The South African Revenue Service (SARS) says the withdrawal of Practice Note 31—relating to interest paid on money borrowed—will take effect on 1 January 2025.
The practice note came into effect inOctober 1994and provides a concession to taxpayers who accrue interest income by allowing them to deduct tax on expenditures incurred in producing that interest income.
This is without the taxpayer having carried on a trade—or if it had, its trade did not necessarily align with its interest income-earning activity.
According to legal firm Bowmans, the practice note has a practical application in funding arrangements and borrowing practices more generally.
“From a private equity (PE) perspective, in a typical PE acquisition, the fund would set up a special purpose vehicle (SPV) that would acquire shares in a portfolio company alongside management and potentially other investors.
“Should the portfolio company require debt funding, the fund would lend the money to the SPV, which would on-lend the funds to the portfolio company on the same terms,” it said.
Similar arrangements occur in incorporated accounting, law, and engineering partnerships, where partners, directors, or executives provide financing to the business operations.
“The latter arrangements take the form of back-to-back financing provided by a financial institution to the said partner, director or executive, which is then advanced to the incorporated partnership to fund its working capital.”
The partners, directors, and executives rely on Practice Note 31 to claim the interest expenditure incurred on the loan provided by the financial institution against the interest income earned from the incorporated partnership.
However, the deduction is also open to abuse – which is why there was a move to withdraw it.
New tax laws take over
SARS first announced its intention to withdraw the practice note in November 2022 as part of a wider strategy to clamp down on tax abuse transactions.
In its place, the National Treasury proposed adding a new section, Section 11G, to the Income Tax Act in the 2023 Draft Taxation Amendment Bill, which was signed into law in December 2023.
Initially, the new section raised red flags with tax and legal experts as it only provided the tax deduction to ‘companies’, whereas Practice Note 31 applied to ‘persons’. This meant that taxpayers who previously would have benefitted from the deduction would now miss out.
However, in processing the draft laws in 2023, the Treasury accepted the comments and expanded the concession in section 11G to apply to any person who incurs interest expenditure in the production of interest income without regard to any shareholding threshold of any back-to-back lending arrangement.
Practice Note 31 wording is as follows:
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.
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 are borrowed at a certain rate of interest 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.
The new section, as recorded in the Act, is as follows:
11G.
- (1) For purposes of this section, ‘interest’ means interest as defined in section 24J.
- (2) For purposes of determining the taxable income derived by any person, there shall be allowed as a deduction from the income of that person, interest incurred by that person to the extent that the interest —
- (a) is incurred in the production of interest that is included in the income of that person; and
- (b) is not incurred in carrying on a trade.
- (3) The amount allowed to be deducted under this section shall not exceed the amount of interest income referred to in subsection (2)(a), that is received by or accrued to the person, during the year of assessment.’’.
Treasury has noted that further consultations on the laws may be necessary and pushed the commencement of the new section to 1 January 2025.
As such, SARS has now also delayed the withdrawal of Practice Note 31 to coincide with this date.
From 1 January 2025, the new laws will be in effect and apply to any tax years that start on or follow that date. Practice Note 31 will remain in effect until then.