Section 23M is set to become effective from 1 January 2015. Its intention is to limit the deduction of interest where such interest is paid to a connected person, which is not subject to tax in South Africa on the interest received. In the majority of cases, non-residents are not subject to normal tax in South Africa on interest received from a South African source due to the exemption provided in section 10(1)(h) of the Act. However, the withholding tax on interest paid to non-residents is to become effective from 1 January 2015. The intention would appear to be that if the interest received is not taxed in South Africa at all i.e. neither subject to normal tax in South Africa nor the withholding tax on interest (for example because a double taxation agreement reduces the withholding rate to zero per cent), then the section 23M limitation needs to be considered. However, section 23M is not limited to situations in which non-residents are the lenders. It could also apply to, for example, loans by retirement funds or by other associations which may be exempt from tax such as public benefit organisations.
There are two specific carve-outs from the application of section 23M, which are:
- Debt funded out of funding granted by an unconnected lending institution; and
- Interest in respect of linked units held by a long-term insurer, a provident fund or a pension fund in certain circumstances.
The limitation in section 23M is calculated based on 40 per cent of the debtor’s ‘adjusted taxable income’ which is taxable income before:
- Interest received or paid;
- Section 9D income; and
- Recoupments or allowances on capital assets.
To this 40 per cent of adjusted taxable income figure is added interest received and is subtracted interest paid on debts not subject to section 23M, in order to arrive at the overall limit.
Numerous objections to the insertion of section 23M have been raised – including that such a limitation would discourage foreign investment. In the case of inbound loans from a foreign connected person, one would think that the transfer pricing rules should be sufficient to protect the fiscus without the need for a further limitation.
In terms of amendments proposed by the Draft Taxation Laws Amendment Bill of 2014, the 40 per cent rate is to be adjusted based on the average repo rate for the year of assessment. More specifically, the rate to be applied will be 40 multiplied by the average repo rate for the year of assessment plus 400 basis points, divided by 10. Therefore where the average repo rate is 6 per cent, the rate will equate to 40. At the time of writing, the current repo rate is 5.75 per cent. This would therefore equate to a rate of 39 per cent in terms of the section 23M formula.
Bad news for taxpayers is that it would appear from a recent presentation by National Treasury that they are considering lowering the 40 per cent figure, possibly to as low as 20 per cent although possibly with the carve out of certain economic sectors. It would appear that research by Treasury into interest to EBITDA ratios among listed companies has revealed that in most sectors, the interest to EBITDA ratio is closer to 20 per cent than 40 per cent.
An objection to this analysis is that listed companies represent relatively mature companies which may be expected to have less debt relative to equity than unlisted companies. Many of the companies hit by the section 23M limitation are unlisted which may be expected to have relatively larger debt to equity ratios.
Good news is it appears that the breadth of section 23M will be somewhat curtailed in that guarantees by a connected person to a creditor which is not subject to tax in South Africa on the interest will no longer trigger the application of the provision. However, back to back arrangements whereby a connected person loans the funding for the debt advanced to the debtor to a creditor, which is not subject to tax in South Africa on the interest, will remain within the scope of the provision.