​Discussion paper on reviewing the tax treatment of excessive debt financing, interest deductions and other financial payments ​

​Discussion paper on reviewing the tax treatment of excessive debt financing, interest deductions and other financial payments ​

• 26 February 2020
• Corporate Tax
• Department: National Treasury

Important

All comments should be sent to hayley.reynolds@treasury.gov.za by 17 April 2020.

Executive summary

Corporate debt bias can be influenced by tax policy design. When in need of capital, businesses – whether purely domestic or multinational – can choose between debt and equity financing. While many factors influence this decision, tax deductibility of interest payments (but not in respect of dividends or returns on equity) can sway the outcome, particularly in cases where tax avoidance is a primary objective. With tax deductions for interest payments being more valuable in countries with higher corporate income tax (CIT) rates, multinational companies can minimise tax liabilities further by placing the majority of their debt funding in high-tax countries.

While debt capital is an important financing source for investment, it can create opportunities for base erosion and profit shifting (BEPS) in South Africa – the CIT rate is high relative to the global average, and especially in relation to some of our key trading and investment partners. The OECD/G20 BEPS Project produced a report on Limiting Base Erosion Involving Interest Deductions and Other Financial Payments in 2015, providing a benchmark against which to assess the existing corporate tax regime in respect of its potential impact on the choice between debt and equity financing.

The OECD/G20 Project considered all the rules in place that limit excessive debt or interest deductions – including transfer pricing rules, thin capitalisation rules, ratios that limit interest deductions and withholding taxes. The consensus recommendation is that the best means of curtailing BEPS is to limit net interest expense deductions to a fixed percentage of earnings before interest, tax, depreciation and amortisation (EBITDA). The OECD recommends using a net interest expense / earnings (NIE/EBITDA) ratio of between 10 and 30 per cent to limit excessive interest deductions and prevent tax base erosion. To constrain those taxpayers that pose the largest BEPS risk, the OECD recommends applying the rule to all entities of a multinational group as a minimum.

Besides the OECD, other international and regional organisations, as well as the Davis Tax Committee, have also contributed to the debate on this issue. The IMF has done a lot of empirical analysis on countries’ existing rules. One of the main findings is that interest limitation rules (including thin-capitalisation rules, for example) are more effective when applied to total interest expense – i.e. interest flowing to both connected and independent parties. The United Nations (2017) Handbook on Selected Issues in Protecting the Tax Base of Developing Countries provides a good overview for why taxpayers use debt, as well as useful thoughts on the OECD recommendations. The African Tax Administration Forum (ATAF) has done a lot of work to assist African countries in this regard – producing a Suggested Approach to Drafting Interest Deductibility Legislation to assist countries in capturing the OECD recommendations in their legislation. The Davis Tax Committee has reviewed the tax treatment of debt financing – agreeing with the OECD in some areas and disagreeing in others. All of the key issues from these parties are discussed in the document.

Many countries have either implemented a version of the recommendations or reviewed their existing rules. Most countries in the European Union have implemented the OECD recommendations already or are in the process of doing so, as they are required to do so under the EU Anti-Tax Avoidance Directive. Some developing countries that have implemented the OECD recommendations include India, Botswana and Vietnam. Australia and New Zealand are retaining their thin capitalisation approaches using balance sheet ratios, rather than opting for interest limitation rules based on earnings.

South Africa’s current interest limitation rules have similar design features to the fixed ratio rule recommended by the OECD, but there are differences. The existing rules are comparatively less strict than the OECD recommendations and narrower in application – they are targeted at a smaller set of transactions and the limitation for net interest expense deductions is set at a higher percentage of earnings. There are also other incumbent rules that mitigate the debt bias. In respect of cross-border loans from connected persons, SARS is able to use the arm’s length test (transfer pricing rules) to question whether: (1) the quantum of debt is excessive; (2) the transaction labelled as a loan is more akin to equity; and (3) the associated interest rate charged is not excessive. Deviations from the arm’s length principle result in a portion of the interest expense being permanently disallowed as a deduction. The withholding tax on interest is set at a standard rate of 15 per cent, but is substantially reduced or nullified for many key investment and trading partners.

In reviewing the existing regime, government (recognising that South Africa is primarily a capital importing country) aims to strike a balance between attracting capital and investment, and protecting the corporate tax base. This brings up the classic tax policy design trade-off between accuracy and simplicity.

National Treasury analysis of SARS administrative data from corporate tax returns reveals NIE/EBITDA ratios for different company types and sizes. Companies are analysed in three groups – South African subsidiaries controlled by foreign multinational companies; group companies (including both South African owned multinational companies and purely domestic groups); and other companies. The companies are also analysed on size, using sales as a proxy.

Based on the analysis conducted, government proposes to implement the OECD recommendations. Illustrative examples show that replacing the existing interest limitation rules (specifically those in section 23M of the Income Tax Act) with the OECD approach will provide a more uniform approach to all interest payments flowing out of the country (regardless of which country the loan emanates from), as well as enhance the level of base protection. Government proposes to restrict net interest expense deductions to 30 per cent of EBITDA.

Government welcomes comments from all interested parties: Taxpayers are invited to submit comments on the proposals. Each submission should include a highlevel list of the main points being made. Additional information on specific transactions / business models that may be negatively affected is requested so that comments are substantiated. Comments might be made public – please clearly mark any information that is sensitive / should not be made public. 

All comments should be sent to hayley.reynolds@treasury.gov.za by 17 April 2020.

This article first appeared on sars.gov.za.

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