Interest Exemption Limitations: Your Options?
30 September 2010
Posted by: Author: Darron West and Dave Bridges
Interest Exemption Limitations: Your Options?
All is not lost for the yield-hungry
The Draft Taxation Laws Amendment Bill 2010 (released on 10 May 2010) has created some concern amongst investors and financial advisers.At issue is the proposed change to exemptions from income tax on interest income afforded to South African residents and non-residents respectively.Presently, the first R22 300 of interest received by a South African resident individual under the age of 65 is exempt from income tax.For individuals over 65, this exemption increases to R32 000.Furthermore,all South African-sourced interest received by a non-resident is exempt.
These exemptions have provided tax planning opportunities, typically involving loans between related or connected persons or closely held companies—the borrower obtains a tax deduction for interest incurred,and the individual recipient benefits from exempt interest income.In its efforts to curtail tax avoidance, National Treasury has now limited the scope of the exemptions.
However, there should be very little cause for concern amongst bona fide investors.For residents and non-residents alike, the form of interest will affect the application of the exemption.Only interest from government bonds, listed debt instruments, bank deposits, benefit funds, stockbroking accounts, and unit trusts will be exempt for years of assessment ending on or after 1 January 2010.A "listed debt instrument” includes listed bonds,debentures, and other similar instruments.Listed corporate and parastatal debt instruments,including debentures, fall within the ambit of this definition.
From a fund management perspective, it is clear that most local investors will not have to alter their portfolios in anticipation of the proposed legislation.This is because very few investors will have interest sources other than those exempted. Certainly, the proposed changes should not prompt any alteration in an ordinary local investor’s portfolio.Non-residents should only have concern about the narrowing of the instruments qualifying for the interest exemption if they have established internal structures to maximise the remittance of interest offshore.
Interest remittance was typically prioritised, as it is presently permitted in terms of the exchange control regulations.For example,non-resident investors may have loaned funds to South African residents such as companies or trusts at high rates of interest (typically at prime plus 2%) so as not to fall foul of other tax and exchange control provisions.It is these structures that are adversely affected by the proposed legislation as the SA-sourced interest income on these loans will now no longer be exempt from SA income tax in the hands of non-residents.
With money market interest rates hovering around 7% per annum, an individual under 65 could invest some R318 000 before receiving interest that would be subject to tax.But in many instances, this amount may be a disproportionately large component of a portfolio.However, for nonresidents a 7% yield may not be sufficiently attractive to justify a continued investment.High-yielding listed debt instruments offer the tax exemption advantages which local and nonresidents seek.
Comment—impact of the changes on small business
The intent of the interest exemption is to motivate savings amongst the middle to lower income groups.This is the very group that is experiencing the highest levels of retrenchments.Many retrenchees start their own businesses.To do this, they withdraw savings that would otherwise be attracting interest that would be subjected to the interest exemption, and injecting that capital into their new business.
The usual medium used for the new business is a close corporation that will be indebted to its founder for the loan capital injected.The founder would prefer to earn interest on their investment.The proposed amendment will result in the interest being fully taxable.Had the founder left their funds in a preservation fund or some other investment, they would have enjoyed the benefit of the exemption.
There are number of adverse consequences arising from this proposed change:
•Less people will inject capital into the small business sector;
•Less jobs will be created in the very sector where most economically active persons are employed (and which it is the government’s stated intention to encourage);
•Start-up businesses will rely upon financial institutions for their capital requirements.This may result in more business failures and job losses.This source may also not be available in consequence of the provisions of the National Credit Act.Therefore, an injection of capital by the founder is the most likely source;
•Sometimes, owners are taxed on their full salaries but, because of cash flow constraints, only withdraw a portion thereof.
These entrepreneurs will be penalised to the extent that the interest earned on the amount retained in the company will now be taxed in full.Some owners have already taken the exemption into account when planning their tax affairs for the 2010 tax year.These taxpayers will be prejudiced by the retrospective introduction of the amendment.One wonders what degree of research and thought went into this amendment given that it seeks to negate the stated intention of the exemption.Commerce and, in particular,small business organisations and representatives should vigorously oppose this proposed amendment that it is intended to introduce retrospectively for years of assessment ending after 1 January 2010.
Source: By Darron West and Comment by Dave Bridges (Tax breaks)