Currently, a taxpayer is entitled to deduct interest calculated in terms of section 24J(2) of the Income Tax Act, 1962 ("Act") if the taxpayer:
- derived income from carrying on a trade; and
- if the amount of the interest is incurred in the production of income.
Many taxpayers who do not carry on a trade have until now relied on Practice Note 31 of 1994 ("PN 31") to claim a deduction for interest incurred on funds borrowed where such funds were invested in interest bearing instruments or on-lent and resulted in the taxpayer earning interest income. In particular, Practice Note 31 states as follows:
"While it is evident that a person (not being a moneylender) earning interest on capital or surplus funds invested does not carry on a trade and that any expenditure incurred in the production of such interest cannot be allowed as a deduction, it is nevertheless the practice of Inland Revenue to allow expenditure incurred in the production of the interest to the extent that it does not exceed such income. This practice will also be applied in cases where funds are borrowed at a certain rate of interest and invested at a lower rate. Although, strictly in terms of the law, there is no justification for the deduction, this practice has developed over the years and will be followed by Inland Revenue."
In 2022, the South African Revenue Service indicated that it intends to withdraw PN 31.
However, after public consultation, taxpayers were given an opportunity to make representations regarding the withdrawal. As a result, during the 2023 Budget Speech, it was announced that the proposed withdrawal of PN31 would be delayed. This was to give time for government to review the impact of the proposed withdrawal and to consider whether changes could be made in the tax legislation to accommodate legitimate transactions affected by the withdrawal. It was stated that the withdrawal of PN 31 will be aligned with the effective date of any legislation arising from the proposed considerations.
The 2023 draft Taxation Laws Amendment Bill ("Draft TLAB") containing the proposed amendments to the Act has now been released and one of the proposed changes is the insertion of a new section 11G into the Act. The proposed section 11G will provide a deduction for expenditure incurred and is effectively the concession as a result of the withdrawal of PN 31.
However, section 11G differs significantly from PN 31 in that:
- It is limited to a company claiming a deduction of expenses incurred by that company. Taxpayers such as individuals and trusts cannot claim a deduction in terms of section 11G whilst PN 31 applies to any person and is not limited to group companies;
- It is a requirement that the expense is not of a capital nature; and
- The expense must be incurred by that company in the production of interest income in respect of a loan, advance or credit advanced directly/indirectly to a group company. As a result, the deduction is limited to companies incurring expenses in order to on-lend funds to group companies from which the company earns interest income. PN 31 does not currently limit the expense to instances where the taxpayer earns interest income from group companies only.
The proposed section 11G also contains a proviso that the amount allowed to be deducted under this section must not exceed the amount of that interest income. This is similar to the current requirement under PN31 that the deduction cannot exceed the income.
The draft Explanatory Memorandum provides that:
"these requirements are aimed at ensuring that where funding is raised by one group company for purposes of another group company for productive purposes, no tax leakage arises. Where the funds are used within the group for non-income producing purposes, a deduction will not be allowed, and other specific provisions must be considered (i.e., section 24O of the Act)."
The proposed effective date for the introduction of section 11G is 1 January 2024 and it will apply in respect of years of assessment commencing on or after that date.
All taxpayers that are claiming interest deductions but not carrying on a trade would be affected by the withdrawal of PN 31 if they do not qualify for the deduction in terms of the proposed section 11G.
The proposed section 11G is significantly more restrictive than the current position. As a result, once the changes enter into force, certain taxpayers will not be able to claim interest deductions where funds were borrowed to invest in interest bearing instruments. Such taxpayers will be taxed on the gross amount of their interest income.
It is not entirely clear what the abuse is that SARS is trying to target with the withdrawal PN 31 and why taxpayers other than group companies would not qualify for the relief offered in section 11G. The Explanatory Memorandum to the 2023 Draf TLAB states as follows:
"It is still Government's policy that deductions should be allowed where the taxpayer is carrying on a trade. Under the general deduction formula, deductions are not limited to the income of the taxpayer, however, the trade requirement operates as a safety net that the fiscus will not simply carry excess expenditure and losses without hope of any tax collection in a future year of assessment. As such, Government seeks to not allow concessions that will enable the circumvention of the trade requirement in allowing for deductions in the business context.
Furthermore, the abuse of Practice Note 31 of 1994 is worsened by taxpayers entering into transactions that are structured to maximise the deduction of interest or other expenditure incurred whilst there is no corresponding inclusion in gross income for the related recipient or where debt funding is ultimately used to fund non-income producing activities or assets. However, it is not in the best interest of the fiscus that efficient access to funding for businesses should be hampered, with particular emphasis on the existing practice for groups of companies to raise funding centrally in a non-trading treasury company and on-lending to a fellow group company in return for interest." [Our emphasis included]
Although the above reasons were provided, they are not entirely convincing since PN31 does not entitle a taxpayer to maximise the deduction of interest or other expenditure as it only provides a concession for the trade requirement. The taxpayer still has to comply with all the other requirement of either the general deduction formula or section 24J of the Act and both of these require the expenditure to be in the production of income. On this basis a deduction may currently only be claimed if the expense produces income (which ensures a corresponding inclusion in gross income). Furthermore, PN31 limits the amount that may be deducted to the amount of the income earned so excess expenditure cannot be claimed as a deduction.
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.