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South Africa Consults On Limits To Interest Tax Deductions

by Lorys Charalambous, Tax-News.com, Cyprus

02 May 2013


The National Treasury has started a first round of public consultation on the South African Government's proposed rules to limit excessive interest deductions in schemes that could lead to tax base erosion.

The Treasury noted that "one of the most significant types of base erosion in South Africa comes in the form of excessive deductions by some corporates with income effectively shifted to a no-tax or low-tax jurisdiction or converted to a different type of income in another jurisdiction. These deductions are typically channeled as interest, royalties, service fees and insurance premiums. Of greatest concern is excessive deductible interest."

In terms of excessive deductible interest, the Government has identified four recurring concerns, leading to a four-part proposal that is being considered for inclusion in the forthcoming draft of the Taxation Laws Amendment Bill, 2013, expected to be released for public comment (and parliamentary hearings) in June 2013. Comments should therefore be sent by May 24, 2013.

Firstly, while the present South African tax code does contain certain anti-avoidance rules that seek to curb the use of hybrid debt instruments – essentially, instruments with the label of debt but with substantive features being more indicative of shares, which are currently labeled as debt in South Africa so that payments are deductible, and as equity in another jurisdiction and thereby benefit from cross-border arbitrage – they are considered to contain various weaknesses.

Revised rules would mainly target non-redeemable debt, debt that is convertible to shares at the instance of the company issuer, debt with yields not interest-related, and debt with repayment terms or yields conditional on the solvency of the company issuer. In terms of impact, the rules simply deem interest to be dividends for both the issuer and holder.

Under the revised exceptions, exemptions will exist for regulatory hybrid debt (for example, Tier II debt) of banks, subordinated hybrid debt of long-term and short-term insurers, and private and unlimited liability debtor companies owing sums to resident individuals.

Secondly, with regard to connected person debt, and particularly debt owed to untaxed entities within the same corporate group, even if an instrument has no equity features, excessive debt between the entities is a concern to the tax authority.

In order to reduce this concern, the aggregate deductions for interest associated with debt between certain entities of the same group will be limited regardless of the terms associated with that debt. More specifically, if a company pays interest to another entity within the same group and the interest is untaxed (or taxed at a lower rate) when received or accrued by the other entity, the interest will be subject to a limitation. The interest limitation will similarly apply if the untaxed group entity guarantees or provides other security in respect of debt owed by the company debtor.

In either of these circumstances, the deduction for interest paid or incurred in respect of the debt will be limited to 40% of the debtor's taxable income. To the extent that interest paid or incurred on debt between group entities exceeds the limitation, the excess can be carried forward for up to five years (remaining subject to the limitation).

Thirdly, in a cross-border context, it has been seen that excessive interest can arise if the interest yield is driven by tax considerations as opposed to arm's length commercial reasons, especially if the debtor and creditor are connected persons, and excessive debt if the "lending" would not have arisen in a commercial context.

While, previously, such excessive interest or debt could have been eliminated by transfer pricing adjustments, the general restrictions on debt as are now being proposed will reduce the need for transfer pricing action and a safe harbor is being considered to add to the transfer pricing rules.

In order to fall within this potential safe harbor, interest on connected person cross-border debt must not exceed 30% of taxable income (with no adjustment for other interest received, accrued, interest paid or incurred); and the interest rate must depend on the currency denomination of the loan.

Finally, under current law, acquisition debt is subject to discretionary limitations as determined by the South African Revenue Service (SARS). These limitations are designed to target potential base erosion caused by excessive debt (where the interest eliminates taxable profits for years to come) and hybrid debt (particularly mezzanine and subordinated debt, containing an escalating number of equity features).

However, it is pointed out that this discretionary system was never intended to be permanent. Taxpayers seeking debt-financing when attempting to acquire control of companies cannot be expected to obtain pre-approval from SARS in the long-run; deal-making of this nature needs clear guidelines when seeking finance before core negotiations can be undertaken.

In view of these concerns, the discretionary system will be terminated in favor of a more concrete set of rules. Under the new system, debt used for the acquisition of the assets of target companies will be subject to a fixed overall limitation roughly comparable to the 40% untaxed group entity limitation.

A comprehensive report in our Intelligence Report series describing how to get an optimal blend of tax-efficiency and profits from global manufacturing operations through judicious use of offshore and onshore techniques, and showing how the corporate supply chain is full of opportunities to save tax while optimising efficiency, is available in the Lowtax Library at http://www.lowtaxlibrary.com/asp/subs_reports.asp and a description of the report can be seen at http://www.lowtaxlibrary.com/asp/description_report8.asp
TAGS: individuals | South Africa | compliance | tax | business | tax compliance | revenue guidance | law | corporation tax | tax authority | multinationals | legislation | transfer pricing | dividends | legislation amendments | Africa

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