Tax-deductibility of Interest on Debt Used to Acquire Shares
Tax-deductibility of Interest on Debt Used to Acquire Shares
By: Associate Professor David Warneke, Tax Director
For expenditure (including interest) to be deductible in terms of section 11(a), one of the requirements is that the expenditure must be incurred ‘in the production of [the] income’. The term ‘income’ in this context takes its defined meaning in section 1 of the Income Tax Act i.e. ‘gross income’ less amounts exempt from normal tax. The phrase ‘in the production of [the] income’ has been held to mean that there must be a close connection between the expenditure and the taxpayer’s income-earning operations, having regard both to the purpose of the expenditure and to what it actually effects (CIR v Genn and Co (Pty) Ltd 20 SATC 113). The dual enquiry into the taxpayer’s purpose and to what the expenditure effects thus contains both a subjective test (the taxpayer’s purpose) and an objective test (what the expenditure effects).
Given the wide definition of ‘instrument’ in section 24J, in practice interest is more often deductible in terms of section 24J than section 11(a). However, section 24J(2) contains the same requirement regarding the production of income as section 11(a).
Since shares generally produce dividends which are exempt from normal tax, the well-established position is that interest incurred on borrowings taken out to finance the acquisition of shares that are held to earn dividends is not incurred in the production of income and is therefore not deductible, since the interest is productive of exempt dividends. Even if shares are not specifically acquired to earn dividends, interest incurred to acquire shares which are held as assets of a capital nature is also not deductible for income tax purposes, since no ‘income’ will be produced from the holding and disposal of such shares. On the other hand, if the shares are acquired with a revenue intention i.e. for purposes of resale at a profit, such that the shares constitute the taxpayer’s ‘trading stock’, the interest on debt used to acquire the shares will be deductible.
Because of the non-deductibility of interest in situations in which the target company’s shares will not be held as trading stock, corporate tax advisors often recommend that in a leveraged acquisition, instead of purchasing the shares in a target company, the acquiror should purchase the income-producing assets out of the target company. In such a case, there should be a sufficiently close connection between the interest expense and the income produced by the assets for the interest to be deductible.
However, often one finds that the purchase of assets out of a target company instead of the shares in the target company does not suit the seller, who may face higher taxes in the target company in that case due to the inclusion of trading stock in gross income or recoupments on tax-depreciable assets. This compares unfavourably with capital gains tax that may arise on the disposal of the shares in the target company by the seller, at the lower inclusion rates for capital gains.
Various tax strategies have therefore emerged, which may, in appropriate circumstances, grant the purchaser company a deduction for the interest incurred on the acquisition of shares in a target company. This is particularly the case where the target and purchaser companies will form a ‘group of companies’ for income tax purposes following the purchase transaction (among other requirements, the definition of ‘group of companies’ requires an equity shareholding of 70 percent or more).
For example, the purchaser company may acquire 70 percent or more of the equity shares in the target company by using interest-bearing debt, immediately whereafter the target company is liquidated and, in the process of liquidation, distributes the pro-rata share of its assets to the purchaser. In these circumstances, section 47 of the Income Tax Act may be utilized to ensure rollover relief applies to the target company upon the disposal of its assets in the liquidation distribution. The same provision ensures that the purchaser company assumes the tax cost of the various assets acquired in the hands of the target company. The purchaser’s argument for the deduction of the interest on the borrowing to acquire the shares in the target company is that the purpose and effect of the borrowing was to acquire the underlying productive assets of the target company in the liquidation distribution rather than to acquire and hold the shares in the target per se - indeed, the shares are disposed of in the liquidation process- and that the interest should be deductible because the necessary close connection between the interest expenditure and the purchaser’s income-earning operations exists. A similar strategy may be employed utilizing the intra-group rollover provisions of section 45 of the Income Tax Act to grant the purchasing company a deduction for interest incurred in acquiring 70 percent or more of the equity shares in a target company by using interest-bearing debt.
Around 2011, concerns that the above strategies were leading to abuse arose within National Treasury, which culminated in the introduction of section 23K and later sections 24O and 23N into the Income Tax Act. The concerns initially appeared to centre on interest mismatch cases in which the lender, either a non-resident or a tax-exempt person, would not be taxed on the interest income, while the purchaser (i.e. the borrower) would enjoy a full deduction for the interest incurred by employing the above strategies. Section 23K effectively does not apply to ‘acquisition transactions’ as defined entered into on or after 1 April 2014, whereas section 24O applies to ‘acquisition transactions’ entered into on or after 1 January 2013.
The aim of section 24O is to grant the purchaser company a deduction of interest incurred for the purpose of acquiring equity shares in a target ‘operating company’ (or equity shares in the ‘controlling group company’ in relation to a target ‘operating company’) without the purchaser having to employ section 47 or 45 interest deduction strategies to acquire the underlying assets out of the target company. If it applies, the effect of section 24O is that the interest incurred on qualifying debt is deemed to be in the production of the purchaser company’s income and laid out or expended for purposes of its trade. In practice, one often finds that if the purchaser company is a mere holding company with no income besides dividend income, the deduction afforded by section 24O is effectively useless. Therefore, the choice of purchaser company is an important one in the context of section 24O – the purchaser must have sufficient taxable income for the section 24O deduction to be of use to it. An ‘operating company’ is defined as a company of which at least 80 percent of the aggregate amount received by or that accrued to the company during a year of assessment constitutes income in the hands of that company. The income must be derived from a business carried on continuously by that company and in the course or furtherance of which, goods or services are provided or rendered by that company for consideration.
Section 24O is a complex provision with many requirements. The most important of these are:
In conclusion, many laypersons believe that interest incurred on debt that is used to acquire shares is not deductible under any circumstances. As discussed in this article, this belief is incorrect. However, careful planning is required to ensure compliance with the various complex provisions in terms of which a deduction may be available, including a possible limit on the quantum of the deduction.
For expenditure (including interest) to be deductible in terms of section 11(a), one of the requirements is that the expenditure must be incurred ‘in the production of [the] income’. The term ‘income’ in this context takes its defined meaning in section 1 of the Income Tax Act i.e. ‘gross income’ less amounts exempt from normal tax. The phrase ‘in the production of [the] income’ has been held to mean that there must be a close connection between the expenditure and the taxpayer’s income-earning operations, having regard both to the purpose of the expenditure and to what it actually effects (CIR v Genn and Co (Pty) Ltd 20 SATC 113). The dual enquiry into the taxpayer’s purpose and to what the expenditure effects thus contains both a subjective test (the taxpayer’s purpose) and an objective test (what the expenditure effects).
Given the wide definition of ‘instrument’ in section 24J, in practice interest is more often deductible in terms of section 24J than section 11(a). However, section 24J(2) contains the same requirement regarding the production of income as section 11(a).
Since shares generally produce dividends which are exempt from normal tax, the well-established position is that interest incurred on borrowings taken out to finance the acquisition of shares that are held to earn dividends is not incurred in the production of income and is therefore not deductible, since the interest is productive of exempt dividends. Even if shares are not specifically acquired to earn dividends, interest incurred to acquire shares which are held as assets of a capital nature is also not deductible for income tax purposes, since no ‘income’ will be produced from the holding and disposal of such shares. On the other hand, if the shares are acquired with a revenue intention i.e. for purposes of resale at a profit, such that the shares constitute the taxpayer’s ‘trading stock’, the interest on debt used to acquire the shares will be deductible.
Because of the non-deductibility of interest in situations in which the target company’s shares will not be held as trading stock, corporate tax advisors often recommend that in a leveraged acquisition, instead of purchasing the shares in a target company, the acquiror should purchase the income-producing assets out of the target company. In such a case, there should be a sufficiently close connection between the interest expense and the income produced by the assets for the interest to be deductible.
However, often one finds that the purchase of assets out of a target company instead of the shares in the target company does not suit the seller, who may face higher taxes in the target company in that case due to the inclusion of trading stock in gross income or recoupments on tax-depreciable assets. This compares unfavourably with capital gains tax that may arise on the disposal of the shares in the target company by the seller, at the lower inclusion rates for capital gains.
Various tax strategies have therefore emerged, which may, in appropriate circumstances, grant the purchaser company a deduction for the interest incurred on the acquisition of shares in a target company. This is particularly the case where the target and purchaser companies will form a ‘group of companies’ for income tax purposes following the purchase transaction (among other requirements, the definition of ‘group of companies’ requires an equity shareholding of 70 percent or more).
For example, the purchaser company may acquire 70 percent or more of the equity shares in the target company by using interest-bearing debt, immediately whereafter the target company is liquidated and, in the process of liquidation, distributes the pro-rata share of its assets to the purchaser. In these circumstances, section 47 of the Income Tax Act may be utilized to ensure rollover relief applies to the target company upon the disposal of its assets in the liquidation distribution. The same provision ensures that the purchaser company assumes the tax cost of the various assets acquired in the hands of the target company. The purchaser’s argument for the deduction of the interest on the borrowing to acquire the shares in the target company is that the purpose and effect of the borrowing was to acquire the underlying productive assets of the target company in the liquidation distribution rather than to acquire and hold the shares in the target per se - indeed, the shares are disposed of in the liquidation process- and that the interest should be deductible because the necessary close connection between the interest expenditure and the purchaser’s income-earning operations exists. A similar strategy may be employed utilizing the intra-group rollover provisions of section 45 of the Income Tax Act to grant the purchasing company a deduction for interest incurred in acquiring 70 percent or more of the equity shares in a target company by using interest-bearing debt.
Around 2011, concerns that the above strategies were leading to abuse arose within National Treasury, which culminated in the introduction of section 23K and later sections 24O and 23N into the Income Tax Act. The concerns initially appeared to centre on interest mismatch cases in which the lender, either a non-resident or a tax-exempt person, would not be taxed on the interest income, while the purchaser (i.e. the borrower) would enjoy a full deduction for the interest incurred by employing the above strategies. Section 23K effectively does not apply to ‘acquisition transactions’ as defined entered into on or after 1 April 2014, whereas section 24O applies to ‘acquisition transactions’ entered into on or after 1 January 2013.
The aim of section 24O is to grant the purchaser company a deduction of interest incurred for the purpose of acquiring equity shares in a target ‘operating company’ (or equity shares in the ‘controlling group company’ in relation to a target ‘operating company’) without the purchaser having to employ section 47 or 45 interest deduction strategies to acquire the underlying assets out of the target company. If it applies, the effect of section 24O is that the interest incurred on qualifying debt is deemed to be in the production of the purchaser company’s income and laid out or expended for purposes of its trade. In practice, one often finds that if the purchaser company is a mere holding company with no income besides dividend income, the deduction afforded by section 24O is effectively useless. Therefore, the choice of purchaser company is an important one in the context of section 24O – the purchaser must have sufficient taxable income for the section 24O deduction to be of use to it. An ‘operating company’ is defined as a company of which at least 80 percent of the aggregate amount received by or that accrued to the company during a year of assessment constitutes income in the hands of that company. The income must be derived from a business carried on continuously by that company and in the course or furtherance of which, goods or services are provided or rendered by that company for consideration.
Section 24O is a complex provision with many requirements. The most important of these are:
- The target company must be an ‘operating company’ or the controlling group company in relation to an ‘operating company’ on the date of the acquisition of the equity shares by the purchaser;
- At the end of the date of the acquisition of the equity shares, the purchaser company, the ‘operating company’ and, if applicable, the ‘controlling group company’ in relation to the ‘operating company’, must form part of a South African ‘group of companies’;
- The shares must have been acquired from a person that was not part of the same ‘group of companies’ as the purchaser company;
- A re-determination of whether or not the target company is still an ‘operating company’ is required by the purchaser company on an annual basis; and
- Where the shares in a ‘controlling group company’ in relation to an ‘operating company’ are acquired, the purchaser is required (also on an annual basis) to determine to what extent the value of the shares in the ‘controlling group company’ relates to the value of the equity shares held by the ‘controlling group company’ in an ‘operating company’ (or ‘operating companies’). If the value of the shares in the ‘controlling group company’ are derived to the extent of less than 90 percent from the value of the equity shares held in the ‘operating company’ (or ‘operating companies), then only a pro-rata portion of the interest incurred will be allowed as a deduction.
In conclusion, many laypersons believe that interest incurred on debt that is used to acquire shares is not deductible under any circumstances. As discussed in this article, this belief is incorrect. However, careful planning is required to ensure compliance with the various complex provisions in terms of which a deduction may be available, including a possible limit on the quantum of the deduction.