Draft Interpretation Note: Section 31 – Definition of “Associated Enterprise”
SARS issued a Draft Interpretation Note to provide guidance on the interpretation and application of the definition of “associated enterprise” in section 31(1) of the IT Act
Section 66(1) of the Taxation Laws Amendment Act No 20 of 2021 amended the effective date such that the inclusion of an “associated enterprise” in section 31 of the Income Tax Act No 58 of 1962 (“IT Act”), comes into operation on 1 January 2023 and applies in respect of years of assessment commencing on or after that date.
Section 31 of the IT Act contains rules which are aimed at preventing a reduction in the South African tax base as a result of the mispricing or incorrect characterisation of specified transactions, operations, schemes, agreements, or understandings. Broadly speaking, this is achieved by applying the arm’s length principle to affected transactions as defined in section 31(1) of the IT Act.
The definition of “affected transactions” in section 31 of the IT Act currently only includes transactions, operations, schemes, agreements or understandings directly or indirectly entered into between specified parties that are connected persons in relation to one another. As such, the application of the transfer pricing rules contained in section 31 of the IT Act has unintended consequences of not always capturing transactions between “associated enterprises” which may fall within the “connected persons” definition. To correct this, it is intended to insert the term “associated enterprise” as contemplated in Article 9(1) of the OECD Model Tax Convention (“Tax Convention”), into the definition of an “affected transaction” in section 31(1) of the IT Act with effect from year of assessment commencing on or after 1 January 2023. This will result in “affected transactions” applying to both associated enterprises and connected persons.
Depending on the facts, a person could be classified as a connected person, an associated enterprise, or both. In other words, connected persons and associated enterprises are not mutually exclusive.
In the event that the parties are found to be “associated enterprises”, the provisions of section 31 of the IT Act may apply, even if they are not connected, persons.
Article 9(1) of the Tax Convention describes two enterprises as being “associated enterprises” where:
In this regard, it is important to note that Article 3 of the Tax Convention provides that the term “enterprise” applies to the carrying on of any business.
In assessing whether participation in management results in the parties to the transaction, operation, scheme, agreement or understanding being considered “associated enterprises”, for the purpose of section 31 of the IT Act, the outcome of such participation in management must result in or have the consequences of controlling, effecting or influencing the terms or condition, which includes pricing, of any transaction, operation, scheme, agreement or understanding, directly or indirectly entered into or effected between or for the benefit of either or both resident or non-resident party. An assessment of whether participation in management resulted in or has the consequence of controlling, effecting, or influencing the terms or conditions, including the pricing, as mentioned above is very fact specific and can only be determined on a case-by-case basis.
Generally, there are two types of control that exist when it comes to authority, namely, de facto control and de jure control. De facto means a state of affairs that is true in fact but may or may not be officially sanctioned, while de jure means a state of affairs that is in accordance with the law.
In the context of the definition of an “associated enterprise”, the type of control that is relevant is the de facto control and relates to the ability of a person, and the exercise of that ability to directly or indirectly materially influence the terms of the condition of the transaction, operation, scheme, agreement or understanding, especially the pricing. In assessing whether participation in control results in the parties to the transaction, operation, scheme, agreement, or understanding being considered “associated enterprise” for the purpose of section 31 of the IT Act, the outcome of the direct or indirect participation in control must result in or have the consequence of controlling, effecting or influencing the terms or conditions, including the pricing of any transaction, operation, scheme, agreement or understanding, directly or indirectly entered into or effected between or for the benefit of either or both resident or non-resident party. An assessment will be done on a case-by-case basis.
ownership of shares or voting rights in an entity. Generally, shareholders with sufficient shares or voting rights are capable of influencing the decisions of an entity’s operations. Article 9(1) of the Tax Convention refers to participation in capital without specifying a percentage holding of shares or voting rights which would be regarded as participation having an ability to sufficiently influence terms and conditions, including pricing, for purposes of transfer pricing. Although shareholding or voting right percentages which are below that specified in the connected person definition in the appropriate circumstances are unlikely to result in a person being an “associated enterprise”, the test is to determine whether a person participates directly or indirectly in the capital of two entities, at a level sufficient to influence the terms or conditions, remains a facts and circumstances test.
Accordingly, if the facts demonstrate that notwithstanding a low shareholding or voting right percentage, a shareholder influences the terms and conditions, including the pricing of a transaction, operation, scheme, agreement or understanding, then the criteria of “participation in capital” will be met.