In the 2013 Budget Speech, the Minister of Finance announced that restricting the deduction of excessive interest expenditure claimed by taxpayers in debt financing schemes has been on the tax policy agenda for a number of years and accordingly, legislative steps are now being taken to limit the interest deductions claimed by taxpayers in such schemes.
In terms of the media statement released by National Treasury on 29 April 2013, one of the proposals sought to be introduced in the Draft Taxation Laws Amendment Bill, 2013 (“DTLAB”) was to impose a limit on the interest deduction claimed by a taxpayer (the “acquirer”) on loan funding used to either:
- acquire the assets of a target company or
- the shares in a target company.
Currently, an acquirer may purchase the assets of a resident company tax neutrally in terms of an intra-group transaction as contemplated in the provisions of section 45 of the Income Tax Act, 58 of 1962 (the “Act”) if both companies form part of the same group of companies at the end of the day of the transaction.
In terms of section 24O of the Act, an acquirer may deduct the interest incurred by it on loan funding utilized to purchase the shares of a target company, if the target company is an operating company, that is, the target company must conduct a business that provides goods or services for consideration and carries on that business continuously.
However, in terms of section 23K of the Act, where interest-bearing loan funding is used by the acquirer to fund the purchase of assets in terms an intra-group transaction in accordance with section 45 of the Act (a “section 45 acquisition”) or to fund the purchase of shares in a target company in terms of section 24O of the Act (a “section 24O acquisition”), the acquirer may not claim a deduction for the interest incurred by it on the loan funding, unless the Commissioner of the South African Revenue Service (the “Commissioner”) issues a directive that the interest may be deducted by the acquirer.
In this regard, the Commissioner may only issue a section 23K directive if and to the extent that the Commissioner is satisfied that the issuing of that directive will not lead nor be likely to lead to a significant reduction of the aggregate taxable income of all parties who incur, receive or accrue interest in respect of and for all periods during which any amounts are outstanding in terms of the loan funding.
National Treasury have indicated that although the provisions of section 23K of the Act were designed to target the potential erosion of the tax base caused by interest deductions on excessive loan funding, these provisions were introduced as an interim measure only. National Treasury have also acknowledged that the process of obtaining a section 23K directive from the Commissioner is not viable as a permanent solution as it is a time consuming and discretionary process, and furthermore, taxpayers who require loan funding for a section 45 acquisition or a section 24O acquisition require decisive rules before entering into and concluding negotiations for such transactions.
Accordingly, and in an attempt to provide certainty to taxpayers, the current section 23K directive system will be terminated and a new system for limiting the deduction of interest incurred by an acquirer on loan funding raised for a section 45 acquisition or a section 24O acquisition will be introduced. To this end, in the DTLAB published on 4 July 2013, it is proposed that a new section, namely section 23N will be inserted into the Act.
Section 23N will apply where an amount of interest is incurred by an acquiring company on loan funding raised for a section 45 acquisition or a section 24O acquisition or in respect of any debt used directly or indirectly for the purpose of redeeming, refinancing or settling the debt raised for a section 45 acquisition or a section 24O acquisition.
The total amount of interest in respect of all debts owed in any year of assessment in which the section 45 acquisition or section 24O acquisition is entered into and for 5 years of assessment immediately following that year of assessment must not exceed:
- the total amount of interest received by or accrued to the acquiring company to the extent that, that interest exceeds interest incurred other than interest to which the provisions of section 23N apply; and
- 40% of the higher of the “adjustable taxable income” of that acquiring company as determined in respect of the year of assessment in which the reorganisation or acquisition transaction is entered into; or in respect of the year of assessment in which the interest is incurred.
Accordingly, to the extent that the interest paid by the acquirer, exceeds the interest limitation, the excess will be carried forward for a period of five years, but will remain subject to the limitation. In terms of the Explanatory Memorandum to the DLTAB, the formula for the limitation is to be determined against two years with the adjusted taxable income in the year of the acquisition setting the minimum base. The purpose of this minimum base is to provide parties undertaking a company acquisition with certainty that they can rely on an initial base calculation when negotiating sale terms.
In the case of a section 24O acquisition, the 40% taxable income limitation will be further adjusted in accordance with the shareholding percentage being acquired if the acquirer is not acquiring all of the shares of the target company. For example, if the acquirer acquires 60% of the shares of the target company, the interest limit will be 60% of 40% of the target company’s taxable income. It is also proposed that the 40% threshold will increase for all taxpayers if the national repurchase interest rate exceeds 10%.
“Adjustable taxable income” is defined in section 23N and means taxable income disregarding interest received, interest accrued, interest paid or interest incurred and net income of a controlled foreign company as contemplated in section 9D(2) of the Act and all currency gains or losses, but including, all interest incurred, capital allowances as well as 75% of gross income from the letting of any immovable property.
The proposed section 23N is expected to come into effect on 1 July 2013 and will apply in respect of transactions entered into on or after that date. The section 23K approval regime will be limited to acquisition transactions before this date and will be repealed in its entirety in respect of interest incurred for years of assessment commencing on or after 1 January 2019.