National Treasury also released a discussion document on the National Treasury website which provides useful insights.
What should the new interest limitation apply to?
It is proposed that the rule will apply to the total (external and connected) net interest expense and equivalent payments. The section 24J definition in the Act is not wide enough to include payments economically equivalent to interest and therefore the rules will apply to a wider concept of interest. It would be very interesting to see what instruments will be regarded as yielding “payments economically equivalent”.
Who will be impacted?
The rule will apply to entities operating in South Africa and forming part of a foreign or South African multinational group. The total net interest expense paid by the entities will be impacted by the rules. Definitions will be introduced for a “Group” and “MNE Group”.
A “Group” will be defined as meaning a collection of enterprises connected through ownership or control such that it is either required to prepare Consolidated Financial Statements for financial reporting purposes under applicable accounting principles or would be so required if equity interests in any of the enterprises were traded on a public securities exchange. The term “MNE Group” will be defined as meaning any Group that includes two or more enterprises the tax residence for which is in different jurisdictions, or includes an enterprise that is resident for tax purposes in one jurisdiction and is subject to tax with respect to the business carried out through a permanent establishment in another jurisdiction.
Calculating earnings and setting the limitation
It is proposed that “earnings” or a tax “EBITDA” will be calculated as the sum of (i) taxable income (ii) net interest expense and (iii) deductions in respect of capital assets (such as depreciation and amortisation).
Various factors were considered in arriving at the interest limitation. The most important considerations were the relatively high interest environment in South Africa and the analysis of taxpayers NIE/EBITDA ratios from 2013 to 2016. If the ratio is set at 30%, roughly 75% of all taxpayers with a positive tax EBITDA will be able to deduct their entire interest expense in the year in which it is incurred.
Smoothing the volatility in earnings
National Treasury realises that earnings fluctuate and will therefore impact on a company’s ability to claim interest deductions. It is therefore proposed that if a taxpayer is not able to fully deduct an interest expense in a year of assessment, the excess amount can be carried forward. The interest charges cannot be carried forward indefinitely and therefore it is proposed that the carry forward is limited to five years on an annual FIFO basis.
De minimis rule
National Treasury realises that it will be overly burdensome and unfair for smaller stand-alone companies to comply with these rules. It is therefore proposed that a de minimis rule is introduced for smaller companies not forming part of multinational groups.
Existing interest limitation rules and transitional measures
The new interest limitation rule will replace section 23M of the Act and transitional measures will be considered for existing third-party loans. It is however proposed that existing targeted rules such as section 23N will remain.
Interaction with other provisions in the Income Tax Act
Transfer pricing rules contained in section 31 of the Act can potentially also limit interest deductions based on an arm’s length test. The interest limitation rule reflects government’s right to protect its tax base from what it deems excessive interest deductions. Therefore, although a financial transaction might have been structured on an arm’s length basis, the transaction can still fall within the ambit of the interest limitation rule on the basis that the NIE/EBITDA ratio is breached. National Treasury proposes that companies firstly apply the arm’s length test to financial transactions followed by the interest limitation rules.
It is certainly a very interesting development and affected taxpayers should participate in the consultation process. The Budget states that the closing date for comments on the discussion document is 17 April 2020.