By Aneria Bouwer,Samir Ellary,Michael Rudnicki,Phuti Kgomo Thursday, October 19, 2023

On 15 November 2022, the South African Revenue Service (SARS) announced its intention to withdraw Practice Note 31 titled ‘Interest paid on moneys borrowed’ (Practice Note 31). In the announcement, SARS stated that changes could be made in the tax legislation to accommodate legitimate transactions affected by the withdrawal.

The legislative changes were published on 31 July 2023, with the introduction of section 11G into the Income Tax Act 58 of 1962 (Income Tax Act), in the 2023 Draft Taxation Amendment Bill published by the National Treasury (2023 DTLAB).

In short, Practice Note 31 provides a concession to taxpayers that accrue interest income by enabling them to obtain a deduction in respect of expenditure incurred in the production of the interest income without the taxpayer having carried on a trade or, if it carried on a trade, its trade did not necessarily align with its interest income earning activity. Such deductions are limited to the interest income as it is intended that they do not give rise to losses.

Its successor, section 11G (in its current draft form), permits the deduction of expenditure incurred in the production of interest income. However, this concession is only provided to (i) companies, whereas Practice Note 31 applied to ‘persons’ and (ii) interest accruing from another company that forms part of the same group of companies (i.e. at least a 70% shareholding).

These shortcomings may have an adverse impact on 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 (usually not established as a ‘company’), would lend the money to the SPV, which would on-lend the funds to the portfolio company on the same terms.

Under the proposed section 11G, if the SPV is not a company, or is a company, but holds less than 70% of the shares issued in the portfolio company, any interest expense incurred on the loan from the fund (or financial institution) would not be deductible against the interest income it received from the portfolio company.

Practical problems also arise where incorporated accounting, law, and engineering partnerships (to name but a few) require their partners, directors, or executives to 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 previously relied 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. The latter issue does not arise where the partnership is an unincorporated common-law partnership.

Likewise in the venture capital space, back-to-back loans into portfolio companies where minority interests are held will also likely be impacted.

In addition to the above, if a businessman legitimately decides to fund his or her business carried on through a company with debt and borrows money to do so, we do not see the harm in allowing the deduction of interest expenditure against any interest income earned from the company in such instance. The fiscus is not out of pocket.

When the announcement was made in 2022 of the intention to withdraw Practice Note No. 31 amidst certain tax abuse transactions, comfort was given by National Treasury that the withdrawal was driven by these tax abuse transactions and that legitimate transactions would not be affected by the withdrawal. It does seem, however, that, as a result of the narrow application of the proposed new section 11G, a number of legitimate transactions would in fact be adversely affected.

We have submitted our comments on the 2023 DTLAB to National Treasury recommending that the provisions of section 11G should at least be expanded to provide for taxpayers other than companies, which would then hopefully mitigate some of the adverse impact that would be felt by a number of funds in the PE space (if implemented in its current form).