Skip to content

South Africa: An overview of SARS’ Interpretation Note 127

26 January 2023
– 13 Minute Read


On 17 January 2023, the South African Revenue Service (SARS) released Interpretation Note 127 (Determination of the taxable income of certain persons from international transactions: intra-group loans) (IN127).

The purpose of IN127 is to provide taxpayers with guidance on the application of the arm’s length principle, in the context of intra-group loans. IN127 applies to loans advanced in years of assessment commencing on or after 1 April 2012.


In 2012, the specific thin capitalisation rules under section 31of the Income Tax Act (ITA) were deleted. Since then, thin capitalisation practices had to be considered in the context of the general arm’s length principle applied under the South African transfer pricing rules. The transfer pricing rules govern not only the rate of interest applied to intra-group loans but also the quantum of debt that a taxpayer can support.

The risk of failing to ensure that cross-border intra-group lending transactions meet the arm’s length standard is that it could result in the non-deductibility of all or a portion of the interest expense (primary adjustment), a secondary adjustment (i.e. the disallowed interest amount paid by a resident company, would be deemed to be an in specie dividend that attracts dividend tax), penalties and interest.

The accurate pricing of intra-group arrangements is dependent on attributes of intra-group loans such as the quantum, interest rate, denomination, maturity arrangements, purpose of the loan, level of seniority or subordination, geographical location of the borrower and lender, and security provided.

Historically, complying with the arm’s length principle was made simple and relatively inexpensive through abiding by a safe harbour published by SARS. Practice Note 2 (PN2) outlined acceptable debt-to-equity ratios and interest rates for related party loans. This guidance provided taxpayers with certainty regarding cross-border intra-group funding transactions that SARS would not subject to audit. This reduced the compliance burden and associated costs for foreign investors into South Africa. PN2 was withdrawn on 5 August 2019, with effect from 1 April 2012.

Although South Africa is not a member state of the Organisation for Economic Co-Operation and Development (OECD), SARS confirmed, in Practice Note 7, that the guidelines as laid out in the OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations should be followed in the absence of specific guidance in terms of Practice Note 7 to determine the arm’s length pricing between connected persons. In the absence of any safe harbour indication for intra-group loans, to ensure compliance with the arm’s length standard, a taxpayer has no other option but to undertake a costly transfer pricing study.

Following the legislative change and the withdrawal of PN2, SARS published Draft Interpretation Note on Thin Capitalisation (Draft Interpretation Note) in 2013 that was never finalised, in which SARS indicated the following:

‘SARS adopts a risk-based audit approach in selecting potential thin capitalisation cases for audit. In selecting cases, SARS will consider transactions in which the Debt: EBITDA ratio of the South African taxpayer exceeds 3:1 to be of greater risk.’ (our emphasis)

However, SARS pointed out that the ratio is not a safe harbour and does not preclude SARS from auditing a taxpayer who is within the range of the abovementioned ratio. The ratio is merely indicative of the level of risk set by SARS for the purpose of selecting cases for audit.

With the removal of a safe harbour and a lack of clear guidance from SARS on how to apply the arm’s length principle since April 2012, taxpayers have been at pains to undertake onerous transfer pricing studies to ensure compliance with the arm’s length principle. Unfortunately, IN127 does nothing to alleviate this problem.

SARS states in PN127 that they will consider a taxpayer’s debt to be non-arm’s length if, amongst other factors, some or all of the following circumstances exist:

  • The taxpayer is carrying a greater quantity of debt than it could sustain on its own (that is, it is thinly capitalised).
  • The duration of the lending is greater than would be the case if negotiated at arm’s length.
  • The repayment, interest rate or other terms are not what would have been entered into or agreed to at arm’s length.

We reiterate that the above are not safe harbour rules, rather SARS would use these measures to select taxpayers for audit. Therefore, meeting these requirements may not be enough to prevent incurring the cost of a transfer pricing study. Taxpayers should therefore seek advice to enable them to weigh the cost of compliance against the benefits of cross-border debt funding and the risks associated with non-compliance.

With regard to a possible secondary adjustment (i.e. the adjusted amount being treated as a dividend in specie, in the case of a company), SARS expresses the view that the reduction of withholding tax on dividends under a double taxation agreement (DTA) would not be available to the recipient of the excess (non-deductible) amount which is treated as a dividend. SARS contends that the reduced rates envisaged under section 64FA(2) of the ITA requires the recipient to be the ‘beneficial owner’ of the dividend. Section 64D defines ‘beneficial owner’ as ‘the person entitled to the benefit of the dividend attaching to a share.’ SARS argues that a recipient of a deemed dividend in specie under section 31(3)(i) is not entitled to the benefit of the dividend because there is no benefit since 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.

SARS expresses the view that 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’. Accordingly, SARS thinks that the deemed recipient is not a ’beneficial owner’. SARS concludes that, 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.

SARS clearly ignores the requirement under all our DTAs that any concept that is defined in the DTA must be given such a meaning in applying the DTA. Therefore, if the DTA in question provides that an amount that is treated as a dividend under our domestic law must be treated as a dividend for purposes of the DTA, the recipient of that deemed dividend must be given DTA benefits, if the recipient qualifies for such benefits.

The disallowed portion of an adjusted interest expense is treated as a deemed dividend under section 31(3)(i). This implies that such amount of interest is re-characterised as a dividend. The recipient of that amount is clearly the beneficial owner of that amount.

In terms of the UK/South Africa DTA, the term ‘dividends’ is defined to mean income from shares, or other rights, not being debt-claims, participating in profits, as well as income from other corporate rights which is subjected to the same taxation treatment as income from shares by the laws of the Contracting State of which the company making the distribution is a resident and also includes any other item which, under the laws of the Contracting State of which the company paying the dividend is a resident, is treated as a dividend or distribution of a company.

The term ‘interest’ as defined in the UK/South Africa DTA means income from debt-claims of every kind, whether or not secured by mortgage and whether or not carrying a right to participate in the debtor’s profits, and in particular, income from government securities and income from bonds or debentures. The term ‘interest’ shall not include any item which is treated as a dividend under the provisions of Article 10 of this Convention.

The term ‘dividends’ as defined in the USA/South Africa DTA means income from shares or other rights, not being debt-claims, participating in profits, as well as income that is subjected to the same taxation treatment as income from shares under the laws of the State of which the payor is a resident.

The term ‘interest’ as defined in the USA/South Africa DTA specifically provides that income dealt with in Article 10 (Dividends) shall not be regarded as interest for the purposes of the DTA.

Most of our DTAs contain similar provisions, based on the OECD Model DTA.

The OECD Commentary on the OECD Model DTA considers the impact of a re-characterisation of interest as dividends and comments that the two Contracting States may exclude from the application of Article 11 any kinds of interest which they intend to be treated as dividends.

In the absence of such specific provisions in the DTA, the excess amount of interest would still qualify as ‘interest’ as defined in the DTA and the re-characterisation under our domestic law would not be allowed. If the DTA provided an exemption from withholding tax in such a case, SARS would not be entitled to impose dividends tax on such a deemed dividend.

The very objective of the secondary adjustments under section 31(3) is to put the two parties in the same position as if no transfer pricing manipulation had occurred (apart from interest and penalties). The intended effect is that the amount received by the counterparty, which is often the parent company, is simply treated as additional dividend distributions. By not allowing a recipient to claim the benefits under the DTA, SARS would not be complying with South Africa’s obligations under the respective DTAs.

Whilst IN127 is not law, it provides insight into the prevailing practice of SARS and guidance on the interpretation and application of provisions of the ITA. Taxpayers are cautioned to have regard to these guidelines when implementing intra-group arrangements of this nature so that they can anticipate SARS’ view of their arrangements.

Furthermore, taxpayers are strongly advised to maintain adequate documentation to substantiate the arm’s length nature of these lending arrangements, especially where the terms conflict with SARS’ view.

We highlight below other key considerations outlined in IN127:

  • Application of the transfer pricing provisions: The transfer pricing provisions are sufficiently broad enough to apply to both direct and indirect financial assistance which may include, but is not limited to, back-to-back transactions with banks or other financial institutions.
  • Guarantees provided by related parties: SARS seems to take the view that the thin capitalisation regime should include domestic lending arrangements that are guaranteed by foreign related parties. However, it is not clear how far they intend to apply the rules to this scenario since the interest is subject to full normal tax in the hands of the local lender. The example provided in IN127 includes payment of a guarantee fee by the local bank to the foreign parent company of the borrower (i.e. a cross-border payment of some nature). However, the preamble to this example does not expressly rule out domestic lending arrangements that do not include a cross-border payment. Parties are therefore cautioned to consider the thin capitalisation rules when seeking local funding that is guaranteed by a foreign related party. Where appropriate, adequate documentation should be prepared in support of the exclusion of the domestic funding from these laws.
  • Interest deductibility: The amount of interest may be limited in terms of section 23M or Section 23N of the ITA. IN127 confirms that, in SARS’ view, section 31 applies prior to the impact, if any, of section 23M and section 23N. Therefore, taxable income must first be calculated as if the transactions had been entered into at arm’s length, prior to the application of the abovementioned interest limitation rules.
  • Determining an arm’s length interest rate: Entities should use the most appropriate pricing methodology, consistent with the actual delineated transaction. SARS notes that the comparable uncontrolled price method may be the method easiest to apply, due to the availability of financial information from lending markets.
  • Withholding tax on interest: Any transfer pricing adjustment to taxable income or tax payable will not impact on the calculation of withholding tax on interest. As indicated above, this may contravene DTA obligations if the provisions of the DTA require the excess interest to be treated as a dividend.
  • Lender and borrower’s perspective: Both the lender’s and borrower’s perspective must be taken into account in the transfer pricing analysis, given that the perspective of each may vary from that of the other. A lender’s perspective would involve, inter alia, evaluating the risks inherent in lending to the particular related party borrower. Conversely, a borrower’s perspective would involve, inter alia, optimising their cost of capital by meeting short-term and long-term objectives.
  • Effect of group membership and the use of credit ratings: Implicit support from a group may affect a borrower’s credit rating. Therefore, it is appropriate to determine whether the credit rating of the borrower must be used on a stand-alone basis or if the prevailing facts require that a credit rating more closely linked to that of the multinational enterprise group be used. It is uncertain whether the downgrading of South Africa’s sovereign credit rating would be considered by SARS when assessing the credit rating used by a borrower.
  • Timing: It is necessary for taxpayers to specifically consider whether, at the time of obtaining that debt, the amount of the debt and the cost of the debt reflect arm’s length arrangements.
  • Permanent establishments: A permanent establishment (PE) in South Africa of a non-resident will be viewed as a separate enterprise. Therefore, the dealings with such a PE should also comply with the arm’s length principle.
  • Safe harbours: IN127 does not make provision for the use of safe harbours, nor risk indicators, by SARS. Therefore, an arm’s length analysis is required to determine whether the arrangements of the particular taxpayer are acceptable.
  • Use of bank opinions: The use of bank opinions to attest to an arm’s length interest rate that an independent bank would charge a related party borrower will not be accepted as evidence to substantiate an arm’s length interest rate, as it does not provide a comparison to an actual transaction.
  • Financing policy: IN127 emphasises the need for a taxpayer to develop and maintain a consistent financing policy. The financing policy should be aligned with the multinational enterprises’ overall strategy. The importance of this cannot be stressed enough, as a taxpayer is required to set out, in its master file, a high-level overview of the multinational enterprise’s global business, which includes its financing policy, business activities, structure, and global transfer pricing policy.