Section 23M of the Income Tax Act, which came into operation on 1 January 2015, was enacted to limit the “tax leakage” which occurs when a person who is resident in South Africa obtains funding by way of interest bearing debt provided by a foreign person (or exempt person) who is in a controlling relationship with the debtor or who is on-lending funding from a person who is in a controlling relationship with the debtor (i.e. a back-to-back arrangement). Section 23M targets debt where an interest deduction is available to the South African person and no South African tax is payable on the interest income in the hands of the foreign (or exempt) person. Section 23M minimises tax leakage by limiting the deduction of the interest by the resident person.
Section 23M will only be applicable where firstly there is a ‘controlling relationship’ present. We do not elaborate on this requirement. The second element of section 23M requires that the amount of interest incurred by the debtor during the year assessment must “not be subject to tax” levied in terms of the South African Income Tax Act in the hands of the creditor during that year of assessment.
A taxpayer would in our view be regarded as being subject to tax where either normal tax or interest withholding tax (IWT) is levied on the interest. In the case of non-residents, the taxation will largely take the form of IWT as interest payable to non-residents is generally exempt from normal tax.
Where the provisions of a tax treaty reduce the rate at which IWT can be levied but does not entirely remove South Africa’s taxing rights in this regard, we are of the view that interest would still be subject to tax for purposes of section 23M. It is unlikely, however, that a taxpayer would be subject to tax where the provisions of a treaty completely suspend South Africa’s taxing rights and effectively reduce the IWT rate to nil.
Importantly, the interest must be subject to tax in the same year of assessment as the deduction is sought in order to escape the provisions of section 23M.
IWT will be levied as from 1 March 2015 on the earlier of the date on which the interest is paid or becomes due and payable. In our view, interest will only be ‘due and payable’ on the date at which the parties contractually agree that payment is due. This date can and frequently is a later date than the date on which the interest is deemed to have been incurred for income tax purposes.
Where an amount of interest is incurred during a particular year of assessment but only becomes due and payable in a subsequent year of assessment, the interest will only be subject to IWT in that later year of assessment. The amount of interest would therefore not be subject to tax in the year of assessment in which the deduction is sought and the provisions of section 23M must be applied to determine the quantum of the interest deduction allowed during that year of assessment.
Interest previously disallowed as a deduction under section 23M, will be allowed as a deduction in the year in which the IWT becomes payable.
Taxpayers who have entered into cross-border loans with persons in controlling relationships should be cautious not to overlook the requirement of section 23M that the interest must be subject to tax in the year of assessment in which the interest is incurred as the section can impact the timing of a significant portion of any interest deduction even where IWT will ultimately be paid on the interest.
Should you have any queries regarding the application of section 23M, please do not hesitate to contact us.