A well-established principle of South African tax law provides that, where debt replaces an existing loan, the purpose of the refinancing debt (and therefore the deductibility of the interest relating thereto) is determined by reference to the original use of the funds advanced.
This principle (the purpose principle) ensures continuity of the deductibility analysis, notwithstanding changes to the formal debt arrangements.
An issue is whether the tax principles governing interest deductibility on debt‑for‑debt refinancing apply equally when debt replaces equity‑type instruments.
In this regard, the South African Revenue Service (SARS) issued Binding Private Ruling 424 (BPR 424) (6 February 2026) on interest deductibility where debt is used to redeem preference shares.
The discussion point in this note considers whether the ‘purpose of capital’ principle will apply in instances where the legal form of the original capital differs from the legal form of the replaced capital.
Interestingly, in BPR 424, SARS accepted that where preference shares were originally used by the applicant to fund construction costs and initial start-up costs in relation to a project, the New Loan raised to redeem those preference shares inherited the productive purpose of the original preference share funding.
Consequently, if preference share funding was originally applied for productive, income-generating purposes, debt raised to refinance those shares should inherit that productive purpose, thereby supporting interest deductibility.
The treatment of rolled-up dividends
In BPR 424, the New Loan was used to settle the principal preference share capital amount and accumulated preference share dividends. Accordingly, the ruling contemplates a scenario where the New Loan funds both (i) the redemption of the original capital subscription and (ii) the settlement of accrued preference dividends.
A question that arises is whether the deductibility of interest incurred in respect of the New Loan extends to the settlement of preference share dividends.
In BPR 424, SARS expressly provides that the applicant will be entitled to deduct interest determined in accordance with section 24J in respect of the New Loan, but only ‘to the extent that the interest does not relate to amounts used to fund the payment of current or accumulated dividends in respect of the preference shares…’. This highlights a significant apportionment issue that arises when accumulated preference dividends are settled with debt funding.
The payment of preference share dividends is not deductible for tax purposes for the following reasons:
- First, dividends do not constitute ‘interest’ as contemplated in section 24J of the Income Tax Act. Section 24J defines ‘interest’ to include the gross amount of any interest or similar finance charges, discount or premium payable or receivable in terms of or in respect of a financial arrangement. Dividends fall outside this definition.
- Second, dividends are generally treated as appropriations of profits, representing distributions to shareholders from after-tax earnings, rather than expenses incurred in the production of income.
- Third, dividends are capital in nature and therefore do not qualify for deduction under section 11(a), which permits the deduction of expenditure and losses actually incurred in the production of income, provided such expenditure and losses are not of a capital nature.
Consequently, debt used to settle preference share dividends is not incurred for productive purposes and the interest attributable thereto will not be deductible.
It is therefore critical to recognise that in the case of a preference share liability which includes accumulated dividends, a distinction must be made between the refinancing debt that settles (i) the original principal capital amount advanced for productive purposes and (ii) accumulated preference share dividends.
Interaction with section 8E and 8EA
Not dealt with in BPR 424, but equally important to consider, is the interaction between refinancing preference shares with debt and the anti-avoidance rules applicable to ‘hybrid equity instruments’ or ‘third party backed shares’.
The ‘hybrid equity instrument’ and ‘third party backed share’ rules, contained in sections 8E and 8EA of the Income Tax Act respectively, apply important anti-avoidance rules to, inter alia, preference shares that have debt like characteristics.
If either section 8E or 8EA is triggered, subject to certain exclusions contained therein, dividends declared and paid on preference shares are recharacterised and deemed to be income in the hands of the preference shareholder and may be subject to income tax. The dividends will remain non-deductible in the hands of the entity paying the dividends.
The deductibility analysis of debt used to refinance preference shares will not exist in isolation from the anti-avoidance provisions contained in section 8E and 8EA.
In this regard, the original classification of the preference share has significant implications for the commercial sensibility of any subsequent refinancing with debt.
For example, one of the requirements that must be met for a preference share to not qualify as a ‘third-party backed share’ is that the funds from the issue of the share are applied for a ‘qualifying purpose’ (as defined in section 8EA). A ‘qualifying purpose’ includes:
- the direct or indirect acquisition of an equity share in an operating company (other than from a company within the same group);
- the settlement of debt incurred for the acquisition of equity shares; and
- the acquisition or redemption of another preference share issued for a qualifying purpose.
Consequently, preference shares issued for a ‘qualifying purpose’ are applied for unproductive purposes on the basis that they are used to acquire shares that produce exempt dividend income. In such cases, if the preference shares are refinanced with debt, the interest incurred would not be deductible and this may alter the overall tax symmetry. A similar consideration would need to be made under section 8E if the preference shares are secured by an interest-bearing instrument.
Taxpayers should carefully evaluate whether, in light of the original tax treatment, refinancing with further preference shares or equity shares (which may preserve the qualification under section 8EA) may be more tax efficient than refinancing with senior debt. The answer will depend on the specific facts, including the identity of the funder, the applicability of any tax exemptions, and the overall structuring objectives.
Section 24O considerations
Section 24O of the Income Tax Act is a deeming provision that treats certain interest incurred in respect of debt used to finance the acquisition of equity shares as having been incurred in the production of income and therefore deductible. This provision applies where a company acquires an equity share in an operating company as part of an ‘acquisition transaction’.
In pure refinancing, particularly where debt replaces preference shares without a new share acquisition, section 24O is unlikely to provide relief. The section is specifically directed at debt incurred for the purpose of financing the acquisition of equity shares, or debt issued in substitution for such debt. It does not extend to the general refinancing of preference share capital with debt.
Taxpayers should not assume that section 24O will apply to validate interest deductions in refinancing structures; rather, the analysis must proceed under the interest provisions of section 24J.
Conclusion
BPR 424 provides welcome clarity on the tax treatment of interest incurred when refinancing preference share funding with senior debt. The key principles are as follows:
- A SARS ruling is only relevant to the applicant in question but does provide a general sense of SARS’s position on the issue.
- Interest on refinancing debt may be deductible where the original preference share funding was applied for productive, income-generating purposes.
- An apportionment is required where the refinancing debt settles both capital and accumulated dividends, with only the portion attributable to the capital portion of the productive funding potentially qualifying for deduction.
- The interaction with sections 8E and 8EA must be carefully considered to ensure tax efficiency and symmetry.
- Section 24O is unlikely to assist in pure refinancing scenarios absent a new equity acquisition.
Taxpayers considering the refinancing of preference share arrangements are encouraged to seek specific advice, having regard to the unique facts of their transaction and the guidance provided in BPR 424.
