Tax bill includes tightening of deduction of interest expense
South Africa’s 2021 Draft Taxation Laws Amendment Bill (DTLAB) proposes major changes to section 23M of the Income Tax Act. Currently, this provision limits interest expense deductions in the hands of a debtor company to a percentage calculated under a formula and applied to the company’s “adjusted taxable income,” as defined. The provision applies in circumstances where the interest is not subject to South African taxation (i.e., either income tax or interest withholding tax) in the hands of the creditor and if the creditor is in a “controlling relationship” with the debtor.
Section 23M typically applies if the creditor is tax resident in a jurisdiction that has concluded a tax treaty with South Africa and the treaty grants exclusive taxing rights on interest income to the foreign jurisdiction. However, the section also applies where the creditor is a South African resident that enjoys a tax exemption on the interest income (e.g., the creditor is an approved public benefit organisation or a retirement fund) that is in a controlling relationship with the debtor company.
BEPS Report on action 4
The OECD’s 2015 report on action 4 of the Base Erosion and Profit Shifting (BEPS) project recommended that jurisdictions implement a mechanical rule to limit the deduction of interest expense. The recommendations define best practices worldwide but are not articulated as a minimum standard requiring implementation by all OECD member countries. 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, taxes, depreciation and amortisation). It stated that a jurisdiction, at its discretion, could set the range for the limit between 10% and 30% of EBITDA. It further recommended that a jurisdiction could consider 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 action 4 report. In February 2020, the South African 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 currently worded.
Section 23M is not aligned with the recommendations contained in the BEPS action 4 report but it also will 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 expense deductions before setting off interest income. The report also recommends that the limitation apply to both related party and third-party net interest expense, whereas section 23M applies only to interest deductions where the creditor is in a controlling relationship with the debtor or, if the creditor is not in a controlling relationship with the debtor, where the creditor obtained the funding for the debt from a person that is in a controlling relationship with the debtor.
Summary of proposed changes
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 tax avoidance arrangements 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, in its current form, the proposal would 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 under a formula. The proposal is that the percentage calculated under the formula would be replaced by a fixed amount of 30%. The majority of countries that have adopted the recommendations in the BEPS action 4 report have chosen 30% for purposes of determining the limit. The Explanatory Memorandum to the DTLAB states that an analysis using the South African Revenue Service (SARS) micro-level data for all taxpayers shows that applying a fixed ratio of 30% 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 allow taxpayers to avoid the application of the provision. These arrangements involve loans that are channeled 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 for Real Estate Investment Trusts (REITs). A REIT may 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 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 would add such qualifying distributions back when determining its interest expense limitation.
- The provision would no longer grant a wholesale exclusion in cases where withholding tax on interest, as well as an exemption from income tax, applies in the hands of the creditor. Instead, a pro rata approach is proposed, under which in cases where a creditor suffers say a 5% rate of withholding tax under an applicable tax treaty, the debtor would be allowed a full deduction of 5/28 of the interest expense, with the remainder of the 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 would be reviewed after five 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, however, 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. The final version of the bill will likely be released mid-November.