Important changes to section 23M of the Income Tax Act (ITA)

Section 23M provides for a limitation on the amount of interest which can be deducted on loans sourced from a person that is in a ‘controlling relationship’ with the debtor where the interest is not subject to tax in the hands of the person to which it accrues.

The first important change in the TLAB amends the definition of ‘controlling relationship’. The section will now require the person to directly or indirectly hold at least 50% of the equity shares in a company or control at least 50% of the voting rights in the company in order to be in a controlling relationship. This is a significant increase in threshold from the existing provisions which treated all connected persons as being in a controlling relationship with the company.

Secondly, the TLAB scraps a problematic provision in section 23M which would have resulted in interest payable to unrelated third parties, which are not subject to tax, being caught by the limitation provisions simply by virtue of the loan being guaranteed by a person that is in a controlling relationship. Interest on loans provided by foreign funders or by exempt institutions in the local capital market and which were secured by other entities within the debtor company’s group would have been subject to the provisions of section 23M. In terms of the revised section 23M, only loans owing to a creditor that is in a controlling relationship with the debtor or is owing to a third party creditor that has obtained the funding from a debt advanced from a person that is in such a controlling relationship are affected by the limitation.  As indicated above, the provisions of section 23M further require that the interest is not subject to tax in the hands of the creditor.

Finally, the TLAB read with the accompanying media release addresses the interaction of section 23M with existing transfer pricing and thin capitalisation provisions set out in section 31 of the ITA as well as with the interest limitation provisions applicable to acquisition and reorganisation transactions contained in section 23N of the ITA. Taxpayers will be required to firstly apply the provisions of section 31 of the ITA to any cross border loans. Where the loan has been used to fund an acquisition and reorganisation transaction, the provision of section 23N must be applied to that portion of the interest which is allowable as a deduction under section 31. Finally, the provisions of section 23M must be applied to determine whether any portion of the interest, not already disallowed under section 23N must be further limited in terms of section 23M.

Whilst the above changes are welcome both in terms of limiting the scope of section 23M as well as in clarifying the interaction with other sections of the ITA, some problems with the section persist. Most notably, the term ‘subject to tax’ remains undefined. Whether the imposition of Interest Withholding Tax (IWT), the introduction of which has been delayed until 1 March 2015 in terms of the TLAB, will result in interest becoming subject to tax may be debated as will be the impact of Double Taxation Agreements which reduce tax rates on interest to zero.