Tax Proposals Target Interest Deductions
09 July 2013
Posted by: Author: Ruan Jooste
Author: Ruan Jooste (BusinessDay, bdlive.co.za)
Last week, the Treasury and the South African Revenue Service (SARS) published the 2013 draft Taxation Laws Amendment Bill for public comment. The draft legislation gives effect to most of the tax proposals announced in this year’s budget review, but also contains proposals aimed at limiting the deductibility of interest payments in certain transactions.
These additional proposals were released in May for public input. The Treasury has stated that the proposed rules will limit excessive interest deductions in schemes that could lead to tax-base erosion.
The Treasury noted that this was one of the most significant types of tax-base erosion in South Africa and that it comes in the form of companies in effect shifting income to a no-tax or low-tax jurisdiction or converting to a different type of income, one subject to less tax in South Africa. These deductions are typically channelled as interest, royalties, service fees and insurance premiums. "Of greatest concern is excessive deductible interest," the Treasury said.
Transactions between related local and offshore parties are a concern. Nonresident lenders are not taxed on interest income by reason of a specific exemption in the Income Tax Act introduced by the government. In the future, they will be subject to an interest withholding tax at a rate that will range from 5% to 15%, depending on double-taxation agreements South Africa has with the country concerned.
SARS also wants to limit the tax deduction applicable to persons to 40% of the debtor’s taxable income (determined before taking into account any interest).
"One of the key justifications is to combat ‘arbitrage’," says Adam Bekker, senior deal maker in the corporate finance department of Bravura. "Situations like where a borrower gets a tax deduction for an interest expense, whilst the lender is exempt from tax, or is taxed at a low rate in respect of the interest income, will no longer be tolerated," he says.
In order to reduce this concern, the deductions for interest associated with debt between certain entities of the same group will be limited regardless of the terms associated with that debt.
More specifically, if a company pays interest to another entity within the same group and the interest is untaxed (or taxed at a lower rate) when received by the other entity, the interest deduction will be subject to a limitation. The limitation will also apply if the untaxed group entity guarantees or provides other security in respect of debt owed by the company debtor.
In either of these circumstances, the deduction for interest paid or incurred in respect of the debt will be limited to 40% of the debtor’s taxable income. To the extent that interest paid or incurred on debt between group entities exceeds the limitation, the excess can be carried forward for up to five years.
Mr Bekker says the 40% cap appears to be arbitrary.
He says the main problem is that the taxpayer’s interest payments will fluctuate in line with interest rates, and its taxable income will change in line with profits. Both are matters over which the taxpayer has no influence. "If interest rates rise or profits decrease, or both, the taxpayer’s interest bill as a proportion of profits goes up, and the nondeductible portion of that interest bill also increases. Then, despite the taxpayer not having done anything, the arbitrary 40% rule can impact on a punitive basis to worsen the effect of an already harsh economic climate," he says.
The proposed rule is, however, limited to situations where the interest is deductible in one person’s hands but exempt, or taxed at a lower rate, in another person’s hands. This measure also limits tax losses available to companies in freeing up some cash and assisting in its financial recovery.
For example, a transaction might have been entered into before the 2008-09 crisis, when a firm was making profit, but then incurred losses during the recession. The rule will prevent a company from building up a tax loss during the tough times and using this in future to lessen a tax liability.
"On an economic fairness basis, that loss should be available to assist you with your tax bill, and therefore your recovery, going forward. This rule won’t allow that," says Mr Bekker.
The "percentage of taxable income" measure to limit interest deductions moves away from the international norm, which favours a debt-to-equity type measure to determine the level of interest allowed as a tax-deductible expense.
"Ultimately, SARS is trying to collect more revenue by curbing areas in which it believes there is abuse. It has targeted areas where it thinks there is a mismatch between economic substance and tax treatment, or a mismatch in tax treatment between countries and between people," Mr Bekker says.
SARS sometimes brings in one set of rules, only to try to reverse their application or consequences through another set. The rules it proposes are often also too broad.