Repeal of beneficial interest deduction practice note worries corporates

There is the letter of the law and there is the spirit – or practice – of the law, and an announcement by the South African Revenue Service (Sars) that it intends to withdraw a practice note covering interest deductions when corporate taxpayers borrow and then on-lend money is causing consternation among these taxpayers.

Tax experts believe the proposed withdrawal could have a severe impact and ‘scupper’ the economics of funding structures.

Several of the larger tax and advisory firms say they will be engaging with Sars on the matter.

Regan van Rooy (RvR), an international tax and structuring firm that focuses on Africa, says in its latest newsletter the announcement is worrisome for a lot of people: “Particularly those who have recently implemented financing or holding structures that rely on an intermediary holding company being able to claim an interest deduction where it on-lends funds.”

Perceived abuse

Practice Note 31 covers interest deductions in certain instances and has been in existence since 1994.

It essentially says that although interest must in theory be incurred in the course of trade to be deductible, in practice Sars would allow the deduction of interest incurred purely for the purpose of earning interest, RvR explains.

Craig Miller, director at law firm Webber Wentzel, says the proposed withdrawal is to curb perceived abuse of the concession, although Sars does not articulate what the perceived abuse is.

He suggests that Sars use its general anti-avoidance rules in the Income Tax Act, which is already available to the tax authority, if it perceives there to be abuse. “This may very well be an isolated case,” he adds.

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RvR is also sceptical about the perception that the practice is being abused by “naughty structures and naughty taxpayers who created transactions with the intention of obtaining a deduction that would otherwise not be permitted”.

The firm believes the practice has been eminently sensible in facilitating normal commercial intra-group funding transactions.

Miller says the purpose of the practice note was to create certainty where a taxpayer borrows to on-lend. The application of the practice note ensures that a taxpayer can deduct interest incurred on the amount borrowed to the extent that the taxpayer accrues or receives interest on the amount which it on-lent.

The note established the practice that where money was borrowed and then on-lent, Sars has been happy to concede that the taxpayer is ‘trading’ even though the company may do nothing else other than borrow to on-lend, says Miller.

Helpful nugget

If a company borrows and on-lends at a small margin, it could claim a deduction on the interest expense and only had to pay tax on the margin between the interest paid and the interest earned.

This “helpful nugget”, as RvR puts it, is what Sars is now getting rid of. This could mean that when a company borrows and on-lends, for example an intermediary holding company, it would have to pay tax on the full interest income with no deduction.

“This, especially nowadays with high-interest rates, could scupper the economics of many a structure,” says RvR. “No wonder so many knickers [are] atwist.”

Miller says companies secure funding from lenders, and for commercial purposes the funding is advanced through an intermediary company. For example, large groups often form treasury companies in order to procure funding from different lenders which is then onward advanced to the rest of the group.

Another example is when lenders structurally subordinate their debt such that certain lenders enjoy greater security than others.

Miller says he would like to know how Sars recommends that these commercial issues be dealt with in the absence of the practice note.

“My view is that this is not a positive development as it will significantly impede the commercial requirements of lenders and borrowers. This can never been a good thing. Hopefully, the financial services industry can consult with the [Sars] Commissioner and this issue can be resolved.”

‘Problematic’

Keith Engel, CEO of the South African Institute of Taxation (Sait), says the proposed removal of the practice note is most problematic for back-to-back group loans in the absence of South African group relief rules.

It is also problematic for small business owners who borrow funds from a bank to finance their small business companies and for holders of real estate investment units who acquired those units with borrowed funds.

Sait believes the practice note achieves the right practical outcome.

However, it lacks a firm legal foundation given the absence of a “trade” normally required for business deductions.

Engel says Sait will be submitting a request for legislative change.

Going forward

RvR is of the opinion that Practice Note 31 will not be repealed completely.

“We do think some concessionary practice will still apply, as on-lending will always be a commercial transaction and it would be unfair to have punitive tax treatment.”

It notes however that claims of unfairness have never stopped the tax man, saying the firm intends “to follow the discussions closely”.

Sars wants to withdraw Practice Note 31 for years of assessment starting from 1 March 2023.

Affected parties have until 15 December to comment on the proposal.

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