By Associate Professor David Warneke, Head of Income Tax Technical

The much-awaited proposed amendments in response to the submissions received by National Treasury on the withdrawal of SARS Practice Note 31 have been released for public comment. They are contained in the Draft Taxation Laws Amendment Bill of 2023 and unfortunately, reveal a lack of appreciation for the importance of this Practice Note in achieving equity in the taxation of ordinary transactions involving borrowed funds.

By way of background, Practice Note 31 was issued by the then Inland Revenue in 1994 and has remained the revenue collector’s practice ever since. Although our income tax system has a separate ‘trade’ test in addition to an ‘in the production of income’ test that usually applies in determining whether expenditure is deductible for income tax purposes, the Note allows for an exception to the ‘trade’ test when determining the deductibility of expenditure that is incurred in the production of interest income. So, if a taxpayer who is not carrying on a trade lends money at interest and incurs non-capital expenditure that is in the production of the interest income, the Note allows the taxpayer to deduct the expenditure against the non-trade interest income, limited to the amount of the interest income.

The reason the Note was originally issued and that the practice it sets out is still required is that, given the existence of our ‘trade’ test and in the absence of a profit-making motive on the part of the taxpayer lending the funds, a taxpayer in scenarios such as the one above would not be able to deduct the expenditure incurred, even if such expenditure was incurred for the purpose of earning the interest income.

The term ‘trade’ is given a wide definition in the Income Tax Act, which includes, among other things, ‘every profession, trade, business, employment, calling, occupation or venture’. In Burgess v CIR 55 SATC 185 which was decided in 1993, shortly before the Note was issued, it was held that the concept of ‘trade’ is extremely wide and that it embraces every profitable activity. However, despite its wide meaning, the term ‘trade’ does not necessarily embrace all activities that might produce income, most notably, passive income in the form of interest, dividends, annuities or pensions.

Although it is true that our income tax system has always had the ‘trade’ test in addition to the ‘in the production of income’ and non-capital tests in determining the general deductibility of expenditure, no comparative requirement to the trade test exists on the income side. An amount forms part of a taxpayer’s ‘gross income’- and is therefore potentially subject to taxation- if it is received by or accrues to the taxpayer during the year of assessment and it is not of a capital nature. There is no requirement that prior to inclusion in a taxpayer’s gross income, an amount must be derived from a trade carried on by the taxpayer. Although it can be accepted that safeguards are required on the deductibility side to safeguard the fiscus, arguably the ‘in the production of income’ test serves that purpose and so one may validly question whether in addition to the ‘in the production of income’ and non-capital tests, the taxpayer should be required to overcome the additional hurdle presented by a ‘trade’ test. In many circumstances it is unclear whether a trade is being carried on or not and therefore whether expenditure incurred is in fact at risk of disallowance by SARS. The Note goes a long way towards mitigating this risk. The requirement that deductions or set-offs have to be in respect of a trade results in a variety of inequitable situations, not only those addressed by the Note. For example, a non-trading holding company that holds a foreign-denominated debt may find itself in the position that if foreign exchange losses are realised in a year of assessment, it is prevented from carrying forward the losses to the following year for offset against foreign exchange gains realised in that year, because it does not carry on a trade. It would then have to pay tax on the foreign exchange gains in that subsequent year without being able to offset the foreign exchange losses it incurred in the earlier year.

Be that as it may, since the Note was issued in 1994 it has assisted in achieving an equitable result in situations in which otherwise deductible expenditure is incurred by taxpayers in earning non-trade interest income. For example, say A and B are spouses, that B carries on a small business but that only A has the asset base acceptable to a South African bank for a working capital loan required by B’s business. Therefore, the bank makes a loan to A who lends it at equivalent rate to B’s business. In terms of the Note, A has an inclusion in gross income of the interest earned from B’s business but is allowed to deduct the non-trade interest expenditure paid to the bank. If the Note is withdrawn, the result will be that A will be taxed on the interest income earned but will not be permitted to deduct the corresponding interest paid to the bank. This will result in both the bank and A being taxed on the same amount of interest income, with only one taxpayer obtaining a deduction – B’s business, which is clearly inequitable.

It is difficult to fathom why SARS and National Treasury would wish to disallow the deduction by A of the interest expenditure incurred against interest income in the above scenario. An appeal to theoretical ‘purity’ of our income tax system – that for consistency the ‘trade’ test should apply in all circumstances - ignores the clear inequity that would be created by an application of the trade test to A in the above scenario. In any event, our income tax system is not otherwise ‘pure’ in that sense because there are instances of deductions which are expressly allowable in the absence of trade: contributions to retirement funds are allowed as deductions from an individual’s taxable income, irrespective of whether the individual carries on a trade or not and the same is true for donations by taxpayers to approved public benefit organisations. When SARS first announced its intention to withdraw the Note in November 2022, it claimed that taxpayers were abusing it in structuring transactions in which deductions were claimed on the basis of the Note, while there was no corresponding inclusion in gross income for the recipient: where transactions are concluded with either exempt or non-resident taxpayers. No more specific information regarding the alleged ‘abuse’ of the Note was provided. If certain structures are considered to abuse the principle in the Note, the contents of the Note should be amended to address the concerns. To disallow the deduction of interest expenditure against interest income in the majority of situations addressed by the Note because certain taxpayers are entering into schemes that exploit the practice, is manifestly unfair.

Comments on the proposed withdrawal of the Note were invited, with a deadline of mid-December 2022. The February 2023 National Budget Review stated that after reviewing the public comments received on the withdrawal of the Note, Government would consider the impact of the proposed withdrawal and whether changes could be made in the tax legislation to accommodate legitimate transactions affected by such withdrawal. In the Draft Explanatory Memorandum to the Draft Taxation Laws Amendment Bill that was released for public comment on 31 July 2023, National Treasury stated that it is still Government’s policy that the trade test should continue to apply to deductions and that ‘clearly legislated tax policies are imperative in ensuring certainty for both taxpayers and SARS’. Thankfully, it did observe that it is not in the best interest of the fiscus that efficient access to funding for businesses should be hampered. The Draft Bill proposes that the Note be withdrawn with effect for years of assessment commencing on or after 1 January 2024 and that a new provision, section 11G, with the same effective date will apply. This provision seeks to legislate the principle contained in the Note, but only in limited circumstances -it would only apply to interest income earned by a company that arises from a loan, advance or credit advanced by that company directly or indirectly to another company, where the creditor and debtor companies form part of the same group of companies. This proposal would therefore grant no relief to companies in other circumstances or to other types of taxpayer. It would also not assist taxpayer A in the small business loan scenario above.

Although there are various technical concerns with the provision, the main issue is the narrowness of its scope. The Draft Bill is open for public comment until 31 August 2023 and no doubt National Treasury will receive numerous submissions on the proposal. However, it seems likely that the Note will be withdrawn as originally proposed. Taxpayers are therefore cautioned to make contingency plans should the current narrow focus of the proposed exception to the ‘trade’ test survive into the Amendment Act.