With effect from 1 October 2011, section 31 of the Income Tax Act, No. 58 of 1962 (the Act), governing transfer pricing and thin capitalization, will be replaced.

Essentially, in the case of cross-border transactions between connected persons (as defined), the new section 31 provides that one will determine whether the taxable income of each person that is party to the transaction can be justified compared to the same transaction entered into between independent persons dealing at arm's length.

The current thin capitalisation rules, which provide a safe harbor debt to equity ratio of 3:1, will be aligned with the transfer pricing rules of whether one is dealing with an arm's length transaction.

An interesting area where section 31 of the Act (ie. the old and new provisions) may be applicable is in the context of guarantees provided between group companies.

Often in a group context guarantees are provided by a parent company in respect of the debt of a subsidiary (or vice versa) and subsidiaries guarantee the debt of a sister entity. The question arises whether a fee should be charged by the entity providing the guarantee to a group company in the other jurisdiction. In other words, would independent third parties acting at arm's length have charged a fee?

It is not a new case, however, the Canadian case of General Electric Capital Canada v Her Majesty the Queen 2009 TCC 653 considered this issue. The parent company in the United States charged the subsidiary (the Subsidiary) a 1% fee for guaranteeing the subsidiary's debts owing to third party creditors (the Fee). The Subsidiary sought to deduct the Fee which was disallowed by the Canadian Revenue Authorities (the Revenue Authorities) on the basis that the Subsidiary received no economic benefit and the arm's length price would be zero. The Revenue Authorities argued that the Fee could not exceed the value of the benefit (ie. the increased credit rating for the group) resulting from the services (guarantee) provided by the parent company.

Extensive submissions were made by both parties as to which methodology should be used to determine whether the guarantee had been provided on an arm's length basis. A detailed analysis was conducted into the benefit obtained by the Subsidiary (and the group) which received an increased credit rating where its debts were guaranteed by its parent company.

The court confirmed that in determining whether one is dealing with an arm's length transaction, the following approach adopted by the OECD should be followed:
"Application of an arm's length principle is generally based on a comparison of the conditions in a controlled transaction with the conditions in transactions between independent enterprises. In order for such comparisons to be useful, the economically relevant characteristics of the situations being compared must be sufficiently comparable. To be comparable means that none of the differences (if any) between the situations being compared could materially affect the condition being examined in the methodology (eg, price or margin) or that reasonably accurate adjustment can be made to eliminate the effect of any such differences."

The court held that a 1% guarantee fee was equal to or below an arm's length price in the circumstances, as the Subsidiary received a net economic benefit from the transaction (ie. the economic benefit of 1.83% was calculated under the yield approach, accordingly, a fee of 1% for the economic benefit was regarded as being arm's length).

If one has the opportunity to read the General Electric judgment, you will appreciate how technical the analysis may become to determine whether one is dealing with an arm's length transaction. In the appropriate circumstances, a fee will not have to be charged for a guarantee provided in a group context. However, one must ensure that both parties have given due consideration (ie. taking into account the benefits and risks to each party) whether or not a fee should be charged for the guarantee. One should also not lose sight of the exchange control implications of cross-border guarantees.

Written by Andrew Lewis, Associate, Tax Practice, Cliffe Dekker Hofmeyr