As part of National Treasury’s efforts to prevent perceived excessive interest deductions and tax mismatches, and in order to protect the country’s tax base against base erosion, section 23M of the Income Tax Act, No 58 of 1962 (“ITA”) was introduced in 2013. The section will become effective on 1 January 2015 (conceivably to allow taxpayers to restructure their current debt arrangements) and will apply to interest incurred on or after the effective date.

Section 23M of the ITA will, in brief terms, limit a South African debtor’s ability to deduct interest incurred (i) on debt owing to a creditor that is in a ‘controlling relationship’ with that debtor, or (ii) on debt funding obtained by a non-related creditor from a person in a controlling relationship with the debtor, or (iii) on debt guaranteed by a person who is in a controlling relationship with the debtor.

A ‘controlling relationship’ exists where one of the parties is a company and the parties are regarded as ‘connected persons’ for tax purposes. Of importance to this article is the further requirement of section 23M of the Act that the interest, being subject to the limitation, must not be subject to tax in the hands of these creditors.

The interest deduction allowed in terms of section 23M, and in terms of the latest proposals contained in the recently released 2014 draft Taxation Laws Amendment Bill, is calculated, essentially, as (i) interest received, plus (ii) an amount calculated with reference to a formula, broadly speaking about 40% of EBITDA, minus (ii) taxable interest incurred in respect of other parties.

As stated, the subject for discussion in this article is the requirement that the interest must not be subject to tax in the hands of the person to whom that interest accrues. Section 23M is rather unclear in that although the subsection (2)(aa) refers to the interest not being subject to tax, its heading states that the person to whom it accrues must not be ‘subject to tax’ on the interest earned from the debtor seeking the tax deduction under Chapter II of the ITA; which chapter essentially contains the ITA’s taxing sections. This requirement becomes particularly interesting where the creditor is a foreign resident.

At first blush it would appear easy to determine whether a foreign creditor, or the interest paid, is subject to South African tax, but it becomes more challenging considering the impact of the interest withholding tax (“IWT”) which will also become effective on 1 January 2015. IWT will subject interest paid to non-resident creditors (which for this withholding tax need not be connected to the local debtor) to a 15% withholding – provided one of the stated exemptions does not apply, or an applicable double tax agreement (“DTA”) doesn’t determine a lower (including zero) rate.

Where a DTA applies, and it determines that the IWT rate may be reduced to, for example 10% (such as the South African DTA with Japan), the non-resident creditor and interest would still be subject to tax. But the question is whether the same reasoning will apply where a DTA reduces the rate to 0%, or simply allocates exclusive taxing rights to the jurisdiction of tax residence, such as those with other major foreign investing jurisdictions which include the United States and the United Kingdom. Does this mean that the creditor/interest is still ‘subject to tax’, but at a rate of 0%, or is it exempt from tax – or merely not taxable at all?

The term ‘subject to tax’ is not defined in the ITA, nor has a South African court had the opportunity to consider its meaning. It does however, feature in some of South Africa’s DTAs, and as a result the interpretation accorded to it in an international tax sense may shed the light required to apply section 23M.

Klaus Vogel, in “Double Taxation Conventions” approached the meaning of the phrase ‘subject to tax’ in the following way:

“According to these provisions, the only requirement is that the taxpayer and the type of income concerned must be generally subject to tax and not that a liability to pay tax must have arisen in each case. Exemption or relief must, therefore, be granted in such cases even if, say on account of losses, no tax becomes payable.”

The UK’s HMRC has, in a treaty context, stated that “…the expression ‘subject to tax’ usually means that the person must actually pay tax on the income in their country of residence….A person is not regarded as ‘subject to tax’ if the income in question is exempted from tax because the law of the other country provides for statutory exemption from tax.” In a 2012 tax case, the HMRC also successfully argued before the UK’s first tier tribunal that “subject to tax” means that an individual must be within the charge to a state’s tax; that is to say the income in question must be included in the computation of the individual’s taxable income with the result that tax will ordinarily be payable in respect of that income, subject to any deductions for allowances and reliefs, etc. In essence, it was argued that ‘liable to’ means the state has the right to tax income, whilst ‘subject to’ means the state actually exercises that right.

There is clearly some debate internationally as to the application of these two terms in a tax treaty context, but we would argue that the inference that can be drawn from the statements (and others like it issued in a DTA context) is that the treaty parties want to prevent instances of international double non-taxation, such as where the person is exempt from tax in the state of residence under domestic law, and also exempt under a DTA in the source state. This is also clear from the US DTA referred to above which requires the interest to be taxable in the state of residence of the recipient.

Therefore a DTA must find application where there is, firstly, tax in the source state, and similarly, tax in the residence state. Whether tax will actually become due after allocation in terms of a treaty is not required.

In a local context, it is submitted that the DTAs to which South Africa is a party effectively form part of the ITA as a result of section 108 of the ITA incorporating such agreements and in fact override the provisions of the ITA. However, DTAs cannot impose tax; they merely allocate, in basic terms, taxing rights. Thus a DTA, it is argued, does not form part of the taxes chapter referred to in the heading of section 23M of the ITA.

Reverting to an example where, say, the US will have sole taxing rights in respect of interest paid to its residents from a South African source, it is arguable that –

• a non-resident creditor must firstly have a potential South African tax liability before it can look to the DTA;
• that potential tax liability may, as from 1 January 2015, be IWT, which tax is contained in Chapter II of the ITA;
• the creditor must also be taxable on such interest in the US; and
• if the above requirements are met, South Africa will forego its taxing rights in favour of the US.

Section 23M of the ITA does not state the creditor must actually pay tax on the interest, but merely that it must be ‘subject to tax’ in South Africa, which in the US DTA example above, is clearly the case. If no tax is consequently paid or payable in South Africa, this does not change the fact that initially an amount was subjected to tax (the IWT here), and therefore, arguably, section 23M of the ITA cannot apply to limit the interest deduction.

Although this view is to be supported, the matter is unfortunately not free from doubt as evidently there is a counter-argument that, having applied the formulation above, and there is no IWT to pay here, the creditor is not subject to tax. As a result, this could well be a case where it advisable for a local company to seek a binding ruling on the manner in which section 23M is to be applied. Absent that, and pending a test case (which could be years away), the more conservative view would be to treat the interest as not being subject to tax.

Written by Leon Rood, director, Werksmans Attorneys