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Interest deductibility · Tax Break: South African tax for professionals

• 0:10
  I had a different topic lined up for this week's episode.
• 0:13
  I wanted to speak about cross-border loans.
• 0:16
  But when I received Sasha's legal counsel Mailer on Friday
• 0:19
  afternoon, I saw that they issued an interesting ruling at
• 0:22
  the end of last week on something that comes up very
• 0:24
  often in practice. And that's the question of
• 0:27
  interest deductibility. So in short, the ruling deals
• 0:31
  with the deductibility of interest on a loan that will in
• 0:35
  future be used to redeem preferences.
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  So in this week's episode of Tax Break your podcast or South
• 0:42
  African tax professionals and practitioners, I'm looking at
• 0:45
  the ruling. I'm doing a bit of a recap on
• 0:48
  when interest would be deductible.
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  And I'm also going to talk about and share my thoughts on why I
• 0:54
  think the tax payer felt it was necessary to apply for this
• 0:57
  ruling. So as per usual, I would like to
• 1:00
  ask you to please rate the post podcast on whatever podcast
• 1:04
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• 1:08
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• 1:10
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• 1:16
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• 1:20
  for the podcast. I also want to remind you if
• 1:23
  you've got any questions or ideas, my e-mail address is in
• 1:26
  the show notes, so you're welcome to send me an e-mail
• 1:31
  back to the ruling that I referred to in the introduction.
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  So the ruling number is binding private ruling 4 to 4.
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  And some of the key facts are the borrower is the applicant.
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  So the borrower is an entity that's developing a project.
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  It seems like quite a capital intensive project and a project
• 1:51
  that takes a while to construct. And there's the other party to
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  the transaction is a bank that offered to provide project
• 1:59
  finance. So initially there will be two
• 2:01
  sources of finance or funding, a senior Jabar facility that would
• 2:05
  cover 40% of the construction costs and initial startup costs
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  and then redeemable preference shares that will cover the other
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  60%. And these redeemable preference
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  shares will be cumulative dividends that they will
• 2:20
  accumulate over while the preferences are in issue.
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  Now the ruling doesn't explicitly say why the split was
• 2:28
  necessary between the Jabar facility and the redeemable
• 2:33
  preference shares. But looking at the detail that
• 2:37
  is shaped in the in the ruling, it, it seems like the preference
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  is are a bit more than the terms are a bit more lenient.
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  It's insofar as repayment is is concerned, is concerned relative
• 2:50
  to the loan. So for example, there's a
• 2:53
  dividend grace period and things like that, right?
• 2:56
  The plan is then and the ruling also specifically mentions this,
• 3:01
  that the preferences will be redeemed and that redemption can
• 3:06
  be funded by a new loan from the same bank.
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  So, and the ruling refers to this is the post construction
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  loan. Now the new loan may be drawn
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  down to fund a unpaid dividends and B the redemption of the
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  preferences, the redemption amount, the capital in other
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  words. So the ruling that such issued,
• 3:30
  they addressed 2 points in the ruling.
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  Firstly, that the applicant may deduct interest under Section 24
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  giant respect of the new loan to the extent that the interest
• 3:41
  does not relate to the funding of the preference dividends, So
• 3:46
  do the extent that something else is being that the funds are
• 3:50
  being used for something else, which would seem like it's the
• 3:53
  the repayment of the capital of the preference dividend
• 3:56
  preference shares. The interest is deductible, but
• 4:00
  to the extent that the new loan will fund the payment of the
• 4:03
  preference dividends, there is no deduction.
• 4:07
  Secondly, the rulings explicitly says that it doesn't deal with
• 4:11
  Section 8 E and Section 88. Now those are the provisions
• 4:15
  that relate to hybrid equity instruments and they always come
• 4:19
  into play whenever you are looking at redeemable shares,
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  right? So let's go back to the law.
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  When would interest be deductible?
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  So for that we look at Section 24J2.
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  Now that provision starts off by saying that you you've got the
• 4:36
  deemed amount of interest that they earn amount that's deemed
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  to be incurred according to the do their timing rules of Section
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  24 J. And then it goes on to say that
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  this amount must be deducted from the income of that person.
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  So in other words, the borrower derived from carrying on a trait
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  if that amount is included in the production of income.
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  And I suspect this is where the real issue with the behind the
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  ruling is, is to say, but what is the purpose of the new line?
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  Can the purpose, can you look back to what the preferential
• 5:12
  funding was, was used for and cyber that's the purpose of the
• 5:16
  loan when you apply Section 24 J or should you just look at, at,
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  at the the closest step in the in the process, which is
• 5:26
  redeeming the preference share funding and the dividends?
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  Now, I think if you if, if we discussed that uncertainty a
• 5:34
  bit, that would have in my mind late to, to the the tax payer
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  applying for the ruling. So of course, these rulings have
• 5:42
  actually actually have very little detail in them.
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  So you can't they they won't explicitly tell you.
• 5:49
  This is why someone went through the for the ruling.
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  And they often also don't tell you the the reasoning or the
• 5:56
  interpretation as to how they how such arrived at that
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  position. They just give you this is the
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  ruling that that was issued. OK.
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  So if a loan is used to fund the payment of dividends, I think
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  it's a well established principle that in that case the
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  the, the, the interest is not included in the production of
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  income, not for purposes of your trade, because it funds a
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  dividend that's paid from profits that's already been
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  earned. Similarly, they sky slow to say
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  that if a loan funds the repurchase of shares, the same
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  principle will apply. So in other words, if it's a
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  return of of capital through the repurchase of of the share.
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  So it's just another way of doing a distribution.
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  Um, so, and then maybe to put all the pieces together and then
• 6:47
  see why this, this ruling was, was perhaps necessary.
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  There is some case law on refinancing loans to say, but
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  then you can look to the purpose of the original loan.
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  But I think as soon as you introduce funding that was
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  initially obtained through shades that will be refinanced
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  with date, you introduce a bit of complexity in there to say,
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  but can you still apply that case law?
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  If you're looking at the at, at the the redemption of the
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  preferential funding, you now funding a return of capital and
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  preferential preference evidence.
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  So how far can you look back in, in, in a case where you've got
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  this type of funding right? So I think what we can get from
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  the ruling is that looking at the overall funding arrangement
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  and the terms that's already been set on day one, it seems
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  that Sash was happy that the intention of the parties insofar
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  as the purpose of this whole funding arrangement was that do
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  they extend that the new loan will replace the the initial
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  preferential funding, the capital of the preferential
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  funding, the linkage to the original purpose remains in
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  place. And on that basis that that
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  would have to be the basis for such to agree that the taxpayers
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  entitled to the 24 J allow the interest deduction.
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  However, to the extent that the loan, the new loan will be used
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  to fund preference dividends similar to any dividends being
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  funded on through loans, this requirement of section 24J will
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  not be made. So in other words, the interest
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  is not incurred in the production of income.
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  So what can you take home from this ruling if you want to go
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  and think about it a bit a bit further?
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  1 is just a reminder again that the interest deductibility
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  depends on the purpose of the loan funding.
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  And I think this loan, although this ruling is a good reminder
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  that when it comes to refinancing arrangements,
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  especially funding arrangements that involve A initially shares
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  and then date, then you have to be very careful in in
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  considering what the purpose of the date funding would be.
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  Secondly, and although there was no view expressed on this, the
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  the ruling is also a good reminder that the sooner she
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  work with and you're looking at redeemable preferences, you need
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  to be aware of the possibility that Section 8, E and 88 may
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  apply. That's it for today's episode.
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  Just a reminder, as always, nothing in this episode is
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  intended to be tax advice or replacement for tax advice.
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  Until next time, goodbye.