The 2021 Draft Taxation Laws Amendment Bill (DTLAB) proposes major changes to section 23M of the Income Tax Act. Currently this provision limits interest deductions in the hands of a debtor company to a percentage calculated in terms of a formula and applied to its ‘adjusted taxable income’ as defined. The provision applies in circumstances in which the interest is not subject to South African taxation (neither income tax nor interest withholding tax) in the hands of the creditor and if the creditor is also in a ‘controlling relationship’ as defined, with the debtor.
Typically, this provision applies if the creditor is tax resident in a jurisdiction with which South Africa has a double tax treaty that grants exclusive taxing rights on the interest income to the foreign jurisdiction. However, it also applies where the creditor is a resident that enjoys an exemption from tax on the interest income, for example an approved Public Benefit Organisation or a retirement fund, that is in a ‘controlling relationship’ with the debtor company.
The 2015 Report on Action 4 of the Base Erosion and Profit Shifting (BEPS) project of the Organisation for Economic Co-operation and Development (OECD), recommended that jurisdictions implement a mechanical rule to limit interest deductions. The recommendations of the Report define best practice at a worldwide scale but are not a minimum standard requiring implementation by all member countries of the OECD. Specifically, the Report recommended a fixed ratio rule whereby the net interest deductions of an entity, in other words net interest expense, whether payable to related or third parties, would be limited to a percentage of a company’s accounting EBITDA (Earnings Before Interest, Taxation, Depreciation and Amortisation). It stated that a jurisdiction, at its discretion, could set the range for the limit between 10 and 30 percent of EBITDA. It further recommended that a jurisdiction could consider also implementing a group ratio rule that could allow an entity to deduct more interest expense than it would under the fixed ratio rule, depending on the relative net interest to EBITDA ratio of the entity when compared with that of its worldwide group and targeted rules to address specific risks.
The catalyst for the proposed changes to section 23M appears to have been the Report on Action 4. In February 2020, Government published a discussion document entitled “Reviewing the Tax Treatment of Excessive Debt Financing, Interest Deductions and Other Financial Payments”. The discussion document and feedback received from commentators highlighted various issues that are considered problematic with the provision as it is currently worded.
Section 23M is currently not aligned with the recommendations contained in the Report but it will also not be aligned with those recommendations if the proposed changes to the provision are implemented. For example, the Report recommends that the interest deduction rules apply to net interest expense (interest expense net of interest income) whereas section 23M applies to limit interest deductions before setting off interest income. The Report also recommends that the limitation apply to related party as well as third party net interest expense whereas section 23M only applies to interest deductions where the creditor is in a ‘controlling relationship’ with the debtor.
In summary, the proposed changes to section 23M in the DTLAB are as follows:
- A broadening of the definition of the term ‘interest’ to include:
- Amounts incurred or accrued under interest rate swap agreements;
- Finance cost elements in respect of IFRS16 finance leases; and
- Foreign exchange differences.
The rationale for this change is that taxpayers may enter into avoidance scenarios where payments that are economically akin to interest are labelled as other types of payments to avoid the application of the provision. It is especially concerning that the proposal in its current form will result in the provision applying to the above items irrespective of whether or not they are connected with the raising of finance.
- Currently, the provision limits interest deductions to an amount calculated with reference to a company’s ‘adjusted taxable income’ multiplied by a percentage calculated in terms of a formula. The proposal is that the percentage calculated in terms of the formula will be replaced by the fixed amount of 30 per cent. The majority of countries that have adopted the recommendations contained in the Report on BEPS Action 4 have chosen 30 per cent for purposes of determining the limit. The Explanatory Memorandum to the DTLAB states that analysis using SARS micro-level data for all taxpayers shows that applying a fixed ratio of 30 per cent would allow the majority of taxpayers to deduct all their interest and equivalent payments without restriction.
- National Treasury has sought to address certain back-to-back arrangements that allowed taxpayers to avoid the application of the provision. The back-to-back arrangements of concern involve loans that are channelled between two or more tax-paying companies that are ultimately owned by another company that is not subject to tax in South Africa.
- Taxpayer-friendly changes are proposed to cater for Real Estate Investment Trusts (REITs). A REIT is entitled to claim ‘qualifying distributions’ to its shareholders as a deduction when computing its taxable income. The Explanatory Memorandum states that these deductions distort the calculation of the ‘adjusted taxable income’ since it results in the REIT having a much lower ‘adjusted taxable income’ than other taxpayers. The proposal is that a REIT should therefore add such ‘qualifying distributions’ back when determining its interest limitation.
- The provision will no longer grant a wholesale exclusion in cases where withholding tax on interest as well as exemption from income tax applies in the hands of the creditor. Instead, a pro-rata approach is proposed, whereby in cases where a creditor suffers say a 5 per cent rate of withholding tax in terms of a double tax treaty, the debtor will be allowed a full deduction of 5/28 of the interest expense, with the remainder of the interest expense subject to potential limitation.
Thankfully, the proposals do not extend to a time-based expiry of excess interest expenses that are disallowed under the provision. However, the Explanatory Memorandum to the DTLAB states that this policy stance will be reviewed after 5 years. The Explanatory Memorandum recognises that businesses in certain industries have longer timeframes between investment and the generation of taxable profits than others. It is unfortunate though that there is no minimum threshold to exclude the application of the provision to smaller businesses. Also, the much-needed legislative clarity on the interaction of section 23M with the transfer pricing rules in section 31 has not been provided. BDO has provided commentary to National Treasury and SARS on the proposals. The final version of the Bill will probably be released towards the end of October. Kindly feel free to contact us should you require advice on the likely impact of the amendments.