The number of provisions contained in the Income Tax Act, 58 of 1962 ("the Act") which deal with tax treatment of interest income and interest expenditure have gradually increased over time. There are numerous aspects to be borne in mind by resident and foreign companies when considering the income tax and withholding tax implications which may arise in respect of transactions giving rise to interest income and interest expenditure.
This article serves as an outline of certain provisions which should be given consideration when assessing the tax impact which interest income or expenditure may have on the position of a company.
- The foundation of the tax treatment of interest lies in section 24J of the Act. Section 24J of the Act applies to qualifying "instruments" and contains the principle that an amount of interest expenditure is incurred by a taxpayer by applying a constant compound rate of interest over the term of an instrument in terms of various formulas contained in section 24J of the Act. No deduction of interest is permitted if the interest is not incurred in the production of "income" as defined. No deduction of interest expenditure will be permitted, for example, if interest is incurred in the acquisition of shares which produce tax exempt dividend income.
- Notwithstanding the section 24J restriction of interest deductions to cases where interest is incurred in the production of "income", section 24O of the Act deems the incurral of interest in terms of certain debts to be, inter alia, in the production of income. Section 24O applies to debts issued by a company for the purpose of financing certain acquisitions of equity shares in an "operating company" as defined. Should the requirements of section 24O be met, then the production of income restriction contained in section 24J will not apply.
Limitation of interest deductions
- Section 23M of the Act limits the amount of interest that can be deducted by a taxpayer and applies to debts directly or indirectly owed to a creditor that is in a "controlling relationship" with that debtor. If the amount of interest paid by the debtor is, inter alia, not subject to tax in the hands of the person to which the interest accrues, the actual amount of interest to be permitted as a deduction will be limited by way of the application of a formula contained in section 23M.
- Section 23N applies to interest incurred in respect of debts applied to finance certain acquisitions of equity shares in an "operating company", as well as to finance the acquisition of assets where such acquisition is effected in terms of some of the so called "corporate rules" provisions (section 45 or 47 of the Act). Section 23N limits the deduction of interest by way of the application of a formula contained in section 23N in the year of assessment in which the transaction is entered into as well as the five years immediately thereafter.
Taxation of Interest income
- Similar to what is set out in respect of section 24J in relation to interest expenditure, section 24J of the Act applies the principle that interest income is deemed to accrue to a taxpayer at a constant compound rate of interest over the term of an instrument. The specific amount of interest which is included in the income of a taxpayer is calculated in terms of the various formulas contained in section 24J of the Act.
Recharacterisation of interest income and expenditure
- The hybrid debt and hybrid interest provisions are contained in sections 8F and 8FA of the Act. These sections recharacterise any amount of interest accrued by a company in relation to a "hybrid debt instrument" and "hybrid interest" as a dividend in specie. The implications for a debtor who makes hybrid payments are that it will not be permitted a deduction of interest expenditure which it has incurred. Furthermore, the recharacterisation of the interest to a dividend in specie may give rise to a dividends tax liability for the debtor making payment of the interest. The creditor who receives hybrid payments will be deemed to have received payment of a dividend in specie. The tax implications of the creditor will therefore be determined with reference to the provisions of the Act which deal with the accrual and exemption, if relevant, of dividend income.
Interest - Non-resident considerations
- Whilst residents will usually be taxable as regards interest income, a domestic exemption applies to any amount of South African sourced interest received by or accrued to any non-resident unless the debt from which the interest arises is effectively connected to a permanent establishment in South Africa.
- The interest withholding tax applies to all South African sourced interest payments made to non-residents and is imposed at the rate of 15% of the amount of interest paid. Interest income is generally from a South African source if it is attributable to an amount incurred by a resident, or if the interest is derived from the utilisation of funds in South Africa by any person. Any amount of South African sourced interest which is paid by any person to a non-resident will therefore give rise to an interest withholding tax liability in the recipient's hands, and an obligation to withhold in the payer's hands, subject to the application of various exemptions and treaty relief.
Fair value taxation of interest
- Section 24JB of the Act applies to a "covered person" as defined. This includes a bank or an authorised user. To the extent that section 24JB applies a covered person will be permitted a deduction or will be required to include in its income, all amounts taken into account in respect of financial assets or financial liabilities that are recognised at fair value in profit or loss in terms of International Accounting Standard 39 of IFRS – ie the tax treatment of the relevant financial assets and liabilities will follow the accounting treatment thereof.
Transactions resulting in interest income or expenditure in the hands of a company require careful consideration for various reasons. Firstly, the scope of the provisions outlined above is wide and the provisions may find application and impact significantly in a number of scenarios. In addition, many provisions relating to the taxation of interest have been introduced fairly recently. The interaction between such provisions in instances where more than one provision applies to the same instrument may not be as clear upon deeper examination of the particular wording of the legislation.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.