An analysis of Section 23M in light of the OECD guidelines relating to thin capitalisation
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Base erosion in the form of profit shifting has become an increasing concern internationally as well as in South Africa. A significant type of base erosion in South Africa is in the form of excessive interest deductions where income is effectively shifted to a no-tax or low-tax jurisdiction. One of the key developments affecting the South African tax laws was the introduction of provisions that target base erosion and profit shifting. Included in these provisions is section 23M, which limits the deduction of interest paid to persons in whose hands the interest received is not subject to tax in South Africa. It was, however, identified that section 23M may target the same interest risks that the new section 31 thin capitalisation provisions address. Section 23M was said to be the enactment of thin capitalisation. Although one of the purposes of tax treaties is to encourage international trade and investment, there is also discriminatory taxation, which runs counter to that purpose and therefore the prevention of such discrimination is important when dealing with tax treaties. The Organisation for Economic Cooperation and Development’s (OECD) Model Tax Convention contains a handful of special criteria in article 24, which must not lead to different or less favourable treatment with regard to taxation. It was found that the non-discrimination article, in particular articles 24(4) and 24(5), may prevent the application of a thin capitalisation regime if the provisions are in contrast with the OECD non-discrimination provisions. Article 24(4) and article 24(5), however, contain an exception that the non-discrimination provisions would not be applicable provided that the thin capitalisation regimes are compatible with the arm’s length principles of article 9. If section 23M was therefore found to be an arm’s length transaction, the article 24(4) and (5) non-discrimination provisions would without further consideration, not be applicable. It was, however, found that section 23M does not consider the factors that should be considered when an arm’s length transaction is applicable, but merely applies the same formula to each company regardless of the size of the company or the industry sector. As a result of this, it appears as if section 23M is arbitrary in nature and therefore would not represent an arm’s length transaction. The exception would not be applicable and would therefore increase the potential non-compliance with the non-discrimination provision. The objective of this study was to determine whether any aspect of section 23M would be contrary to the OECD guidelines relevant to thin capitalisation and in particular the non-discrimination provisions. It was, however, found that although it appears as if section 23M’s primary focus is on cross-border transactions, the provisions do not directly discriminate on the basis of residence. As a result of the discrimination being indirect discrimination and the fact that the cause of section 23M being applicable is not foreign ownership, but rather due to the creditor not being subject to tax, it was concluded that the OECD non-discrimination provisions would not be applicable to section 23M.