In the current environment where there is a huge amount of debt being incurred by taxpayers it is useful to remind ourselves in what general circumstances interest is deductible for income tax purposes by taxpayers including companies that form part of a banking group.
In this regard, the provisions of section 24J of the Income Tax Act, 1962 (“Act”) regulate, amongst others, the incurral or accrual of interest on financial instruments. It enacts the principle that interest accrues on a “yield to maturity” basis and applies to all “instruments”, defined as including any interest-bearing arrangement or debt.
Section 24J (2) of the Act deals with the deductibility of interest. In particular, in terms of section 24J(2), interest is deductible whether or not the interest is seen as capital in nature.
Section 24J(2) provides that where a person is the “issuer” in relation to an instrument during any year of assessment, such person shall for purposes of the Act be deemed to have incurred an amount of interest during such year of assessment which is equal to the sum of all accrual amounts in relation to all accrual periods falling wholly or in part within such year of assessment in respect of such instrument, which must be deducted from the income of that person derived from carrying on any trade, if that amount is incurred in the production of the income.
An “issuer” is defined as any person who has incurred interest or has any obligation to repay an amount in terms of an instrument.
Accordingly, in terms of section 24J(2) of the Act, a person (the “issuer”) may deduct an amount of interest (calculated in accordance with section 24J) “from the income of that person derived from carrying on any trade, if that amount is incurred in the production of the income”.
For interest to be deductible, it must thus be incurred “in the production of income” as part of a “trade”.
The “trade” requirement
The term “carrying on any trade” is not defined in the Act. However, the term “trade” is widely defined in section 1 of the Act and includes inter alia every profession, trade, business, employment, calling, occupation or venture, including the letting of any property.
In Burgess v Commissioner for Inland Revenue  2 All SA 511 (A), the court considered whether the appellant was carrying on a trade within the meaning of the general deduction formula contained in section 11(a) read with section 23(g) of the Act. The court described the principle that “trade” should be given a wide interpretation as being “well established”. Regarding the meaning of “venture”, the court stated as follows:
“…although an element of risk is included in the concept of a “venture” in its ordinary meaning, I must not be taken to suggest that a scheme like the present would only constitute a “trade” if it is risky. Whether it would or not would depend on its own facts. If there is no risk involved, it might still be covered by giving an extended meaning to “venture” or by applying the rest of the definition, which is in any event not necessarily exhaustive” (our emphasis).
In Commissioner for South African Revenue Service v Tiger Oats Ltd, the court considered whether an investment holding company listed on the Johannesburg Stock Exchange was in fact carrying on a business for purposes of the application of the Regional Services Council Act, 1985. In this regard, the court held, inter alia, that:
“in a very real commercial sense the respondent [was] actively involved in the business of its subsidiaries and associated companies and it [was] its making of investments in those companies which enabled it to be actively involved;…[the respondent was] not simply a passive investor in [its subsidiaries and associated companies], equatable with a member of the public who invest[ed] in listed shares on the stock exchange” (our emphasis)”.
The principles regarding “carrying on any trade” as distilled from case law can be summarised as follows:
- the term “trade” should be given a wide interpretation,
- the definition of “trade” is not exhaustive,
- merely “watching over” investments does not constitute a trade – it requires something more, for example, dealing in securities, and
- the test as to whether a taxpayer carries on a “trade” is a factual enquiry and no single set of rules can be laid down in this regard.
In practice, the South African Revenue Service (“SARS”) generally allows the deduction of expenditure incurred in the production of income even though the receipt or accrual of the income does not constitute the carrying on of a trade. This practice of SARS is set out in Practice Note No. 31 (income tax: interest paid on moneys borrowed) (“PN31”). Although PN31 provides that the practice set out therein will be followed by SARS, PN31 is not binding in terms of South African law.
The “in the production of income” requirement
The locus classicus on when expenditure will be incurred “in the production of income” (albeit in the context of the general deduction formula in section 11(a) read with section 23(g) of the Act) is Port Elizabeth Electric Tramway Company Ltd v CIR where Watermeyer AJP formulated the test in terms of which the following questions need to be asked:
- whether the purpose of the act, to which the expenditure is attached, is to produce income; and
- whether the expenditure is linked closely enough to this act.
In respect of the first leg of the test, in accordance with, inter alia, CIR v Allied Building Society, the purpose to be determined, is the dominant purpose of the taxpayer in question. In Sub-Nigel Ltd v CIR it was established that the words “incurred in the production of the income” do not mean that before a particular item of expenditure may be deducted it must be shown that it produced any part of the income for the particular year of assessment. The important question is whether the expenditure incurred for the purpose of earning income as defined in section 1 of the Act, whether in the current or in a future year of assessment.
Section 24JB – “covered persons”
Section 24JB of the Act deals with the taxation of any profit or loss recognised by “covered persons” in the statement of comprehensive income in respect of “financial assets” and “financial liabilities”.
“Covered person” is defined in section 24JB(1) and includes, inter alia, a bank, a branch of a bank or any company that forms part of a banking group as defined in section 1 of the Banks Act, 1990 (“Banks Act”).
For purposes of section 24JB, the terms “financial asset” and “financial liability” are defined as a financial asset / liability defined in and within the scope of International Accounting Standard (“IAS”) 32 of International Financial Reporting Standards (“IFRS”) or any other International Accounting Standard that replaces IAS 32.
In terms of section 24JB(2), subject to inter alia section 24JB(4), there must be included in or deducted from the income of any covered person for any year of assessment all amounts in respect of financial assets and financial liabilities of that covered person that are recognised in profit or loss in the statement of comprehensive income in respect of financial assets and financial liabilities of that covered person that are measured at fair value in profit or loss in terms of IFRS 9, excluding certain specified amounts (such as amounts in respect of a dividend or foreign dividend received by or accrued to a covered person).
The essential elements in order for section 24JB(2) to find application , thus permitting a deduction against the taxpayer’s income, are:
- the taxpayer must constitute a “covered person”;
- the relevant amounts are in respect of a “financial liability”;
- amounts in respect of the “financial liability” are recognised in profit or loss in the covered person’s statement of comprehensive income; and
- that financial liability is recognised in profit or loss of the covered person in terms of IAS 39.
As set out above, section 24JB(2) is subject to the application of the section 24JB(4). Section 24JB(4) contains an anti tax-avoidance provision and states that 24JB(2) does not apply to any amount in respect of a financial asset or financial liability of a covered person where:
- “ a covered person and another person that is not a covered person, are parties to an agreement in respect of a financial asset or financial liability; and
- the agreement contemplated in paragraph (a) was entered into solely or mainly for the purpose of a reduction, postponement or avoidance of any liability for tax, which, but for that agreement, would have been or would become payable by the covered person” (emphasis added).
Provided all the requirements for the application of section 24JB(2) are met, in terms of section 24JB(2) any positive (increase in) fair value movements arising in respect of a “financial liability” would provide a “covered person” with a deduction against its income.
Section 24JB(2A) further requires a covered person to include in or deduct from income for a year of assessment a realised gain or realised loss that is recognised in a statement of other comprehensive income as contemplated in IFRS if that realised gain or realised loss is attributable to a change in the credit risk of the financial liability as contemplated in IFRS.
Section 24JB(3) provides that any amount to be taken into account in determining the taxable income of a person in terms of any provision of part 1 of chapter II of the Act (normal tax), or in determining any assessed capital loss of a covered person in respect of a financial asset or a financial liability contemplated in section 24JB(2), must only be taken into account in terms of section 24JB.