Definition of “Associated Enterprises” – Section 31 of the Income Tax Act

On Friday, 14 October 2022, the South African Revenue Service (SARS) published a Draft Interpretation Note: Definition of “Associated Enterprises” (the Note) for public comment.

This Note provides guidance on the interpretation and application of the definition of “associated enterprise” in section 31(1).

Section 66(1) of the Taxation Laws Amendment Act 20 of 2021 amended the effective date such that the inclusion of an “associated enterprise” in section 31 comes into operation on 1 January 2023 and applies in respect of years of assessment commencing on or after that date.

The Act contains rules in section 31 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, this is achieved by applying the arm’s length principle to affected transactions, as defined in section 31(1), and requiring the persons specified in section 31(2) to calculate their taxable income or tax payable as if transactions, operations, schemes, agreements or understandings had been entered into on terms and conditions that would have existed had the persons been independent persons dealing at arm’s length.

In summary, affected transactions are transactions, operations, schemes, agreements or understandings directly or indirectly entered into or effected between or for the benefit of specified parties that are connected persons in relation to one another and that contain any terms or conditions that differ from those that would have existed had the parties been independent persons dealing at arm’s length.

The definition of “affected transaction” currently only includes transactions, operations, schemes, agreements or understandings directly or indirectly entered between the specified parties that are connected persons in relation to one another.

As such, the application of the transfer pricing rules contained in section 31 have the unintended consequence of not always capturing transactions between “associated enterprises” which may not fall within the “connected persons” definition. To correct this unintended consequence and to bring the legislation in line with international standards, the term “associated enterprise” as contemplated in Article 9(1) has been inserted into section 31(1) and into the definition of an affected transaction with effect from years of assessment commencing on or after 1 January 2023. This will result in “affected transactions” applying to both associated enterprises and connected persons in respect of years of assessment commencing on or after this date.

“Affected transaction” and its relationship to connected persons and associated enterprises.

The definition of “affected transaction” 4 in section 31(1) contains two paragraphs:

• Paragraph (a) of the definition relates to the specified persons between which any transaction, operation, scheme, agreement or understanding must be entered, and
• Paragraph (b) of the definition relates to any term or condition that differs from any term or condition that would have existed if the persons had been independent persons dealing at arm’s length.

Currently, section 31(1) defines an “affected transaction” as any transaction, operation, scheme, agreement or understanding entered into for the benefit of specific persons that are “connected persons” in relation to one another as defined in section 1, read with section 31(4). The current definition of “affected transaction” only captures transactions entered into between connected persons and does not capture transactions between “associated enterprise(s)”. Therefore, the term, as contemplated in Article 9(1) of the OECD Model Tax Convention, has been inserted into section 31(1) and into the definition of “affected transaction” with effect from years of assessment commencing on or after 1 January 2023.

The Note describes two enterprises being “associated enterprises” where there is a participation (directly or indirectly) in the management, control or capital of an enterprise of the other Contracting State or, the same persons participate directly or indirectly in the management, control or capital of an enterprise of a Contracting State and an enterprise of the other Contracting State. In addition, an ‘enterprise’ is defined in Article 3 as “carrying on a business”.

For a transaction, operation, scheme, agreement or understanding to be an “affected transaction”, both paragraph (a) and paragraph (b) must be met.

Paragraph (a) of the definition of “affected transaction” essentially means any transaction, operation, scheme, agreement or understanding directly or indirectly entered into or effected between or for the benefit of either or both:

• a resident and a non-resident;
• a non-resident and another non-resident that has a permanent establishment in South Africa to which the transaction, operation, scheme, agreement or
understanding relates;
• a resident and another resident that has a permanent establishment outside South Africa to which the transaction, operation, scheme, agreement or understanding relates; and
• a non-resident and any other person that is a controlled foreign company in relation to any resident;

If those persons are connected persons or, in respect of years of assessment commencing on or after 1 January 2023, associated enterprises in relation to one another.

The Note further provides guidance and examples on each facet of the definition, in particular:

Direct or indirect participation in management.
Direct or indirect participation in control.
Direct or indirect participation in capital.
Therefore, SARS is seeking to widen the tax base, by expanding the ambit of section 31 to apply not only to “connected persons” as defined in section 1, but also to “associated enterprises”, as defined.

The Note envisages scrutiny of a wide range of information and commercial and legal relationships in order to evaluate whether enterprises are associated. These include identifying and considering de facto, as opposed to de jure relationships – which may involve the need for a detailed factual enquiry and for judgement to be exercised in relation to subjective, and not purely objective, information.

Taxpayers need to carefully consider the implications of the widening definition of an “affected transaction” in section 31 to ensure compliance with local transfer pricing regulations. Don’t delay assessing the management, control and capital of the entities within your organisation that may potentially be affected by the proposed amendment.

The Note is now open for public commentary and comments are to be submitted to SARS by no later than Friday, 13 January 2023.

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