“There can be no objection in principle to the deduction of interest on loans in suitable cases. Loan capital is the life blood of many businesses but the mere frequency of its occurrence does not bring about that this type of expenditure requires different treatment.

Whilst these words of Hefer JA in the well-known judgment of Ticktin Timers CC v The Commissioner for Inland Revenue (1999 (4) SA 939 (SCA) at 942I) are still apposite two decades later, there has been increased focus by National Treasury on cross-border financing and how it may lead to tax avoidance, base erosion and profit shifting. As a result of this scrutiny, sections which are intended to have an effect on the deductibility of interest incurred in respect of cross-border loans have been included in the Income Tax Act No. 58 of 1962 (the “Act”). For the current purposes, we have only focused on section 23M and section 31 of the Act, and specifically revisited the interaction between the two.

Section 23M of the Act provides for a limitation on the deduction of interest incurred where a loan has been advanced by a creditor who holds more than 50% of the equity shares or voting rights in such a debtor (i.e. a controlling relationshipexists). The limitation will also be applicable where the creditor is not in a controlling relationship with the debtor, if the creditor obtained the funding for the debt so advanced from a person who is in a controlling relationship with the debtor. However, such an interest deduction limitation will only apply if the amount of interest is neither “subject to tax” in the hands of the recipient, nor included in the net income of a controlled foreign company and also not disallowed under the provisions of section 23N of the Act, which deals with the limitation of interest deductions in respect of reorganisation and acquisition transactions.

Generally speaking, the provisions of section 23M of the Act apply to cross-border inbound interest-bearing loans advanced by foreign holding companies to their subsidiaries in South Africa. In terms of such an arrangement, the interest income derived by the foreign company would usually not be subject to tax in terms of the provisions of the Act. This is especially prevalent where loans are advanced from creditors who are resident in Luxembourg, Cyprus, and the Netherlands because of the Double Tax Agreements concluded between South Africa and these respective countries.

Such inbound loans may also be subject to the transfer pricing provisions of section 31 of the Act. Section 31 of the Act targets “affected transactions”, which are, generally speaking, transactions or agreements concluded between “connected persons” (as defined in section 1 of the Act), where one person to the transaction is resident in South Africa for income tax purposes and the other person is non-resident. In addition, a transaction will only be an affected transaction if any term or condition thereof would not have existed if the contracting parties had been dealing at arm’s length.

Section 31(2) of the Act provides that where such a transaction results in a “tax benefit”, the taxable income of the person who derives the tax benefit must be determined as if that transaction had been entered into on the terms and conditions that would have existed between independent persons dealing at arm’s length. Accordingly, where the quantum or interest-rate of an inbound loan does not reflect what would have been agreed between parties dealing at arm’s length (e.g. between a Bank and a third-party borrower), the taxpayer is required to disregard such interest incurred for purposes of calculating its taxable income. This is known as the so-called Primary Adjustment.

In addition, section 31(3) of the Act provides that to the extent that the application of section 31(2) of the Act causes a difference in any amount applied in the calculation of the taxable income, the difference is deemed to be a dividend in specie declared by the taxpayer (i.e. the so-called Secondary Adjustment). Effectively, the amount of interest which was disallowed as a deduction is treated as a deemed dividend in specie, and is subject to dividends tax at a rate of 20% in terms of section 64E(1), read with section 64EA(b) of the Act.

Thus, the question arises: which of these provisions must be applied first in the instances where they both apply to the same in-bound loan? We understand that it is the view of National Treasury and the South African Revenue Service, as observed in their Draft Response Document presented to the Standing Committee on Finance in respect of the 2014 Taxation Laws Amendment Bill. As stated above, any adjustment in terms of section 31 of the Act gives rise to both the Primary and Secondary Adjustment, whereas the application of section 23M of the Act only results in a lesser allowable interest deduction, which has the same effect as the Primary Adjustment.

In respect of legislation one should attempt to read the relevant legislative provisions together and, only in circumstances where they conflict, to consider which provision should apply in preference to the other. We analyse below whether it may be possible for the provisions of section 23M and section 31 to be read together.

As stated above, section 23M of the Act applies a statutory formula which limits the deduction of interest. This provision tests factual issues and may therefore be applied in the context of the above-mentioned inbound loans.

The definition of “adjusted taxable income” in section 23M(1) of the Act refers to an amount of interest incurred that has been allowed as a deduction from income. In this regard it is arguable that consideration could be given to any interest incurred which has been disallowed as a deduction in terms of the provisions of section 31(2) of the Act.

In terms of section 31 of the Act it is necessary to consider, inter alia, whether there is any “tax benefit” and whether the terms of the loan are arm’s length in nature. In particular consideration will be given to the quantum and interest rate on the loan. If any term of the loan (in particular relating to quantum and interest rate) is not arm’s length and a tax benefit arises then it will be necessary to calculate the taxable income of the borrower as if the loan was entered into on arm’s length terms.

In this regard the borrower’s taxable income will already be reduced by the application of the statutory formula set out in section 23M of the Act and this should be taken into account in applying the provisions of section 31 of the Act.

In Natal Joint Municipal Fund v Endumeni Municipality which is now considered the seminal case on the purposive approach to statutory interpretation, the Supreme Court of Appeal (“SCA”) held that when interpreting legislation, one should consider the text of the document under consideration (as a point of departure) read in context and having regard to the purpose of the provision and the background to the preparation and production of the document. It is submitted that both section 23M and section 31 of the Act are intended to combat base erosion and profit shifting, whilst section 23M has the further specific purposes of addressing the bias for debt funding over equity funding, and hybrid entity mismatches. Accordingly, having regard to the purpose of both provisions does not sway the interpretation in favour of applying either of the provisions before and the exclusion of the other. This supports the argument that both sections could be read together.

In the Endumeni case, the SCA held that where a person is faced with two or more possible interpretations of a statute, the one which gives rise to “impractical, unbusinesslike or oppressive consequences” must be avoided.

In conclusion, where the provisions of section 23M and section 31 of the Act apply to the same inbound loan, the first approach should be to attempt to read the provisions of these sections together. This would mean firstly applying the statutory formula set out in section 23M. The only input required in terms of section 31 in relation to the statutory formula would be the amount of interest incurred that has been allowed as a deduction from income.

The provisions of section 31(2) of the Act would then be applied to the same loan and a determination made as to whether there is a tax benefit and whether the arrangement constitutes an “affected transaction”. A further adjustment to the taxable income may be necessary having regard to the provisions of section 31(2) of the Act.