South Africa: Interest Deductibility In South Africa

Introduction

In South Africa, interest is deductible under the Income Tax Act, 1962 (the "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.

To determine the deductibility of interest incurred on a loan, it is necessary to determine whether moneys outlaid constitute expenditure incurred in the production of income, requiring a consideration of the purpose of the expenditure and what the expenditure actually effects. 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 enquiry is the taxpayer's subjective purpose in borrowing the moneys upon which it incurs interest. If the purpose is to apply the funding to produce income that is taxable, the interest expenditure incurred ought to be deductible.

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. Interest as defined may be wider than the common law concept thereof.

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.

Summary

Interest is deductible in terms of section 24J(2) of the 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". Section 24JB of the Act provides for the deduction of interest amounts incurred in respect of financial liabilities (so recognised in terms of applicable international standards) against the income of certain taxpayers, such as banks and companies that form part of banking groups.

It is settled law in South Africa that in order to determine the deductibility of interest incurred on a loan, it is necessary to determine whether moneys outlaid constitute expenditure incurred in the production of income, which requires a consideration of (1) the purpose of the expenditure and (2) what the expenditure actually effects. In making this determination, a court will assess the closeness of the connection between the expenditure and the income-earning operations of the taxpayer. Whether moneys are borrowed for a specific identifiable purpose or more generally in order to raise floating capital for use in business, the vital enquiry is the taxpayer's subjective purpose in borrowing the moneys upon which it incurs interest. Where the taxpayer's purpose is to apply the funding to produce income that is taxable, the interest expenditure incurred ought to be deductible.

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, discount or premium payable or receivable in terms of or in respect of a financial arrangement. As this definition of interest itself refers to "interest", the common law meaning thereof has to be established. Based on case law, interest may be understood at common law as compensation payable by the borrower to the lender for the service provided by the lender to the borrower (ie, the service of supplying credit). However, the concept of interest as defined in section 24J (referred to above) may be wider than the common law concept of interest.

As regards the limitation on interest deductibility the South African transfer pricing rules require that the arm's length principle be applied to financial assistance (defined as including any debt, security or guarantee) in the same way as it is applied to any other "affected transaction" which is subject to the transfer pricing rules.

Section 23M of the Act now contains a "fixed-ratio" rule, which limits the deduction for interest paid between connected persons where the interest is not taxed in the hands of the recipient of such interest. The interest deduction permitted thereunder is calculated as interest received plus an amount calculated with reference to a formula (approximately 40% of EBITDA minus taxable interest incurred in respect of other parties).

Section 23N of the Act provides for a statutory ceiling for the amount of deductible interest incurred by company in respect of certain specific categories of debt in the context of corporate reorganisation and acquisition transactions.

In respect of limitations on interest deductibility based on the recharacterisation of interest as non-deductible distributions, in terms of section 8F interest incurred by a company in respect of a "hybrid debt instrument" (as defined therein), or interest incurred by a company in respect of "hybrid interest" as provided for in section 8FA, is deemed to be a (1) dividend in specie declared and paid by the company and (2) non-deductible in the company's hands.

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