As South Africa's international relations increase, with greater foreign investment coming in and more South Africans investing offshore, the importance of transfer pricing legislation increases.
What is transfer pricing? It is the term for when connected people supply goods, loans, and services to a each other, and the amount charged for those supplies. If you supply goods to a company you own, the price at which you supply those goods is the transfer price.
In July 1995 tax legislation was amended to enable the South African Revenue Services (SARS) to adjust the transfer price if it was of the view that the price used between connected people was not market related. The term "connected" is defined and is very broad.
The price is adjusted so that any tax that would have been paid in South Africa, had the transaction been at a market price, becomes payable. In addition, any benefit an offshore person receives is treated as a dividend paid and secondary tax on companies (STC) is payable at 12,5 percent of the benefit.
So, for example, if your company sells goods to an offshore company owned by your brother who emigrated some years ago, at a price which is lower than the price you would charge a third party, the SARS may tax you on the profit you would have made if you had sold the goods at the third-party price. In addition, your company will have to pay 12,5 percent STC on the amount which is disallowed.
If you are doing business with a connected person, you must be able to justify the prices you are charging or paying that person.
In the past many tax consultants believed that transfer pricing legislation did not apply to an offshore company investing in a branch here, since the branch is not a separate person. However, it is likely that new legislation will be introduced this year to include branches in the ambit of the law.
Overseas investors must also be aware of rules relating to the ratio of debt to equity and interest rates on loans.
These provisions apply if the recipient of funds is a company and the investor has a 25 percent or more shareholding in the recipient company, or is able to exercise 25 percent or more of the voting rights
The transfer pricing section of the law stipulates that if loans provided by an offshore investor to a company, are more than three times the amount of share capital provided, any interest paid by the local company on the excess amount of the loan will not be allowed as a tax deduction, and STC will be payable on any excess interest.
In addition if the interest rate is considered to be excessive on any loan within the debt-equity ratio limit or on a loan to a person other than a company, for example you as a natural person or a trust, then the excess interest will also not be allowed as a deduction for tax purposes in the local person's hands. STC will be payable on the excess
The interest will be considered to be excessive if it is greater than prime plus two percent if the loan is denominated in rands, or the London interbank offered rate (Libor) plus four percent if the loan is in a currency other than rands.
Ignoring transfer pricing rules could prove to be expensive so bear them in mind when entering into connected party international transactions.