In South Africa, interest is deductible under the Income Tax Act, whether or not the interest is capital in nature, provided the interest is incurred “in the production of income” and as part of a “trade”. The Act provides for the deduction of interest amounts incurred in respect of financial liabilities against the income of certain taxpayers, including banks.
The provisions of section 24J of the Income Tax Act regulate the incurral or accrual of interest on financial instruments. It enacts the principle that interest accrues on a “yield to maturity” basis and applies to all “instruments”, defined as including any interest-bearing arrangement or debt.
To determine the deductibility of interest incurred on a loan, it is necessary to determine whether money outlaid constitutes expenditure incurred in the production of income, requiring a consideration of the purpose of the expenditure and what the expenditure affects. In making this determination, a court will assess the closeness of the connection between the expenditure and the income-earning operations of the taxpayer.
The vital inquiry is the taxpayer’s subjective purpose in borrowing the money upon which it incurs interest. If the purpose is to
apply the funding to produce income that is taxable, the interest expenditure incurred should be deductible.
Section 24J (2) of the Act deals with the deductibility of interest whether or not the interest is seen as capital in nature.
Section 24J(2) provides that where a person is the “issuer” in relation to an instrument during any year of assessment, such person shall for purposes of the Act be deemed to have incurred an amount of interest during such year of assessment which is equal to the sum of all accrual amounts in relation to all accrual periods falling wholly or in part within such year of assessment in respect of such instrument, which must be deducted from the income of that person derived from carrying on any trade, if that amount is incurred in the production of the income (such as trade).
An “issuer” is defined as any person who has incurred interest or has any obligation to repay an amount in terms of an instrument.
The term “carrying on any trade” is not defined in the Act. However, the term “trade” is widely defined in section 1 of the Act and includes inter alia every profession, trade, business, employment, calling, occupation or venture, including the letting of any
property.
SARS typically allows the deduction of expenditure incurred in the production of income even though the receipt or accrual of the income does not constitute the carrying on of a trade. This practice of SARS is set out in Practice Note No. 31 (income tax: interest paid on money borrowed) (“PN31”). Although PN31 provides that the practice set out therein will be followed by SARS, PN31 is not binding in terms of South African law.
Whilst Section 24J is relevant, one must also consider the changes made to Section 23M, of the Income Tax Act, effective from 01 March 2023. One of these changes includes amendments to the rules on the limitation of deductions of interest payable to creditors where the interest is not subject to tax or is not imputed as part of the net income of a controlled foreign company, as contained in section
23M of the Income Tax Act.
Under the existing requirements, the provisions of section 23M apply where the creditor is in a controlling relationship with the debtor. The definition of “controlling relationship” requires that the creditor should directly or indirectly hold at least 50% of the shares, or control at least 50% of the voting rights in the debtor.
The applicability of section 23M has been expanded as follows:
- The first applies where the creditor is not in a controlling relationship with the debtor but forms part of the same group of companies as the debtor, applying a test of a holding of more than 50%. The limitation extends to loans by a subsidiary to a parent company,
which was arguably not the case previously. - Section 23M now also applies to so-called ‘back-to-back’ loans. These ‘back-to-back’ loans were generally structured so that a foreign company provided funding to a South African holding company, which then on-lent the funds to its South African subsidiary. This imposes a significant burden on a taxpayer to identify the origin of loan financing.
Under the new rules, where the withholding tax rate, applicable to the interest paid to a non-resident, is reduced to less than 15%, the
remainder would be regarded as having not been subject to tax.
One of the significant changes relates to the term “interest” which is subject to section 23M. This definition was expanded and specifically includes:
- Amounts incurred or accrued in terms of an “interest rate agreement” as defined in section 24K(1);
- Any finance cost element that is recognised for the purposes of IFRS in respect of any lease arrangement that is a finance lease under IFRS 16;
- Amounts taxed or allowed as exchange differences in terms of sections 24I(3) and (10A); and
- Amounts treated as interest under section 24JA in terms of Sharia-compliant financing arrangements.
Before the amendments, the limitation of the deduction was based on a formula that took into account 40% of the taxpayer’s “adjusted taxable income”. The 40% was however adjusted by a repo rate factor which effectively took fluctuations in the repo rate into account. The amended rule now applies a fixed rate of 30% in the relevant formula, effectively having the effect of reducing the limitation.
The Act does not define interest other than in section 24J, where it is defined as including the gross amount of any interest or similar finance charges. As this definition refers to “interest”, the common law meaning thereof has to be established. Interest may be understood at common law as compensation payable by the borrower to the lender for the supply of credit provided by the lender to the borrower.
There have been no changes to the deductibility of interest or the interest definition following the BEPS Action 4 Report. Regarding
the limitation on interest deductibility, before the BEPS Action 4 Report, transfer pricing rules require that the arm’s length principle be applied to financial assistance in the same way as it is applied to any other “affected transaction”.
The Act now contains a “fixed-ratio” rule. The interest deduction permitted is calculated as interest received plus an amount calculated with reference to a formula. The Act provides for a statutory ceiling for the amount of deductible interest incurred by a company in respect of certain debt categories. Under the Act, interest incurred by a company in respect of a “hybrid debt instrument”, or interest incurred in respect of “hybrid interest”, is deemed to be a dividend in specie declared and paid by the company and non-deductible in the company’s hands.
A separate article will deal with transfer pricing rules.