In order to understand the new rules it is useful to recap on the legislative journey so far. In June 2011 legislation was introduced to address the growing concern regarding the adverse effect that highly geared leveraged buy-out transactions were having on the South African tax base. The legislation regulated the deduction of interest on debt used to acquire assets under certain types of acquisition transactions. These acquisition transactions involved two distinct phases – the first being the acquisition of the shares in a target company, and the second phase the transfer of the assets from the target company to an acquiring company within the same group in a tax neutral manner, utilising the tax rollover relief in either section 45 or section 47 of the Income Tax Act. Legislation introduced in 2011, contained in section 23K of the Income Tax Act, required the acquiring company that borrowed funds for the acquisition of assets, to apply to the South African Revenue Service (SARS) for a directive as to the amount of interest which could be deducted. Refinancing of the debt also required section 23K SARS approval.
With effect from 1 January 2013, provisions were introduced to allow taxpayers to claim an interest deduction in relation to debt used to acquire equity shares in a target company, provided a minimum of 70% of the shares in the target company were acquired. Due to this change, it was no longer necessary to follow the two phased approach for attaining an interest deduction. However, the quantum of the interest which could be claimed under these transactions was made subject to the section 23K SARS approval process.
The discretionary approval system introduced by section 23K was always intended as a transitional measure that will ultimately be replaced with a permanent solution. While a discretionary system creates uncertainty and the inclusion of the approval as a condition precedent in reorganisation transactions gave rise to unnecessary delays, the permanent solution proposed under section 23N and section 23O may leave taxpayers in a worse off position.
The new section 23O proposes to disallow an acquiring company in any of the above transactions, a deduction of the interest, where the acquiring company and the selling entity are in a so-called ‘controlling relationship’. The aim is to prevent a shift of assets within the same group of companies, to raise debt and justify a deduction of the interest in respect of the debt, The proposed legislation, which will apply in respect of transactions entered into or after 1 July 2013, will take into account any ‘controlling relationship’ within a 36 month period prior to the raising debt which endured for at least 18 months.
In terms of section 23N of the draft bill, interest on any reorganisation transaction or acquisition transaction entered into or after 1 July 2013 will be limited for a period of five years from the year of assessment in which the transaction was concluded. The interest on the loans will generally be limited to 40% of the ‘adjusted taxable income’ of the acquiring company for the year of assessment, during which the transaction was concluded or the year of assessment in which the interest is being claimed, whichever is the greater. ‘Adjusted taxable income’ is defined as taxable income adjusted for any interest received or accrued and interest incurred, any net income from a controlled foreign company, any allowances claimed in respect of capital assets and 75% of gross income for the letting of immovable property. The provisions provide for an upward adjustment of the 40% limit in circumstances where the repo rate is above 10%. Any interest not claimed during this initial five year period cannot be claimed as a deduction in later years.
Section 23N also regulates the deduction of interest on debt applied to refinance the acquisition debt relating to any of the above transactions. Therefore the limitation imposed by section 23N will only apply to the first five years after a particular transaction – any refinancing of the debt thereafter would trigger a new limitation period.
Finally, section 23N will also apply to the refinancing of section 23K approved transactions (i.e. transactions entered into during the transitional period).
Leveraged buy-out transactions entered into before the introduction of section 23K will continue to fall outside the interest limitation provisions, a position which some may see as unfair.