The repeal of Practice Note 31 and the impact on the deductibility of interest

Practice Note 31 (PN31), released on 3 October 1994, survived almost 30 years in circumstances where both SARS and taxpayers attacked its validity over time. Ironically, when a taxpayer has relied on the validity of PN31, SARS has queried the legal justification thereof, and vice versa.

28 Feb 2023 6 min read Special Edition Budget Speech Alert Article

At a glance

  • Practice Note 31 (PN31) has been a subject of controversy between SARS and taxpayers for nearly 30 years, with both questioning its validity.
  • The Constitutional Court has ruled that interpretation notes and practice notes only bind SARS, not taxpayers, and should not influence the interpretation of statutory provisions.
  • The withdrawal of PN31 will be delayed until new legislation is effective, providing some relief to taxpayers and allowing for potential changes to accommodate legitimate transactions.

It is still not clear why taxpayers wanted to attack the validity of PN31 as it only benefits a taxpayer. In any event, since the judgment of the Constitutional Court in Marshall v CSARS 80 SATC 400 it is clear that interpretation notes (and for that matter practice notes) would only bind SARS and not necessarily taxpayers. In that case, the Constitutional Court held that a unilateral practice of one part of the executive arm of Government should not play a role in the determination of the reasonable meaning to be given to a statutory provision. As such, the relevant provisions should be interpreted independently of the interpretation note / practice note.

Some reprieve has been given to taxpayers on the basis that the repealing of PN31 will be postponed such that one could consider whether changes can be made in the tax legislation to accommodate legitimate transactions. Accordingly, the withdrawal of PN31 will be delayed until new legislation has become effective. 

PN31 only consists of two short paragraphs. The first paragraph indicates that one can only claim a deduction of expenditure in terms of section 11(a) of the ITA if they are carrying on a trade. Should one therefore borrow money at a certain rate of interest (say 5%) with the specific purpose of making a profit by lending it out at a higher rate of interest (say 6%), PN31 indicates that “it may well be” that a person has entered into a venture and is thus carrying on a trade.

Firstly, it is clear that a person will in those circumstances have entered into a venture and thus be carrying on a trade. In ITC 1429 50 SATC 40 this type of scenario was specifically considered by the Tax Court and it was confirmed that the taxpayer incurred the interest in these circumstances for purposes of trade. A once-off borrowing of funds and the on-lending thereof at a profit would thus constitute a trade resulting in the deduction of interest.

The importance of PN31 to taxpayers is found in the second paragraph. It indicates:

“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”.

The first issue for consideration in this statement is that there seems to be a confusion between the test whether an expense is on capital account and whether an expense has been incurred for purposes of trade. The test of whether one is a moneylender is used to determine whether an expense or loss has been incurred on capital account or on revenue account. This element plays a role in determining whether one can claim a loss should the borrower fail to repay the capital amount, but not whether the interest is deductible. Whether one is a moneylender does not play a role to determine whether an expense has been incurred for purposes of trade. A trade is defined very widely in section 1 of the ITA to include a once-off venture. The issue, however, is whether one is conducting a trade to the extent that no profit is derived from the venture (for instance borrowing at 6% and on-lending at 5%). To the extent that one therefore enters into a venture without the expectation to make a profit and there are no other reasons why the ostensible loss is derived (for instance to support an existing business), there is no reason to allow the deduction of the interest in these circumstances. Nevertheless, SARS did allow the deduction of interest to the extent that it did not exceed the income.

However, a wider interpretation evolved over time as to the meaning of this paragraph. For instance, if one received R100 of interest and incurred R90 of interest on a different transaction, the argument was that one should still be entitled to claim a deduction of the R90 even though there is no ostensible link between the earning of the interest and the incurring of the interest. For instance, to the extent that interest has been incurred in order to derive exempt income (for instance dividends), the argument was that one should still be entitled to claim a deduction to the extent that interest has been received on a different unrelated transaction or investment. In such an instance the question is not whether one is a moneylender or not, but what the purpose of the relevant expenditure may be and what it affects. That is the first hurdle to determine whether the expenditure has been incurred in the production of income of the taxpayer. Only thereafter does one need to consider whether the expenditure has also been incurred for purposes of trade.

The requirement that income should be received by a taxpayer and that there should be an expectation to derive a profit has become quite relevant in the context of a holding company advancing funds to subsidiaries. The argument has been made by taxpayers that the loans to the subsidiaries would be part and parcel of the investment made into the subsidiary and that interest should therefore be deductible whether or not the loans to the subsidiaries are made on a profitmaking basis. This clearly becomes a problem to the extent that one cannot show a direct link between any borrowing by the holding company and the lending of funds to the subsidiaries.

One should not confuse the purpose of making a profit with a scenario where one conducts treasury operations. In the case where one conducts treasury operations, the general purpose of the treasury company would be to borrow monies and to on-lend to group companies. Even to the extent that one or two loans to group companies may not be at a profit (taking into account the average borrowing rate of the treasury company), the interest incurred by the treasury company may still be deductible to the extent that the treasury company overall derives a profit. This follows from the principle that one can borrow money generally in order to on-lend at a profit without necessarily being required to link the relevant transactions. However, in these circumstances one would then need to show that one is in fact conducting treasury operations and that one is effectively acting as a moneylender (such that the transactions are all on revenue account on the part of the moneylender). The risk for a treasury company is that it enters into transactions for the benefit of the group, as opposed to itself. In the well-known Solaglass case it was held that the taxpayer was a moneylender, but that the expenditure was incurred for the benefit of the group as opposed to considering the position of the treasury company itself. Given the fact that South Africa has not adopted a group taxation basis, each transaction needs to be considered from the taxpayer’s perspective, irrespective of whether it is also intended to benefit the group.

The withdrawal of PN31 may also impact upon a scenario where a taxpayer does generate cash form its business operations and does not use that within the business, but generally borrows money in order to fund its trading stock. Generally, taxpayers in these circumstances would take most of the cash that is generated by the business activities in order to settle an investment in, say, shares that derives exempt income investment which would otherwise be unproductive. The argument for taxpayers is that, for as long as the taxpayer borrows money in order to acquire trading stock, the interest should be deductible even though the cash that is generated from the trading activity is not used to bulk up the trading stock, but to fund a different transaction. One should be careful that, in those circumstance, the purpose of the borrowing is not ultimately found to be for the non-productive purpose (to derive dividends) in circumstances where the funds so generated are all used to pay for the non-productive asset and where one has to borrow money each time to acquire trading stock.

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