SARS is making a big tax deduction change
Here is everything you need to know about the withdrawal of Practice Note 31.
The South African Revenue Service (SARS) is preparing the withdrawal of Practice Note 31, which came into effect in October 1994.
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Although this plan was first announced in November 2022, it will only be carried out on 1 January 2025.
According to BusinessTech, Practice Note 31 relates to interest paid on money borrowed and ultimately provides a concession to taxpayers who accumulate interest income by allowing the deduction of tax on costs acquired in producing that interest income.
From a private equity (PE) perspective, in a typical PE acquisition, the fund would set up a special purpose vehicle (SPV) that would acquire shares in a portfolio company alongside management and potentially other investors. Should the portfolio company require debt funding, the fund would lend the money to the SPV, which would on-lend the funds to the portfolio company on the same terms.
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These kinds of arrangements also occur where partners, directors or executives in incorporated accounting, engineering, and law partnerships provide financing to business operations.
The latter arrangements take the form of back-to-back financing provided by a financial institution to the said partner, director or executive, which is then advanced to the incorporated partnership to fund its working capital.
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These partners, directors, and executives are dependant on Practice Note 31 to claim.
Why is Practice Note 31 being withdrawn?
This deduction is open to abuse in an attempt to clamp down on tax abuse transactions.
The National Treasury has proposed a new section, Section 11G, be added to the Income Tax Act through the 2023 Draft Taxation Amendment Bill.
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Here is the exact wording for Practice Note 31:
1. To qualify as a deduction in terms of section 11(a) of the Income Tax Act (the Act), expenditure must be incurred in the carrying on of any “trade” as defined in section 1 of the Act.
In determining whether a person is carrying on a trade, the Commissioner must have regard to, inter alia, the intention of the person. Should a person, therefore, borrow money at a certain rate of interest with the specific purpose of making a profit by lending it out at a higher rate of interest, it may well be that the person has entered into a “venture” and is thus carrying on a trade (50 SATC 40 ).
In other words, interest paid on funds borrowed for purposes of lending them out at a higher rate of interest will, in terms of section 11(a) of the Act, constitute an admissible deduction from the interest so received by virtue of the fact that this activity constitutes a profit making venture.
2. While it is evident that a person (not being a moneylender) earning interest on capital or surplus funds invested does not carry on a trade and that any expenditure incurred in the production of such interest cannot be allowed as a deduction, it is nevertheless the practice of Inland Revenue to allow expenditure incurred in the production of the interest to the extent that it does not exceed such income.
This practice will also be applied in cases where funds are borrowed at a certain rate of interest and invested at a lower rate. Although, strictly in terms of the law, there is no justification for the deduction, this practice has developed over the years and will be followed by Inland Revenue.
And this is the new section, 11G:
- (1) For purposes of this section, ‘interest’ means interest as defined in section 24J.
- (2) For purposes of determining the taxable income derived by any person, there shall be allowed as a deduction from the income of that person, interest incurred by that person to the extent that the interest —
- (a) is incurred in the production of interest that is included in the income of that person; and
- (b) is not incurred in carrying on a trade.
- (3) The amount allowed to be deducted under this section shall not exceed the amount of interest income referred to in subsection (2)(a), that is received by or accrued to the person, during the year of assessment.’’.
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