The general purpose of Section 23K of the Income Tax Act (58/1962) is to disallow interest deductions for debt used in certain reorganisation transactions. One of the targeted transactions is where a taxpayer has indirectly obtained interest deductions for debt used to purchase shares. Generally, interest paid on debt used to purchase shares is not deductible, as shares produce exempt dividend income.

Using what is known as a 'debt push-down' structure, a taxpayer could obtain such an indirect interest deduction on the purchase of shares. To illustrate, holding company A wishes to purchase the business of company B. Company A does not wish to purchase the shares in company B, because it will be unable to get an interest deduction if it buys the shares with borrowed money. However, the shareholders of company B would prefer to sell their shares to company A. In order to purchase the shares in company B and also get an interest deduction, company A makes use of the debt push-down technique. Company A buys the shares in company B and obtains bridging finance from a third party in order to settle the purchase price of the shares. Company A then forms a subsidiary, company C. Since company B and company C now form part of the same group of companies, company C purchases the assets from company B in terms of a Section 45 intra-group transaction – without triggering any tax. Company C obtains a long-term loan from a bank to settle the purchase price of the assets. Company B distributes the cash up to company A and company A uses it to settle the bridging finance. The result is that the group has acquired the shares while also obtaining interest deductions through the long-term loan to company C.

Such transactions are problematic for the government, especially in cases where the interest is paid to foreign lenders, in which case the taxpayer gets a deduction, but the government cannot tax the interest as income in the hands of the lender because the income is exempt under Section 10(1)(h) of the Income Tax Act.

Section 23K(2) of the act reads:

"no deduction is allowed in respect of any amount of interest incurred by an acquiring company in terms of a debt instrument if that debt instrument was issued or used directly or indirectly - (a) for the purpose of procuring, enabling, facilitating, or funding the acquisition by that acquiring company of any asset in terms of a reorganisation transaction."

A 'reorganisation transaction' is defined in Section 23K(1) of the act as including an intra-group transaction in terms of Section 45 of the act.

Interest deductions on such debt instruments which are used in reorganisation transactions are allowed only if special application is made to the South African Revenue Service for a directive allowing such deductions under Section 23K(3), or if a specific prescribed exclusion under Section 23K(9) applies.

Consider the following scenario: company A and its subsidiaries company B and company C are pre-existing companies. Company C has a long-term loan from a bank, which it has held for many years and in respect of which it claims interest deductions. Company C purchases all assets of company B, its fellow subsidiary. Company C settles the purchase price by making use of the funds from the long-term loan.

In terms of Section 23K(2) of the act, company C will no longer be entitled to claim interest deductions on the loan, because it has used the debt to fund the acquisition of assets in terms of a Section 45 intra-group transaction (assuming that no specific prescribed exclusion applies). Company C will have to apply for a directive from the South African Revenue Service in order to continue claiming interest deductions on the loan.

It is therefore irrelevant whether the loan was specifically obtained for the purpose of acquiring assets in terms of a Section 45 intra-group transaction. The fact that the loan funds were used for the Section 45 intra-group transaction is sufficient to trigger the provisions of Section 23K of the act.

For further information on this topic please contact Heinrich Louw at Cliffe Dekker Hofmeyr Inc by telephone (+27 11 562 1000), fax (+27 11 562 1111) or email (