Unpacking the Bills
17 December 2013
Posted by: Author: Lesley Isherwood
Author: Lesley Isherwood (KPMG)
The Taxation Laws Amendment Bill (the "TLAB”) and Tax Administration Laws Amendment Bill (the "TLAAB”), collectively referred to as the Bills, were tabled before parliament on the 24th of October 2013. At the time of writing, the Bills had not yet been promulgated and were therefore not officially law. However, in practice, save for correction of typographical errors, the Bills as tabled are what will be signed into law.
The Bills are extensive and analysis of all or even most of the changes is beyond the scope of this article. However, there are some provisions which mark a fundamental shift in law and it is these provisions which form the focus of this writing. From the outset we note that not all of the proposals contained in the draft Taxation Laws Amendment Bill have made their way into the TLAB and many of the provisions that did survive have been relaxed in some form. Not only have some of the proposals in the draft Tax Administration Laws Amendment Bill been abandoned, but there are welcome additions in the final bill.
Taxation Laws Amendment Bill
The class of changes in the TLAB which will be discussed are those relating to the treatment of interest on certain types of loans. The TLAB focuses on three areas in relation to interest bearing arrangements. These areas are discussed briefly below.
Hybrid debt instruments or debt with equity like features
The TLAB will introduce new provisions targeting interest bearing arrangements which contain features normally associated with equity instruments. The existing section 8F of the Income Tax Act, which deals with hybrid debt instruments, will be replaced with new rules that will have the effect of re-characterising interest as a dividend in the hands of both debtor and creditor. Any interest incurred on or after 1 April 2014 in relation to tainted instruments will be deemed to be a dividend in specie that accrues to the creditor on the last day of the debtor’s year of assessment.
Interest bearing arrangements will fall within the ambit of section 8F in any one the following broad circumstances:
- The interest bearing arrangement has a term of 30 years or longer and the parties are connected persons. Instruments which are payable on demand are excluded from this class of interest bearing arrangements; or
- The interest bearing arrangement contains terms which provide that the obligation to pay any amount under that arrangement is conditional upon the market value of the assets of the debtor not being less than the market value of the liabilities of that company; or
- The debtor is entitled to or obliged to settle the debt through the issue of or delivery of shares unless the market value of the shares is equal to the amount owed in terms of the debt, on the date that the shares are issued or exchanged in settlement of the debt.
In addition to the revised section 8F provisions, the TLAB will introduce section 8FA which will regulate the treatment of "hybrid interest”. Like section 8F, section 8FA will re-characterise interest incurred after 1 October 2014 as a dividend in specie in the hands of both debtor and creditor. Section 8FA will be triggered if:
- The interest on an instrument is not determined with reference to a specified interest rate or with reference to the time value of money; or
- The interest rate increases as a result of an increase in the profits of the debtor i.e. where the instrument contains a so-called equity kicker.
In the first instance, the entire return on the instrument will be treated as a dividend. However, where the only tainting factor is the existence of an equity kicker, it is only the additional interest charged as a result of the increased profits which will be re-characterised.
Limitation of interest payable to connected persons who are not subject to tax
From 1 January 2015, the interest payable by a resident on debts owed to connected persons will be subject to section 23M of the Income Tax Act if the interest is not subject to tax in the hands of the creditor or is not included in the net income of a controlled foreign company (”CFC”) in terms of section 9D of the Income Tax Act. There are carve-outs for back to back loans and special rules which apply if the loan is granted by a third party but is secured by a connected person. These carve-outs are not discussed.
The term ‘subject to tax’ is somewhat problematic and has not been defined for purposes of section 23M. However, based on the contents of the explanatory memorandum (which would constitute a generally prevailing practice in terms of the Tax Administration Act), it would appear that a creditor would be regarded as not being subject to tax where a creditor completely escapes both the Income Tax as well as Interest Withholding Tax nets (the effective date of section 23M is aligned with the effective date of the Interest Withholding Tax), whether by virtue of an exemption in the Income Tax Act or through the operation of a Double Taxation Agreement.
Where the requirements of section 23M are met in respect of any instrument, the taxpayer will be required to apply a formula set out in section 23M to determine the extent to which the interest on section 23M debts may be deducted. The starting point in applying this formula is to determine the ‘adjusted taxable income’ for the year of assessment in question. This is essentially the taxable income for the year, adjusted for all interest accrued and incurred, any capital allowances claimed during the year as well as any recoupments of capital allowances and finally any CFC income included in the taxable income by virtue of section 9D.
The interest allowed as deduction in respect of all section 23M debts owed may not exceed the sum of the interest accruing to the debtor (on all debts) and 40% of adjusted taxable income for the year of assessment less any interest incurred on non-section 23M debts. Any interest in excess of this amount can be carried forward and will be deemed to be an amount of interest incurred in the subsequent year of assessment.
The provisions of section 23M will only come into effect on 1 January 2015 so there will be an opportunity for refinements to be made to the section prior to the effective date. Changes may be needed as the section does not necessarily achieve the base erosion effect targeted. Compare for instance the position of an operating company which pays interest to a parent company who is not subject to tax. Applying the formula set out in the section 23M would result in a limitation of the interest deduction on the loan to the parent company. If, however, a resident investment holding company is interposed between the parent company and the operating company and the loan is advanced to the operating company via the investment holding company, the provisions of section 23M may apply to the loan between the investment holding company and the parent company but the formula set out in section 23M will still allow a deduction of interest to the extent of the interest received from the operating company. Furthermore, section 23M would not apply to the loan between the investment holding company and the operating company as both parties would be subject to tax. Whilst interposing an investment holding company purely in order to obtain the above result can and should be challenged on anti-avoidance grounds, there are many instances where the investment holding company exists or will be required for valid commercial purposes. The legislation does not, however, appear to cater for this eventuality.
Limitation of interest in respect of acquisition debt
From 1 April 2014, a new interest limitation regime in respect of acquisition debt will replace the current discretionary section 23K regime. The new provisions, contained in section 23N of the Income Tax Act will apply to interest on debt used to finance any section 45 (intra-group) transaction or section 47 (liquidation) transaction – collectively referred to as "reorganisation transactions” - or any section 24O "acquisition transaction” (section 24O provides for the deduction of interest on debt used to acquire at least 70% of the equity shares in an operating company) entered into on or after 1 April 2014. In addition, the provision of section 23N will apply to interest on any debt used to refinance any reorganisation transactions entered into on or after 3 June 2011 (the effective date of section 23K) and any acquisition transactions entered into on or after 1 January 2013 (the effective date of section 24O). Reorganisation transactions entered into before the introduction of section 23K can be refinanced without attracting the interest limitations imposed by section 23N.
Where a taxpayer has obtained a section 23K approval in anticipation of entering into a reorganisation or acquisition transaction but the transaction only becomes effective after 1 April 2014, the provisions of section 23N will not apply to the taxpayer and interest on debt used to finance the transaction will be limited in accordance with the section 23K approval.
Section 23N applies similar methodology to section 23M in determining the quantum of the interest that can be claimed. Like section 23M, the starting point is to determine adjusted taxable income. However, in determining adjusted taxable income a further inclusion of 75% of the rental income derived from immovable property can be made. The interest on any debt affected by section 23N will then be limited to the sum of interest received by the taxpayer during the year of assessment plus the adjusted taxable income of either the year of assessment in which the transaction was concluded or the year of assessment in which the interest was incurred, whichever is higher, less the amount of any interest paid on debts which are not subject to section 23N. Any portion of interest disallowed may not be carried forward to the subsequent year of assessment but the provisions of section 23N will only apply to limit the interest in the year of assessment in which the transaction was concluded and the five subsequent years of assessment.
Tax Administration Laws Amendment Bill
Whilst the amendments to the Income Tax Act create a bold new framework for the taxation of debt instruments, the amendments to the Tax Administration Act ("TAA”) in respect of penalties represent, for the most, a softening of the provisions.
The changes proposed in the TLAAB in relation to penalties can be broadly categorised into two parts. The first category of changes relate to penalties levied on assessments where the returns were submitted prior to the effective date of the TAA i.e. before 1 October 2012. The second category affects all returns assessed under the TAA.
Changes only affecting returns submitted prior to 1 October 2012
The implementation of the TAA saw the introduction of a new understatement penalty regime characterised by fixed percentages levied according to set categories of behaviour and very limited powers conferred on the South African Revenue Service ("SARS”) to remit the penalties. In particular, the provisions of the TAA required taxpayers, seeking remittance of understatement penalties, to have obtained a tax opinion (which met set requirements laid down in the TAA) from a registered tax practitioner supporting the tax position taken by the taxpayer and to have obtained this opinion prior to the date on which the relevant tax return was due. Prior to the introduction of TAA, taxpayers could not possibly have been aware that this requirement would be introduced and moreover could not have obtained an opinion from a tax practitioner registered as such in terms of the TAA.
SARS has in practice imposed understatement penalties in terms of the TAA in respect of tax periods prior to 1 October 2012, making the remittance of understatement penalties practically impossible. The TAA contains transitional provisions which state that SARS may impose additional tax, penalties and interest under the previous legislation if these amounts "were capable of being imposed” by the commencement date of the TAA. Taxpayers have disputed the application of the understatement penalties in respect of returns submitted prior to 1 October 2012, arguing that additional tax, penalties and interest under the previous legislation were capable of being imposed in respect of tax returns submitted prior to 1 October 2012 and that in those circumstances SARS does not have a discretion as to whether to impose penalties under the previous legislation or the TAA and is compelled to apply the previous dispensation.
The amendments contained in the TLAAB seek to address these disputes in the following three ways:
- The term "capable of being imposed” has been defined with reference to the completion of the verification, audit or investigation necessary to determine the additional tax, penalty or interest. The transitional provisions will therefore only find application if this process was completed prior to 1 October 2012.
- Taxpayers will be provided with an opportunity to obtain a tax opinion from a registered tax practitioner in support of the tax position taken. The tax opinion will be deemed to have been obtained prior to the date on which the tax return was due.
- SARS has been granted a discretion to remit understatement penalties on Income Tax returns and VAT returns if the taxpayer objects and the following circumstances are met:
- In respect of Income Tax returns: If a senior SARS official is satisfied that there are extenuating circumstances; and
- In respect of VAT returns: In circumstances other than where intentional tax evasion is present.
The above amendments will be made with retrospective effect, with the effective date being 1 October 2012.
Changes affecting all returns assessed under the TAA
In addition to the changes affecting understatement penalties on returns submitted prior to 1 October 2012, the TLAAB will introduce three important changes which will impact the penalty regime applicable to all returns assessed under the TAA.
The first of these changes creates an exclusion to the understatement penalty regime in circumstances where the understatement is as a result of a bona fide inadvertent error. These errors can be either factual or legal in nature. Where such errors exist, SARS will not impose understatement penalties. The amendment to the TAA in this regard will be made with retrospective effect, with the effective date being 1 October 2012.
The second significant change is in respect of the percentages which SARS is required to levy in relation to understatement penalties. These have been reduced significantly. By way of example, substantial understatements will attract a 10% penalty rather than a 25% penalty. Unfortunately the reduced rates will only apply from date of promulgation of the TLAAB.
Finally, the requirement that taxpayers obtain an opinion from a registered tax practitioner in order to remit understatement penalties will be amended with effect from the date of promulgation of the TLAAB and will require that the opinion is obtained from an independent tax practitioner. In-house tax functions will therefore not be able to issue opinions for purposes of the remittance of understatement penalties.
Whilst the amendments to the TLAAB are for the most part a move in the right direction, issues of interpretation as to what will constitute a bona fide inadvertent error and as to the nature of extenuating circumstances will no doubt ensure that the question of understatement penalties remains a contentious issue.