Draft Responses by National Treasury on the Excessive Interest Limitation Rules

interestOn 15 October 2014, National Treasury and SARS stated in a Response Document (‘Document’) presented to the Standing Committee on Finance (‘SCoF’) that the ‘excessive interest limitation rules’ are in line with international practice and measure up well in light of current discussions at the OECD.

Sections 23M and 23N were introduced in the 2013 Taxation Laws Amendment Act as measures to limit the amount of interest that a company can deduct, which the Document describes as a more reasonable level since debt finance was used to create opportunities for base erosion in the past.

With respect to the formula in these rules, the Document states that some comments received were positive, while others requested that there be a minimum percentage provided, with no upper cap.

The view of National Treasury and SARS is that the formula in the rules represents a balanced reflection of market conditions in that it is flexible, recognising that the costs of debt funding fluctuate and that there is no evidence showing that levels of 60% or higher relate to legitimate (commercially driven) debt financing. Graphs were presented by National Treasury that indicated that the current 40% limitation might be too high.

The other concerns received by institutional investors were in relation to guarantees and the definition of a ‘controlling relationship’. The controlling relationship definition will be amended to a concept of control through a requirement of 50% of equity shares (or voting rights). It is also agreed that guarantees are often provided by a parent company for debt financing and that these types of transactions should not be caught by the rules.

The interaction between section 23M, section 23N and section 31 (transfer pricing) was also one of the issues that was requested to be addressed, and this interaction is explained as follows:

‘The purpose of section 31 is to ensure that if cross-border transactions, such as debt financing, are entered into by connected persons, they must be treated (for tax purposes) as if the amount lent and the interest rate charged between the parties are equivalent to that between two independent parties, i.e. the arm’s length principle. In essence, section 31 seeks to correct mispricing due to the terms and conditions of the transaction.

The excessive interest limitation has a broader objective. By limiting the amount of interest deductible, companies are discouraged from excessive leveraging, which is often done because the tax system inherently encourages debt over equity financing. Interest limitation rules based on profitability and the ability to fund the finance charges are closer aligned with commercial practice and are more effective at protecting the South African economy than a simple debt-to-equity ratio.

A cap on the amount of interest deductible thus assists in both how much debt (in relation to equity) a company takes on, as well as the price thereof. Transfer pricing always applies first by determining the correct pricing. The draft legislation will be changed to ensure that section 23N applies first and thereafter section 23M, and that interest expenses disallowed under section 23N are not covered by 23M as well.’

In regard to the fact that section 23N does not allow a rollover of lost interest deductions to the following year of assessment, it is emphasised that the objective of this provision was a set of rules to disallow the deduction of interest exceeding a percentage of the tax equivalent of EBITDA according to a formula that adjusts with changes to the repo rate. This rule purposely prevents the use of excessive acquisition debt mainly to achieve tax savings. A carry-forward (although available in section 23M) of lost interest deductions goes against this purpose.