An often misunderstood aspect of tax law is the relationship between a company borrowing funds and declaring dividends. This is illustrated by the plethora of case law on this particular topic. The battle lines are clearly drawn – SARS’ attempts to link the borrowing of money by a company to the dividend declaration. If it succeeds, then the interest cost is not deductible since it is not incurred in order to produce income, but rather to declare the dividend.
The taxpayer company typically argues that it had excess cash which it used to declare a dividend to its shareholders. It then subsequently needed to borrow funds for the purpose of running its business operations. Therefore the interest cost is linked to the income earned by the company from running its business operations and is deductible.
In the three main cases on this topic the taxpayer is a short neck ahead with two cases going the way of the taxpayers and one going the way of SARS. However various cases have gone all the way to the Supreme Court of Appeal in Bloemfontein. In order to avoid a trip to that city we illustrate below the main principles which should be applied when a company considers borrowing money around the time of declaring a dividend.
In Giuseppe Brollo Properties (Pty) Ltd, the court summarised the principles as follows:
”In a case concerning the deductibility or otherwise of interest payable on money borrowed, the enquiry relates primarily to the purpose for which the money was borrowed. That is often the „dominant‟ or „vital‟ enquiry, although the ultimate user of the borrowed money may sometimes be a relevant factor. Where a taxpayer‟s purpose in borrowing money upon which it pays interest is to obtain the means of earning income, the interest paid on the money so borrowed is prima facie an expenditure incurred in the production of income…..If on the other hand the purpose of the borrowing was for some other purpose than obtaining the means of earning income (eg to pay a dividend), the interest is not deductible. “
In the Ticktin Timbers CC case it was held that the purpose of the loan was to enable a dividend to be paid to Dr Ticktin as without the loan there would have been no dividend, and without the dividend there would have been no loan. The court therefore held that the interest was not deductible in the hands of the taxpayer.
The Supreme Court of Appeal in this case found that the making of the distribution and the making of the loan were not separate and unconnected transactions, but interdependent and neither was intended to exist without the other.
The Scribante case stands in contrast with the Ticktin Timbers CC case. In the Scribante case, it was held that the purpose of the loan back from shareholders of money which the company did not need, was to enhance the already healthy position of the company by advancing its financial profile so as to obtain future business expediently and, in addition, to earn interest for the company.
In the BP case, the taxpayer had declared a dividend to its holding company and simultaneously entered into a loan agreement. At the time of the declaration of the dividend, the company had cash reserves significantly in excess of the dividend.
The financial director’s evidence was that if the dividend had been paid in full, the taxpayer (BPSA) would have been able to continue with its normal business activities including its capital expenditures for the year in which the dividend was declared, but would have required funding towards the end of the next year. Therefore, the court found that the taxpayer did not have to simultaneously borrow an amount to replace the amount of the dividend or any part thereof and that, based on the Ticktin case that should be the end of enquiry.
The court held that it seemed conceivable that a company may be borrowing money to fund a dividend notwithstanding the fact that it has resources available to enable it to continue its income-earning activities. The court proceeded on the basis that it nevertheless had to be determined whether the purpose of the loan was to enable the dividend to be paid or whether the purpose was to provide BPSA with the liquid funds required to enable it to pursue its income-earning activities. In the determination of the purpose of the loan, the intention of the taxpayer company, as evidenced by its financial director, was critical.
The following principles can be distilled from the case law set out above:
- The purpose for which the money was borrowed must be determined. If the purpose of the loan is to obtain the means of earning income, the interest paid on the loan is prima facie expenditure incurred in the production of income and therefore deductible.
- If a dividend is declared and a loan agreement is simultaneously entered into by a taxpayer, this does not by itself mean that the interest on the loan is not deductible. It is still necessary to determine the purpose of the loan. In particular, it is relevant to determine whether the dividend and loan are interdependent and whether one can exist without the other.
- The purpose of a company in obtaining a loan is a question of fact and regard will be had to, inter alia, the intention of the company. The intention of the directors, being those who collectively represent the directing mind and will of a company, becomes critical.
- In determining the purpose of the loan, our courts gave much consideration to whether sufficient cash was available to pay the dividend and still be able to conduct its normal trading activities without the loan (eg. the BP and Scribante cases). However, this factor is not decisive and it should still be determined whether the dividend and the loan are interdependent and whether the intention is that they can exist without each other.
- Another factor which our courts have regarded as being relevant was whether the income earning capacity of the taxpayer declaring the dividend has been increased by the loan funding obtained.
In conclusion, if a company wants to be very sure that it will not incur the ire of SARS it should follow the principles set out below.
The purpose of the loan should be to enable the company to carry on its business operations and not to pay the dividend.
In this regard it is important that, from a factual perspective, it can be demonstrated that the company has sufficient cash available to pay the dividend and to continue its business operations without an immediate need to procure finance by way of a loan.
It should factually also be the case that, absent the loan, the dividend would still have been paid.
The loan should then be raised to the extent that the company has a need to fund its future business operations.