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:
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.
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