue. Innodis further submitted that the notion of ‘deemed interest’ is unknown in Mauritian law and there is no legal basis for the assessment on interest income.

ARC considerations

The ARC found that the wording of section 75 of the ITA is clear and that its application is not restricted to cases involving non-residents only but targets indiscriminately any person controlling an income earning business in Mauritius. The arm’s length test applies either under subsection (1)(a) of section 75 of the ITA in a case where a business or income earning activity in or from Mauritius is controlled by a non-resident or carried on by a non-resident company, or under subsection (1)(b) in a case of any business or income earning activity carried on in or from Mauritius and controlled by any person.

The ARC further found that the assessment is on interest under section 75 of the ITA and the term ’Deemed Interest’ used in the heading is only a term to designate the nature of the amount assessed, i.e., interest which would have been derived if the transactions had been at arm’s length.

Supreme Court considerations on appeal

The Supreme Court confirmed that the arm’s length principle under section 75 of the ITA is not limited to either non-residents doing business in Mauritius or cross-border transactions, but also applies to transactions involving domestic companies only. 

The Supreme Court agreed that the Director General of the MRA is empowered to determine the amount a business would have generated had all its commercial and financial transactions and relations been wholly at arm’s length. This power is to be exercised where the MRA is of the opinion that, by reason of relationship or otherwise, any person controlling a business in Mauritius is not at arm’s length with any other person, and that the business is producing less net income than could be expected. The Supreme Court further held that since the transactions targeted were loans, which in practice generate interests as income, there can be no wrong in designating the income that Innodis ought to have derived from them as ‘deemed interest’.

Takeaways

Interest free loans have been on the radar of the MRA for some time now. There are various cases where the MRA is questioning the arm’s length nature of interest free loans advanced by Mauritian companies.

 The position of the MRA is that Interest free loans are de facto not at arm’s length. It would not consider the financial situations or commercial circumstances of the related party borrower to ascertain whether, in the normal course of business, a third-party lender would be willing to advance a loan to the borrower or whether the borrower has the ability to repay the loan. This approach has been blessed by both the ARC and the Supreme Court in the Innodis case.

The Organisation for Economic Co-operation and Development (OECD) acknowledges in its Transfer Pricing Guidelines, which provides guidance on the application of the arm’s length principle, that there is a practical difficulty in applying the arm’s length principle to transactions between related parties that independent parties would not undertake. The Guidelines further provide that the mere fact that a transaction may not be undertaken between independent parties does not itself mean that it is not at arm’s length. These transactions are commercially justifiable as group companies may face different commercial circumstances when dealing with one another. 

While the MRA has based its assessment on the market interest rate applied by the SBM and MCB on loans granted to Innodis around the same period in determining the ‘deemed interest’ income of Innodis, the question that remains is whether the SBM or MCB would have been willing to grant a loan to a subsidiary of Innodis having no assets or a subsidiary facing financial difficulties.

Nevertheless, as it stands, any person carrying on a business or income earning activity in or from Mauritius should avoid interest-free loan funding arrangements. One accepted way to justify the interest rate under a loan to a related party is to compare it with a loan obtained by the lender from a banking institution around the same period.