Consider a situation where Company A, Company B and Company C form part of a group of companies, Company A advances an interest bearing loan to Company B which, in turn, advances an interest bearing loan to Company C as part of a single arrangement. Now consider that in back to back funding arrangements such as this, Company C may obtain no tax deduction for the interest incurred on its loan from Company B whilst Company B will be taxed on such interest. This arises from the provisions of section 24J of the Income Tax Act ("Act").

Section 24J was originally introduced into the Act principally to regulate the incurrence and accrual of interest in respect of "instruments". The section prescribes, inter alia, that interest accrues on a day-to-day basis using a yield-to-maturity methodology (unless an alternative method has been used) and applies to all instruments.

The provisions of section 24J therefore require the existence of an "instrument". An instrument is defined as any form of "interest bearing arrangement" and includes any secured or unsecured loan, advance or debt.

Section 24J(2)(a) of the Act provides that the issuer of an "instrument" is deemed to have incurred an amount of interest during a year of assessment equal to the sum of all "accrual amounts" in relation to all accrual periods falling, whether in whole or in part, within such year of assessment in respect of such instrument.

In calculating the "accrual amount" of an instrument, the "yield to maturity" is applied to the "adjusted initial amount".

The proviso to paragraph (b) of the definition of "adjusted initial amount" provides in relation to the issuer of any instrument, that where such instrument forms part of a transaction, operation or scheme—

"any payments made by the issuer to any other person pursuant to that transaction, operation or scheme with a purpose or with the probable effect of making payment directly or indirectly to the holder or a connected person in relation to the holder, must be deducted for purposes of this paragraph; and

in the case where any party to that transaction, operation or scheme is a connected person in relation to that issuer, any payments made by that connected person to any other person pursuant to that transaction, operation or scheme with a purpose or with the probable effect of making payment directly or indirectly to the holder or a connected person in relation to the holder, must be deducted for purposes of this paragraph".

The "yield to maturity" is defined as, inter alia, the rate of compound interest per accrual period at which the present value of all amounts payable or receivable in terms of any instrument in relation to a holder or an issuer, as the case may be, of such instrument during the term of such instrument equals the initial amount in relation to such holder or issuer of such instrument. The proviso to the term "yield to maturity" is similar to the proviso to paragraph (b) of the "adjusted initial amount" definition set out above.

The provisos were inserted into the Act by the Revenue Laws Amendment Act No. 32 of 2004. The Explanatory Memorandum issued by SARS in conjunction therewith, state the following in relation to the insertion of the provisos:

"A number of structured finance schemes which are based on convertible loans have been identified. The schemes under investigation were entered into between members of groups of companies (large and smaller companies) and are as a general rule facilitated by financial institutions.

Common characteristics of the structures are the use of compulsory convertible debt, the circular flow of funds through a number of related and unrelated companies and the borrowing of an inflated amount by the party claiming interest for tax purposes. The tax benefit for the group of companies entering into the scheme is the deduction of interest on the principal amount of a loan on an accrual basis and the creation of a deferred capital gain which in essence results in the deduction of interest and capital of the actual financing needs of the borrower.

...

In order to address the tax avoidance element of schemes which are based on the circular flow of funds to which more than one company in a group of companies are party to it is proposed that the interest claimed by a group company be limited to the net amount borrowed in terms of the scheme by the group of companies. It will be required that payments made by the borrower in respect of a financial arrangement or scheme as well as payments made by any connected person in relation to the issuer in respect of a financial arrangement or scheme should be taken into account. A circular flow of funds would then reduce the amount of interest claimed by a group company.

The definitions of "adjusted initial amount" and "yield to maturity" in section 24J(1) are to be amended to provide that where an instrument forms part of any transaction, operation or scheme and, any payments made by the issuer or connected person must be taken into account if made with a purpose or the probable effect of making payment directly or indirectly to the holder (or a connected person to the holder)."

However, unfortunately the wording of the provisos is far wider than their intended ambit as expressed in the Explanatory Memorandum. In the example set out at the start of this article, Company A is a connected person in relation to Company C. Payments are made by Company A to any other person (Company) B with both the purpose and probable effect of making payment to the holder (Company B).

In these circumstances Company C's "adjusted initial amount" is reduced by the value of the entire loan advanced to it by Company B. In addition these amounts reduce Company C's yield to maturity.

The effect of this is that Company C obtains no tax deduction for the interest it incurs on its loan from Company B whilst Company B is taxed on the full amount of such interest.

Given the wording of the Explanatory Memorandum the issue arises whether it is possible to reason that the provisos should be given a narrow meaning which does not apply to the example set out above or indeed a multitude of other transactions entered into with no tax avoidance motive or circular flow of funds as identified in the Explanatory Memorandum.

An argument could be made that, on the facts as stated above, the proviso does not apply since it requires payments to be made "to any other person" with a purpose or probable effect of making payment to the holder. Therefore it could potentially be argued that the "other person" cannot also be the "holder". However, this is not the view of the writer and even if this were the case, the proviso would still apply to a multitude of other transactions with no tax avoidance motive.

One could also analyse the meaning of the word "payment". In this regard the term "payment" is not defined in the Act.

The Shorter Oxford English Dictionary on Historical Principles, (5th Ed Vol 2) defines "payment" as:

"an act or the action or process, of paying (Foll. By of the money etc. paid, the debt discharged…for the thing bought or recompensated).

Black's Law Dictionary, (8th Ed) defines a payment as:

"Performance of an obligation by the delivery of money or some other valuable thing accepted in partial or full discharge of the obligation".

However, it is difficult to see how in circumstances where Company A agrees to loan a certain amount of money to Company B and Company B agrees to loan a certain amount of money to Company C that when Company A and Company B make payment in terms of their respective obligations under these loan agreements, they are not making "payment" to Company B and Company C respectively.

The "golden rule" in interpreting statutes is set out in Venter v R 1907 TS 910 at 913 as follows, "the most important (golden) rule of statutory construction is to ascertain the intention of the legislature. This was to be done by taking the language of the instrument, or of the relevant portion of the instrument as a whole and where the words are clear and unambiguous to place upon them their grammatical construction and to give them their ordinary effect. Under certain circumstances it would, however, be permissible to depart from the ordinary meaning of the words" These circumstances would include where such a result will lead to absurdity or when ambiguity is present (see Union Government v Mack 1917 AD 731).

A primary canon of legislative interpretation is the "literal rule". In the dictum of Lord Cairns in Partington v Attorney-General: if the person sought to be taxed comes within the letter of the law, he must be taxed, however great the hardship may appear to the judicial mind to be. In other words, if there be an equitable construction, certainly such a construction is not admissible in a taxing statute." (See Meyerowitz on Income Tax at 3.7.)

Nugent JA in the case of Defy Ltd v Commissioner for the South African Revenue Services (192/09) [2010] ZASCA 11 reported in the March issue of The Taxpayer stated as follows:

"It needs to be born in mind that a statute is not a statement of policy by the legislature that leaves the detail to be filled in by a court. It is policy that has been translated into law. If it has not been adequately translated I do not think that it is for courts to rewrite the statute. That would seem to me to strike at the heart of the rule of law."

In respect of the weight to be given to the above-mentioned quote from the Explanatory Memorandum, statements made in Explanatory Memoranda have historically been inadmissible as evidence of legislative intent. However there is recent authority that one may in certain circumstances have regard to Explanatory Memoranda (see Chaskalson CJ's judgement in the Minister of Health and Another No v New Clicks South Africa (Pty) Ltd and Others (Treatment Action Campaign and Another as AMICI CURIAE) 2006 (2) SA 311 at 391).

The question arises whether taxpayers may rely on a "purposive" approach to interpretation of fiscal legislation. In this regard, in the realm of what SARS often refers to as "aggressive tax planning" whether the courts may give a purposive interpretation to fiscal legislation.

In CSARS v Airworld CC and Another [2008] 2 All SA 593 (SCA), Hurt AJA seemed to favor a purposive construction to tax statutes. He pointed out that "in recent years courts have placed emphasis on the purpose with which the Legislature has enacted the relevant provision. The interpreter must endeavor to arrive at an interpretation which gives effect to such purpose. The purpose (which is usually clear or easily discernible) is used, in conjunction with the appropriate meaning of the language of the provision, as a guide in order to ascertain the legislator's intention". In Metropolitan Life Ltd v CSARS [2008] 70 SATC 162, Davis J approved the dictum of Hurt AJA in CSARS v Airworld CC and Another. He indicated that the Act and its amendments should be "interpreted purposively and holistically and that provisions should be given a clear meaning whenever plausible".

The object of statutory interpretation is to establish "the intention of the Legislature", albeit that this is an artificial construct to be ascertained principally if not exclusively from the wording of the statute itself. Therefore there is a place for a purposive approach being allied to intention. The difficulty with applying a purposive approach to the example set out above is that whilst it seems that in a broad commercial sense the "purpose" of the provisos to section 24J of the Act was not to penalise Company C in the example set out above since there is no tax avoidance motive in the transaction, it seems that such example falls within the ambit of the words of the provisos using the golden and literal rules of interpretation. In particular, the words seem sufficiently clear and unambiguous to place upon them their grammatical construction and to give them their ordinary effect.

In the view of the writer the appropriate mechanism to remedy this particular issue is to add a requirement that, for example, there must be a purpose of avoiding tax before the provisos apply or to include some other explicit reference to the tax avoidance mischief identified in the Explanatory Memorandum.

In the absence of such clarity taxpayers should take great care when obtaining funding on a back to back basis.