Deduction limitations proposed by National Treasury

Very important proposals in this regard are the following:

A new section 23M:

It is proposed that any amounts owed (other than in respect of the acquisition of trading stock) between debtors and creditors will be deemed to be incurred only when the amount is paid, under the following circumstances:

• Where the creditor is not subject to South African tax (as levied under Chapter II of the Income Tax Act), AND
  
• The debtor and creditor are in a 'controlling relationship' i.e. if the debtor directly or indirectly holds more than 70% of the equity shares or voting rights in the creditor, or vice versa, taking into account connected persons in relation to the debtor and creditor.

The rationale for this proposal is to defer deductions in respect of payments such as interest, royalties and fees for other services that are made to a person that is not subject to South African tax as a result, for example, of an exemption. It is unclear whether the intention is that the provision should apply in cases where the amount is not subject to South African tax as a result of the application of a Double Taxation Agreement.

The provision deems the amount 'to be incurred' only when the amount is paid. This is a problem in that this wording conflicts with that of section 24J in the case of interest. Of major concern is that it is proposed that the provision be backdated to apply to expenditure incurred on or after 1 July 2013.

In addition, in respect of interest payable, an overlap exists with a new proposed section 23P (see below).

A new section 23N:

It is proposed that interest incurred by a company in terms of a debt assumed or applied directly or indirectly to facilitate or fund:

• The acquisition of an asset in terms of a section 45 intra-group transaction or a section 47 liquidation transaction OR
  
• A section 24O acquisition (where a company acquires a controlling group stake in an operating company utilising debt and can claim a deduction in respect of the debt) be limited for the year of acquisition and the following 5 years of assessment to an amount determined with reference to a formula.

The interest deduction is limited to the amount calculated in the formula below:

1. The total interest received by or accrued to the acquiring company less interest incurred in respect of other debt, PLUS
   
2. 40% of what is termed 'adjustable taxable income', which is the taxable income of the acquiring company (in circumstances in (1)) or the acquired company (in circumstances in (2)), calculated by taking into account a number of adjustments.
   

These adjustments are as follows:

• Subtract from taxable income: interest received or accrued, net income inclusions of a controlled foreign company and section 24I foreign exchange gains; and
  
• Add to taxable income: interest incurred, capital allowances, 75% of gross income from the letting of immovable property and section 24I foreign exchange losses. One takes into account the higher of the 40% of 'adjustable taxable income' figure in the year of assessment in which the reorganisation transaction / acquisition transaction is entered into or the year of assessment in which the interest is incurred. So, in effect, the 'adjustable taxable income' figure in the year of assessment in which the transaction was entered into becomes a minimum or baseline figure in calculating subsequent years' deductions. The proposal includes a pro-rata scaling up of the 40% factor where the repo rate rises above 10%.

This provision is intended to replace the current discretionary regime contained in section 23K of the Act for reorganisation / acquisition transactions entered into on or after 1 July 2013. Of major concern is that it is proposed that the provision be backdated to apply to reorganisation/ acquisition transactions entered into on or after 1 July 2013 and refinancing arrangements entered into on or after that date.

Also, where an acquiring and acquired company are in a 'controlling relationship' as defined in the proposed section 23M referred to above, there is a further proposal, to be contained in section 23O. This proposes that interest incurred in an acquiring company in terms of a debt assumed or applied directly or indirectly to facilitate or fund acquisition transactions referred to in (a) or (b) above will be wholly disallowed if the controlling relationship existed during any 18 month period in the 36 months prior to the date on which the debt was assumed or applied. This proposal also has retrospective effect as it applies in respect of acquisition or reorganisation transactions entered into on or after 1 July 2013.

A new section 23P:

It is proposed that interest incurred by a debtor in respect of a debt owed to a creditor be limited with reference to a formula, under the following circumstances:

• Where the creditor is not subject to South African tax (as levied under Chapter II of the Income Tax Act) AND
  
• The debtor and creditor are in a 'controlling relationship' as defined in section 23M as discussed above. This includes back to back arrangements, wherein the debt is advanced from a person who is not in a controlling relationship on the strength of a guarantee by a person that is in a controlling relationship.

The rationale for this proposal is to limit what are perceived to be excessive deductions in respect of interest payments that are made to a person that is not subject to South African tax as a result, for example, of an exemption. It is unclear whether the intention is that the provision should apply in cases where the amount is not subject to South African tax as a result of the application of a Double Taxation Agreement.

'Excess' interest is carried forward for up to 10 years on a FIFO basis after which time the ability to claim a deduction in respect of the excess is permanently lost.

The formula is essentially calculated in the same manner as the formula in terms of section 23N above.

The proposal contains an exclusion in circumstances where the creditor obtained the funding in respect of the debt from a lending institution that is not in a controlling relationship with the debtor, which funding is determined directly on the strength of the market value of the assets less liabilities of the creditor. The proposal includes a pro-rata scaling up of the 40% factor where the repo rate rises above 10%. Once again the proposal has been made retrospective to interest incurred on or after 1 July 2013.

For more information, go to www.treasury.gov.za or www.bdo.co.za