The Deduction of Interest
21 July 2015
Posted by: Author: Emil Brincker
Author: Emil Brincker (DLA Cliffe Dekker Hofmeyr)
Analysis of Practice Note 31 and its practical application when it comes to the deducation of interest
It has been said that money is the source of all evil. However, it seems that currently it’s the expectation of making money that is the source of much debate.
This debate, which has been raging on for a number of years, pertains to whether a taxpayer is entitled to deduct interest in respect of loans sourced. The proceeds of the loan are then used to make a loan to a third party, which in turn generates interest. This issue has become much more contentious in circumstances where the interest rate in respect of the second loan is lower than the interest rate applicable on the funds that have been sourced by the taxpayer.
A Speculative Transaction Par Excellence
This exact issue came to a boiling point in the case of Burgess v CIR, 55 SATC 185. In the case, the taxpayer was approached by an insurance broker during 1987 who indicated that "over a year period we could make you a considerable amount of money". Given the performance of the Johannesburg Stock Exchange (JSE) at the time, the scheme comprised a scenario where the taxpayer would borrow an amount from a bank and invest some for a short period of one or two years in shares traded on the JSE. At the end of the period, the shares would be realised, the loan repaid and the profit retained. However, there was still a risk that the share price would not perform according to expectations, leaving the taxpayer exposed.
As a variation, the insurance broker introduced the so-called "Fenton Scheme” to the taxpayer. As opposed to purchasing the shares directly, the scheme entailed that the taxpayer would borrow an amount of money and instead of acquiring the shares directly, he would purchase a single premium non-standard endowment policy from a long-term insurance company. In this particular instance the insurance company, being Lifegro, would make the investment. The benefit to the taxpayer was that Lifegro guaranteed a minimum return of 4 percent. The taxpayer was still exposed, given the fact that he paid interest at the rate of 12,5 percent, whereas the guarantee of Lifegro was only equal to 4 percent.
Unfortunately for the taxpayer, black Monday occurred during October 1987 resulting in a crash on the JSE. Share portfolios were wiped out and it resulted in the taxpayer only receiving his 4 percent minimum guaranteed return from Lifegro. Even though the amounts were not exactly calculated, he thus suffered a loss of 8,5 percent, given the interest that was incurred on the loan that the taxpayer raised through means of a partnership.
Should the Fenton Scheme have worked, the taxpayer would have been entitled to deduct interest over the period and only account for the profits on the maturity of the endowment policy. There was thus a timing mismatch between the deduction of the interest and the profits which would have been accounted for in a subsequent financial year.
Even though there was a tax motive Mr Justice Grosskopf, who presided over the case, indicated that obtaining a tax advantage does not imply that a taxpayer cannot conduct a trade. If a course of conduct is pursued which constitutes the carrying on of a trade, the fact that one of the purposes, or even the main purpose of the taxpayer is to obtain a tax advantage, does not detract from the trade that is carried on. The motive of a taxpayer in carrying on a trade is thus irrelevant.
One of the arguments on behalf of SARS in the Burgess case was that the taxpayer did not, in fact, conduct a trade. A trade is defined as including every profession, trade, business, employment, calling, occupation or venture, amongst others. SARS argued that the taxpayer made an investment and was not carrying on a trade. In response, the court held that the concept of trade should be given a wide interpretation. It should include treaties intended to embrace "every profitable activity". The court indicated that the taxpayer did conduct a trade:
"He had laid out the money required to obtain a bank guarantee, and risk the amount of the guarantee, in the hope of making a profit. It was a speculative enterprise par excellence".
This conclusion was reached notwithstanding the fact that the taxpayer may not have appreciated the risks inherent in the scheme upfront.
Even though not directly on point, the court did indicate that although an element of risk is generally associated with the concept of a venture in its ordinary meaning, it does not imply that the type of scheme in question would only constitute a trade if it is risky. This would depend on its own set of facts. Even if there is no risk involved, one could still be engaged in a venture by applying an extended meaning to this concept. It was emphasised that the definition of trade is not exhaustive. Specific reference was made to the fact that, if a person borrows money at a low rate of interest and invests it at a higher rate, they would be engaged in a trade even if the investment "was a safe one". This approach was confirmed by SARS in argument.
Earlier, the tax court in ITC 1429 50 SATC 40 also allowed the deduction of interest in circumstances where the taxpayer borrowed money from their shareholders and lent it on to a third party. The trading argument, however, was strengthened in that case due to the fact that the underlying assets held by the taxpayer were acquired for speculative or trading purposes. It was indicated that in the context of section 11(a) of the Income Tax Act, 1962 (the "Act"), expenditure must be incurred in the production of income. Should one receive interest, it would be in the production of income. It was indicated that there is nothing in section 11(a) of the Act which requires that interest receivable should be equal to the interest payable before a deduction can be claimed under that section. In the context of section 23(g), however, it was said:
"It may well be, and probably is so, that if money is borrowed for the purpose of relending it at a rate of interest lower than that being paid, it could not be claimed that the interest payable was being paid exclusively for the purpose of trade. I say this because, as a general rule, a business will endeavour to trade at a profit, and if therefore it deliberately enters into a venture designed to be carried on at a loss, it may well be that such would not be regarded as trade."
However, the taxpayer was not so fortunate in Kirsch vs CIR, 14 SATC 72. In that case the employee advanced money to his employer in return for a share of the profits based on the ratio that the money advanced bore to the total capital employed. Equally, the employee was required to suffer a proportionate amount of loss. It was indicated that:
"In a sense, very many investments by way of loan are attended with risk but it would be going much too far to suggest that wherever risk is run in a loan the lender has engaged in a venture."
Pursuant to this case it is argued that the loan made by a person who does not carry on a business of money lending would not constitute a trade. However, if the loans are made as part of the normal trading activities, the "investment" of monies in pursuit of one of the objects may well form part of the trade conducted by the taxpayer.
So the scene was set for intervention by SARS, pursuant to the Burgess case.
Practice Note 31
On 3 October 1994 Practice Note 31 was released by SARS. It (still) reads as follows:
"1. To qualify as a deduction in terms of section 11(a) of the Income Tax Act (the Act), expenditure must be incurred in the carrying on of any "trade" as defined in section 1 of the Act. In determining whether a person is carrying on a trade, the Commissioner must have regard to, inter alia, the intention of the person. Should a person, therefore, borrow money at a certain rate of interest with the specific purpose of making a profit by lending it out at a higher rate of interest, it may well be that the person has entered into a "venture" and is thus carrying on a trade (50 SATC 40). In other words, interest paid on funds borrowed for purposes of lending them out at a higher rate of interest will, in terms of section 11(a) of the Act, constitute an admissible deduction from the interest so received by virtue of the fact that this activity constitutes a profit making venture.
2. 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 ae borrowed at a certain rate of interests 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."
Irrespective of the Practice Note, it can still be argued that if money is borrowed with the intention of relending it at a higher rate of interest, it may be that the interest paid to obtain that money is deductible. In the Practice Note, it is indicated that interest will only be deductible from a technical perspective if it is incurred in the carrying on of a trade. In determining whether a person is carrying on a trade, SARS should have regard to the intention of the taxpayer amongst other considerations. Should a person borrow money at a certain rate of interest with the specific purpose of making a profit by lending it out at a higher rate of interest, it was indicated that the person "may well be" seeming to have entered into a venture. This wording is reliant on the verdict in ITC 1429. As such, the first part of the Practice Note does not go further than what was already indicated in case law at the time. In fact, the Burgess judgment goes much further in the sense that risk is not necessarily inherent in whether a trade or venture is conducted. It was specifically indicated that, if money was borrowed at a low rate of interest and invested at a higher rate, there is definitely a trade and not "that there may well be a trade".
What makes the Practice Note more important, however, is that it also deals with a person investing surplus funds. It specifically allows the deduction of interest or "expenditure" to the extent that it does not exceed such interest. It is then indicated that the "practice" will also be applied in cases where funds are borrowed at a certain rate of interest and invested at a lower rate. One of the issues is that the focus in the Practice Note is on interest and not so much other expenditure. In practice (sic), however, taxpayers rely on Practice Note 31 to deduct all expenditure up to the amount of interest (accrued). This may not necessarily be supported by the wording of the Practice Note even though reference is made to the allowance of "expenditure".
Subsequently, SARS has also not been so comfortable with the outcomes determined by the Practice Note. In ITC 1675 62 SATC 219 it questioned the validity of the Practice Note. SARS argued that a Practice Note cannot override the provisions of the Act. It was held that, in view of the approach adopted by SARS, one cannot always safely assume that SARS will consider itself bound by its own Practice Note. It was specifically indicated that the issue of a Practice Note does not present good policy if the content of the Practice Note constitutes a departure from the provisions of the Act. It was said:
"It may be that the Commissioner decided to adopt a lenient approach after the judgment in the Burgess case which had been given a year before, but, if it is intended to regulate the deductibility of interest incurred in the circumstances set out in the Practice Note, the place in which to do it is the Income Tax Act."
That was not the end of the discomfort of SARS with the Practice Note. Subsequently in Special Board Decision Number 187 9 SASBDR3 the Commissioner also issued a revised assessment in this regard of Practice Note 31. It was indicated that the Commissioner is not lawfully entitled to issue assessments in disregard of his own Practice Note. A published Practice Note has legal consequences and SARS is bound to observe those consequences.
At that point in time, at least, the position was thus as follows –
- One would be conducting a trade if one borrows money at a low rate of interest and invests it at a higher rate irrespective of the fact that there may not be risk associated with it;
- Practice Note 31 allows the deduction of interest for "expenditure" to the extent that it does not exceed the income;
- Practice Note 31 equally allows the deduction of interest even if funds are borrowed at a certain rate of interest and invested at the lower rate;
- SARS could not depart from the contents of the Practice Note even if it may be contrary to law.
Not Cast in Stone
Given the history of the Practice Note, it is with trepidation that one opens the SARS website to establish its views about the validity of the Practice Note now - more than twenty years later. However, it is clearly indicated that all Practice Notes that are still effective will eventually be reviewed and, depending on the circumstances, either be withdrawn or replaced by Interpretation Notes.
What is the consequence then of the Practice Note still being effective? In itself there is no reference to a Practice Note in the Tax Administration Act, No. 28 of 2011 (the "TAA"). However, section 5 of the TAA deals with a practice generally prevailing, being a practice set out in an official publication regarding the application or interpretation of a Tax Act. The Practice Note would thus fall into this requirement and be a practice generally prevailing. It is indicated, however, that a practice generally prevailing will cease to be so if a court overturns or modifies an interpretation of the Tax Act which is the subject of the official publication to an extent material to the practice from the date of judgment, unless –
- the decision is under appeal;
- the decision is fact-specific and the general interpretation upon which the official publication was based is unaffected; or
- the reference to the interpretation upon which the official publication was based was obiter dicta.
It is also indicated that the practice will cease to be a practice generally prevailing if the official publication is withdrawn or modified by SARS, from the date of the official publication or the withdrawal or modification.
Section 99 of the TAA provides that SARS may not issue an assessment if the amount which should have been assessed to tax was not assessed according with the practice generally prevailing at the date of any proceeding assessment. The same consequence would follow if an amount was not assessed in accordance with a practice generally prevailing. In other words, if an amount has not been assessed in terms of a practice generally prevailing or a deduction was allowed of interest in terms of a practice generally prevailing (which would include the Practice Note), SARS may not issue an assessment. It follows that Practice Note 31 is still valid and can be relied upon by taxpayers. However, the risk is always that it can be set aside by a court of law or be withdrawn by SARS.
The issue is that the ambit of the Practice Note is not so clear. Even if it allows the deduction of interest where monies are borrowed at a higher rate of interest and invested at the lower rate, it is not clear to what extent one can be said to be trading if there is little or no risk involved. Pursuant to the Burgess case it would be allowed. In ITC 1675 it was indicated that the facts of that case resulted in much less risk to the taxpayer. However, he was still seen to be engaged in a venture. Also, it does not matter that the profit that is expected to be made is relatively small.
The question arises if interest is incurred to obtain other forms of income that do not constitute interest. One good example is the introduction of Real Estate Investment Trusts (REITS). Should one invest in a REIT, the dividends that are distributed by the REIT are not exempt from the payment of tax and will be seen to be taxable in terms of the provisions of section 10(1)(k)(i)(aa) of the Act. Incidentally, in a case of non-residents these distributions are subject to dividends tax. If an investor borrows money with a view to obtain an interest in a REIT in circumstances where the investment is made for long term purposes, one is thus faced with a scenario where there is an investment purpose pertaining to the shareholding in the REIT. The taxpayer is still to receive taxable distributions from the REIT. In other words, the taxpayer will not be receiving exempt dividends as would otherwise be the case with an investment in a normal company. If that is the case, the argument for not deducting the interest incurred by the taxpayer should fall away as the taxpayer would no longer be receiving exempt dividends. However, the taxpayer still has an investment purpose associated with the investment in the REIT as opposed to the distributions that are to be made subsequently. Therefore one is dealing with a dual scenario where there may be capital gains at some point in time, as well as taxable distributions which form part of the income of the taxpayer. In this instance it is not so clear whether the Practice Note will still apply. In itself and if one argues that it extends to expenditure incurred, it could apply.
However, The Practice Note is specifically focused on the receipt of interest. In the current instance where a REIT is involved, the investor will not be receiving interest, but income which is taxable. On that basis, the ambit of the Practice Note would from a technical perspective, not cover this type of scenario. This means one is reliant on common law principles to argue the deduction of the interest.
One of these arguments is found in CIR vs Drakensburg Garden Hotel Proprietary Limited, 23 SATC 251. In this case, the taxpayer borrowed money with a view to acquire shares in a company. The purpose of the taxpayer in purchasing the shares was to ensure the continuance of its income from subletting and trading. The interest was thus held to be deductible. Similar to that approach, one could also argue in the case of a REIT that the purpose is to receive taxable distributions, which would then result in income. However, whether one can be said to be trading is a different question and that is where the importance of the Practice Note comes in.
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This article first appeared on the May/June 2015 edition on Tax Talk.