TAX UPDATE: THE TRANSFER PRICING IMPLICATIONS ON SHAREHOLDERS’ LOANS FOR TANZANIA BUSINESSES
- Why related party financing?
- Conformity of intra-group financing to the arm’s length principle
- What transfer pricing method should one use to test intra-group financing
- Are interest-free loan arrangements a safe business decision?
- The maximum limit of interest that is deductible on related party loans
It is a common phenomenon in the business arena for companies to borrow money in order to meet their working capital obligations and other investment plans. On multiple occasions, such borrowings can be secured from either shareholders or sister companies who would really like to see the group’s business progress from the loan proceeds. Therefore, with these loans being extended between related parties, some key aspects of transfer pricing must be considered by the business.
In practice, we do see loans between related parties that are issued with or without interest charges and others that do not require a regular repayment plan. All these come in different forms and manners that might not be possible if a similar loan was sought from a third-party lender, for instance, a commercial bank.
1.0 Conformity of intra-group financing to the arm’s length principle
According to the prevailing transfer pricing laws and regulations in Tanzania, these related party arrangements are termed as intra-group financing and should ideally conform to the arm’s length principle. With that in mind, an arm’s length analysis for intra-group financing has to consider three key categories as provided under item 13.6 of the Transfer Pricing Guidelines 2020 which include:
- Conditions of the transaction (justification on the nature and quantum of the debt and interest cost, repayment schedule effect on pricing, existence of security);
- Circumstances surrounding the transaction (borrower’s creditworthiness, ability of borrower to secure loan from the third party, economic conditions of the lender and borrower jurisdiction); and
- Confirmatory tests (whether the loan was actually delivered, utilization of the loan consistency with the stated purpose, the interest charged at arm’s length).
During the process of justifying that the loan is at arm’s length, the charged interest rate is one of the factors taken into consideration. Both the OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations, 2022 (“OECD Guidelines, 2022”) and the Tax Administration (Transfer Pricing Regulations), 2018 (“TP Regulations 2018”) advocate for related parties to charge one another arm’s length interest rate
2.0 Appropriate transfer pricing method to use
The comparable uncontrolled price (CUP) method is mostly preferred in determining whether the interest rate is at arm’s length and as such, appropriate indices such as the Bank of Tanzania (BoT) interest rate in force at the time, the London Inter-Bank Offered Rate (LIBOR) or specific rates quoted by banks for comparable loans can be used as reference points. Adjustments (if any) are then made on the rates used, based on the comparative analysis
3.0 The issue on interest-free loans
On a separate note, we also see interest-free loans issued by related parties (including shareholders) which mostly aim at easing the financing burden for the borrower. However, from a transfer pricing angle, as provided under Regulation 10 (3) of the TP Regulations 2018, such financing assistance entered through arrangements with or without consideration (interest) does require determination of the arm’s length interest rate for such assistance.
If no interest has been charged, the revenue authority will be obliged to determine the arm’s length interest rate that would have been charged on such financing assistance. Broadly enough, this will be termed as a deemed interest that was incurred by the borrower and as such would result in the imposition of withholding tax at a rate of 10% as read from the provisions of Section 82 of the Income Tax Act, 2004 (“ITA 2004”).
Whilst there have been various tax disputes between taxpayers and the revenue authority on the demand-ability of the withholding tax on deemed interest expense, we are yet to honour the ultimate decision from the utmost Court of Appeal as the recent decision by the Tax Revenue Appeals Board which was in favour of the taxpayer has been appealed boldly by the revenue authority.
Looking on the other side of the coin, should the shareholders intend to gain much from such financing assistance and end up demanding higher interest rates, this also leads to a transfer pricing problem. The arm’s length principle would mean knocking off the extra interest charge that is over and above what is prevailing in the market and this will have a detrimental effect on the borrower’s corporate income tax calculations as such interest will be treated as a disallowable expense. Additionally, a transfer pricing penalty will be imposed on that adjustment.
To caution, the financing assistance that we can easily construe to mean loans can also be provided in other forms such as related party payables unsettled for a long period.
4.0 The thin capitalization rule
In the same context, shareholders should also have a look at the restrictions imposed by the thin capitalization rules for purposes of corporate income tax. Thin capitalisation denotes a position where a borrower is financed through a fairly high level of debt compared to equity. The rules as imposed in the ITA 2004 limit interest which can be claimed by reference to a debt to equity ratio of 7 to 3. For that reason, any interest expense on debt that exceeds the aforementioned allowable ratio is disallowed for corporate income tax purposes.
It is of paramount importance that each of the above-mentioned categories is examined closely by the parties in order to avoid instances of the loan being rejected by the tax man for non-conformity with the tax laws and suffering unwelcomed penalties.
As such, in any related party financing, the key items to be aware of should include an analysis of the intended financing assistance to check the repayment schedule effect on pricing, the creditworthiness of the borrower, the ability of the borrower to secure a loan from third-party and debt-to-equity ratio. Thereafter, determination of an interest rate that will be within the arm’s length principle.
Breakthrough Advisory Services can assist in analysing the shareholders’ loans and any other related party transactions with the aim of determining if the same fall within the arm’s length principle.
For clarification and guidance regarding the transfer pricing reach out to us via email@example.com or call directly through +255 754 710 330.
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