South African approach to BEPS and transfer pricing in light of Covid-19

Thu 02 Dec 2021

The South African (“SA”) tax regime is being strengthened by the implementation of base erosion and profit shifting (“BEPS”) action 4, relating to the limitation of interest deductions, but extra borrowings by businesses to deal with Covid-19 has caused the Government to defer its introduction.   This article highlights some aspects relating to the implementation of BEPS as highlighted by the SA Finance Minister in his latest medium-term Budget policy statement (“MTBPS”), delivered on 11 November 2021. The article also highlights the South African Revenue Service’s (SARS’) approach to transfer pricing when it comes to balancing the country’s tax revenue requirements.

The SA Finance Minister’s maiden MTBPS revealed that SA’s gross tax revenue for the current fiscal year is expected to be R120.3 billion higher than was projected in the 2021 Budget. The vast majority of the R120.3 billion difference came from the SA mining sector where demand and prices have surged, resulting in record profits for many mining companies. Most SA mining companies form part of multinational enterprise groups (“MNEs”). Many countries, including SA, have been tightening their transfer pricing policies to protect revenue streams from profit shifting by MNEs.

Postponement of the proposed interest deductibility rules

In February 2020, the SA government issued a discussion document detailing the proposed tax treatment for SA companies that are excessively financed by way of debt. The changes were proposed given that debt funding can create opportunities for base erosion and profit shifting. Essentially, MNEs with operations in SA could extract profits from SA by using loan finance and charging interest to their SA companies, resulting in a tax deduction in SA, which in effect shields them from SA’s relatively high corporate income tax rate. Interest income due to a debt issuer located outside SA could in turn be subject to tax at a lower rate, where debt has been issued by a tax resident of a country with a lower tax rate than SA. The proposal, which is aligned with the recommendations of the Organisation for Economic Co-operation and Development (“OECD”) through BEPS Action 4, would have restricted net interest deductions by SA entities to 30 percent of earnings before interest, tax, depreciation, and amortisation (“EBITDA”), for years of assessment commencing on or after 1 January 2021.

From an African perspective, Botswana has led the way when it comes to the tax treatment of excessive debt financing, as it had already implemented the OECD’s recommendations by restricting net interest deductions of entities forming part of MNE groups to 30 percent of EBITDA from 1 July 2019.

Although SA companies in some sectors, such as mining, agriculture, and online retailing, managed to excel throughout the pandemic, there is no doubt that many others are struggling to survive. Companies experiencing reduced sales as well as those seeking to expand their operations can require significant financial resources.  As a result,, taking into account public commentary provided to the SA Treasury in respect of the impact of Covid-19 on the business of companies, the SA Treasury has decided to postpone the implementation of the interest limitation rules. This postponement was announced in the draft response document on the 2021 draft tax bills (“the draft response document”), as issued by the SA Treasury on 11 November 2021.

It is noted in the SA Treasury’s draft response document that the proposal was first introduced before Covid-19 had impacted the SA economy. The draft response document reiterates the importance of strengthening the current interest limitation rules to curb profit shifting but also notes that the government is understanding of the fact that many taxpayers would have had to take on additional debt to withstand the impact of the pandemic and the lockdowns imposed. The SA Treasury notes that the latter, along with lower earnings by many companies, provides sufficient rationale to postpone the proposed rules, allowing time for financial recovery.

Interestingly, the draft response document highlights that “the proposals will come into operation on the date on which the rate of tax in respect of the taxable income of a company is first reduced after the announcement by the Minister of Finance in the Annual National Budget”. This statement confirms that it is still the SA Treasury’s intention to reduce the SA corporate income tax rate from 28% to 27%, as indicated by the Finance Minister’s predecessor during his last Budget speech. The lowering of this rate will provide some tax relief for SA companies and is also intended to attract foreign investment to SA.

Foreign investments, Covid-19, and transfer pricing compliance

Foreign investors attracted by the potential reduction in the SA corporate income tax rate and which are considering investment into SA should also bear in mind the increased focus on transfer pricing by the South African Revenue Services (“SARS”), as well as the ongoing enhancements to the SA transfer pricing regime. The enhancements referred to, include the introduction of the concept of “associated enterprises” to SA’s legislative framework. In terms of the draft response document this change, which will extend further than the definition of connected persons as currently provided for by the SA transfer pricing regime, has been postponed to 1 January 2023. 

Although the implementation of the proposed interest limitation rules is being postponed to provide taxpayers with relief, it is also clear that SARS has identified transfer pricing as “low-hanging fruit” for the collection of taxes. Regarding clamping down on so-called “white-collar schemes”, the Commissioner of SARS has previously noted that “there are comfortably tens of billions [of Rand] that can be collected”.

Given the increased focus on transfer pricing, along with intended changes to the regime, it has become increasingly important for taxpayers to properly consider the operation of their cross-border group relationships. It is also critical to have those transactions which are subject to transfer pricing appropriately addressed, analysed, and substantiated by way of transfer pricing documentation.

Conclusion

As can be seen from the recent MTBPS and the associated documents issued by the SA Treasury, the SA government recognises the significant effect of Covid-19 on businesses. The impact of the pandemic on MNE groups with operations in SA and the implications on their cross-border payments is an increasingly important issue when it comes to transfer pricing studies. As some sectors are thriving in the “new normal” and others struggling to survive, transfer pricing studies have to take into account and properly address, the short-term and long-term effect of Covid-19 on the business and financial performance of taxpayers.

For a further discussion of the practical application of tax in the African continent, please get in touch with Mike Teuchert, National Head of Taxation Services at Mazars in South Africa.