The limitation of deductions for untaxed interest
26 January 2014
Posted by: Author: Kyle Mandy
Author: Kyle Mandy (PwC)
The Taxation Laws Amendment Bill 39 of 2013 proposes the introduction of a new section (section 23M) to the Income Tax Act (ITA) to limit the deduction of interest incurred by a debtor in respect of a debt owed to a creditor that is in a ‘controlling relationship’ with the debtor and the interest in question is not subject to South African tax. The restriction will apply to interest incurred on or after 1 January 2015. In essence, the section limits the deduction for interest paid between connected persons where the interest is not taxed in the hands of the recipient to an amount determined with reference to 40% of taxable income before interest and capital allowances.
This new provision is, however, not as simple as it appears at first blush. Before the provision applies, the following requirements must all be present:
- the debtor must be a South African resident for tax purposes;
- the debtor and the creditor must be in a controlling relationship;
- the interest incurred must not be subject to tax during that year of assessment.
Each of these requirements deserves further consideration and analysis.
The debtor must be resident
The implications of this requirement seem obvious at first. Clearly, any debtor that is resident in South Africa will meet the requirement. The bigger issue is with respect to debtors not covered by the provision. Notably, a South African branch of a non-resident would not be a debtor as defined and any interest incurred by such a branch would not be subject to the interest limitation. This may raise some interesting constitutional issues. Section 9(3) of the Constitution of the Republic of South Africa, 1996 (the Constitution) provides that "The state may not unfairly discriminate directly or indirectly against anyone on one or more grounds”. Section 9(5) goes on to provide that "Discrimination on one or more of the grounds listed in subsection (3) is unfair unless it is established that the discrimination is fair.”
There is little doubt that section 23M discriminates against South African tax residents in favour of non residents. The question then is whether this discrimination is fair. It is difficult to see how such discrimination could be fair, particularly given the objective of protecting the South African tax base against excessive interest deductions; after all, South African branches of non-residents are as much part of the tax net as South African resident companies. The arguable result is that the provisions of section 23M are unconstitutional and invalid and may therefore not be enforced.
The debtor and creditor must be in a controlling relationship
A ‘controlling relationship’ is defined in section 23M as a relationship between a company and any connected person in relation to that company. The implication is that at least either the debtor or the creditor must be a company. The provisions will therefore not apply, for example, to debts between a beneficiary and a trust or a partner and a partnership. The provision also contains an anti-avoidance rule to prevent an unconnected person being interposed. This rule will apply where an unconnected creditor obtained the funds advanced to the debtor from a person that is in a controlling relationship with the debtor or the creditor where the debt is guaranteed by a person that is in a controlling relationship with the debtor.
The interest incurred must not be subject to tax during that year of assessment
The first issue which requires consideration is what is meant by ‘tax’ in the context of section 23M. This is a defined term in section 1 of the ITA and means any tax imposed by the Act. In effect, what it means is that if the interest is subject to either the normal tax (income tax) or the withholding tax on interest, the interest deduction will not be limited in the hands of the debtor. It also does not matter whether the interest is taxable in the hands of the recipient or in the hands of a shareholder of a controlled foreign company.
The second issue that needs to be considered is what is meant by ‘subject to tax’. Does this include all amounts that fall within the scope of the taxing legislation, whether exempted or not, or does include only amounts that are actually taxed? The answer is the latter. Notwithstanding that an amount of interest may, for example, constitute gross income, it will not be regarded as being subject to tax if it is exempted. Similarly, an amount of interest will not be regarded as being subject to the withholding tax on interest if it is exempted from that tax, either in terms of the legislation or in terms of a double tax treaty. However, an amount of interest that is fully offset by deductible amounts such that not actual tax liability arises is still regarded as being subject to tax.
The third aspect that should be considered is the time at which the interest is subject to tax. It is clear from the section that the interest must be subject to tax in the year of assessment of the debtor. Ordinarily, this would present no problem with regard to income tax as the interest income will accrue at the same time that the interest expense is incurred.
However, insofar as the withholding tax on interest is concerned, some risks do arise with regard to potential timing mismatches. This is because the liability for withholding tax on interest arises only when the interest is paid or is due and payable. Where the terms of the debt are such that interest is payable only periodically, a debtor could find itself in the position where the interest falls foul of section 23M, notwithstanding that the interest may be subject to tax in the future. For example, assume a company has a June year end. It incurs interest in relation to that year; however, the interest is only payable annually in arrears on 31 December each year. The result is that the interest from January to June of each year is not subject to withholding tax on interest during the year of assessment of the debtor, but only in the subsequent year.
Interaction with other provisions
Another issue that is not clear is the interaction between section 23M, section 23N and section 31. Although section 23N is made subject to section 23M, all 3 sections could potentially apply to the same debt. Assume Company A borrows an amount of R1000 at 10% from Company B, a connected non resident in a treaty country where the treaty provides for a nil withholding tax on interest, in order to fund a reorgan-isation transaction as contemplated in section 23N. Company A has adjusted taxable income of R200 and no interest received. Applying section 23M, Company A’s interest deduction will be limited to R80 and the balance of R20 will be carried forward to the next year. An identical result arises in terms of section 23N, with the exception that the excess is entirely disallowed for the first 6 tax years. The question then arises as to whether the interest is permanently disallowed under section 23N or rolled forward to the next year under section 23M. Section 31 could also apply if Company A is considered to be thinly capitalised.
The implication of this section being applied is also a permanent disallowance of the deduction. However, it also gives rise to a secondary adjustment in the form of a deemed loan. Arguably, section 31 cannot be applied to the extent that section 23M has been applied as there would be no tax benefit as contemplated in section 31.
Arguably, section 23M could fall foul of the non-discrimination provisions of double tax treaties. Paragraph 4 of Article 24 of the OECD Model Tax Treaty (MTC) provides as follows: "Except where the provisions of paragraph 6 of Article 11 apply, interest paid by an enterprise of a Contracting State to a resident of the other Contracting State shall, for the purpose of determining the taxable profits of such enterprise, be deductible under the same conditions as if they had been paid to a resident of the first mentioned State.”
The reference to paragraph 6 of Article 11 is a reference to excessive interest in accordance with the arm’s length principle. The commentary on the MTC states that this non-discrimination provision does not prohibit the country of the borrower from applying its domestic rules on thin capitalisation insofar as these are compatible with paragraph 6 of Article 11. However, if such treatment results from rules which are not compatible with paragraph 6 of Article 11 and which only apply to non-resident creditors (to the
exclusion of resident creditors), then such treatment is prohibited by paragraph 4.
The provisions of section 23M seemingly do not comply with the arm’s length principle as the limitation is purely arbitrary. While the rules do not strictly speaking discriminate on the basis of residence, but rather on the basis of whether the recipient is subject to tax, this issue would only arise in a situation where South Africa has surrendered its right to tax interest arising from a South African source in terms of a negotiated treaty. It seems at odds with this position that South Africa should then unilaterally be able to introduce legislation that penalises the debtor as a result of the application of such a treaty. It would be interesting to see if any taxpayer is prepared to challenge the section on the basis of treaty non-discrimination.
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This article first appeared on the Jan/Feb edition of Tax Talk.