Interest incurred on replacement loans

shares trendsThis private ruling from SARS deals with interest incurred on replacement loans and addresses whether such loans retain their initial business purpose for purposes of determining whether the interest incurred on the loans qualifies for a deduction under section 24J(2).

The background

The applicant, a public company resident in South Africa, has a number of subsidiaries within its group of companies. Certain of these group companies had surplus funds which they extended as interest-free loans to other group companies which had a need for those funds (debtor companies). Four such groups existed. Three of the group loans were used by the debtor companies for the purpose of financing working capital, various building projects or for the purchase of capital equipment to be used in the business of the group. The fourth loan was intended to be used by one of the debtor companies for future capital expenditure – the capital expenditure could, however, only be incurred once this debtor company was granted an operating license for which it had applied. Until then the loan was deposited into a fixed interest-earning account.

The transactions

In order to facilitate the repurchase by the applicant of certain of its shares from one of its shareholders, it is proposed that the debtor companies refinance the four existing interest-free intra-group loans through interest-bearing bank loans, in other words, the existing interest-free intra-group loans will be replaced with interest-bearing bank loans. The cash obtained from the replacement loans will be used by the debtor companies to repay the intra-group loans.

The various group entities will then distribute their refinanced cash and any excess cash to the applicant as a dividend. The applicant will use these cash resources to effect the share repurchase.

The ruling

Three of the interest-free intra-group loans were used for business purposes, i.e. they were applied to finance working capital, building projects and to purchase capital equipment to be used in the business. Accordingly, if interest had been payable on these loans such interest would have been incurred in the production of income and would have been deductible in accordance with section 24J(2). When these three loans are substituted for interest-bearing bank loans, they will retain their purpose, namely, to finance working capital, building projects and the purchase of capital equipment. The purpose will not change upon loan substitution and the interest incurred on the replacement loans will qualify for deduction under section 24J(2). This ruling, although not generally binding, is a very welcome indication of SARS’ view on replacement loans.

Interest incurred on the loan used to replace the fourth intra-group loan will, in terms of the ruling, not be deductible. The reason for this is not entirely clear from the information presented in the ruling. However, assuming the debtor company uses the funds in the fixed deposit to repay the group loan and uses the proceeds of the replacement loan to fund a dividend declaration, then the purpose of the replacement loans is the financing of a dividend which is not in the production of income.