Author: Gerdus van Zyl (Tax Manager at ENSAfrica)
The conundrum of the interplay between interest deduction limitations, interest withholding tax and double tax agreements
The deductibility of interest has for years been a contentious issue and this has been reaffirmed with the introduction of section 23M into the Income Tax Act No 58 of 1962 (the “Act”) with effect from 1 January 2015. A further addition to the interest sphere of income tax is the introduction of interest withholding tax provisions in sections 50A to 50H, which came into effect on 1 March 2015.
Shorn from its technicalities, the purpose of section 23M is to limit the deduction allowed to a resident in respect of any interest paid on debt owed to persons which are not subject to tax in South Africa, and such persons are in a controlling relationship (i.e. direct or indirect shareholdings of 50% or more). Section 23M provides for a formula which should be adopted in determining which portion of the interest incurred on such debt, if any, will be allowed as a deduction. Interest withholding tax, on the other hand, is also levied (at a rate of 15%) on interest paid by any person to a non-resident to the extent that such interest is regarded as being from a South African source.
Section 23M applies to the person paying the interest (i.e. the debtor) whilst interest withholding tax is levied on the person receiving the interest (i.e. the creditor).
One of the many questions which arises is how the introduction of the above two sections would impact the quantity of foreign debt being injected into the South African market which is already under strain as a result of various instabilities from an economic and political perspective.
Although both section 23M and the interest withholding tax section provide for certain exemptions, the sections are not mutually exclusive and it begs the question whether this was an unintentional omission by National Treasury, or whether it was specifically intended that both sections would apply in all instances.
From a technical perspective, section 23M(2) provides that the interest deduction will be limited where the amount of interest incurred is not subject to tax in the hands of the person to which the interest accrues. On the basis that interest withholding tax is levied, the interest which accrues to the non-resident would be subject to tax and the provisions of section 23M should not apply.
The above potentially sheds some light on the uncertainty regarding the interplay between these two sections, although it does not specifically solve the conundrum of adding a favourable double tax agreement (“DTA”) into the mix of an already technical interpretation. Most favourable DTA’s either reduce the withholding tax on interest or, in some instances, even grants the sole taxing right to the other jurisdiction and not to South Africa (i.e. the interest will not suffer any tax in South Africa). Although this puts the non-resident in a favourable position to the extent that this results in the non-resident not being subject to tax on the interest accrued the resident paying the interest would be subject to a limitation on interest incurred and payable to the non-resident. In these circumstances it is then necessary to analyse whether the provisions of section 23M would apply. Section 23M is intended to protect the tax base against base erosion. This is in line with the objectives of the BEPS (i.e. Base Erosion and Profit Shifting) action plan driven by the OECD. It would however, appear as if SARS’ main concern in is not the deduction but to safeguard the tax base from excessive interest deductions in a group context. The concept of excessive expenditure is a separate analysis in itself which has been considered in some instances by our courts.
The prevailing question is however what the impact would be where the interest deductions are not excessive and whether the application of the provisions of section 23M may be mitigated through the application of a DTA in terms of which South Africa has no taxing right