Lenders of money are not all ‘money lenders’

In many groups of companies, intra-group loans make sense as a way of funding the operations of the group.

If the funds are sourced from outside the group by a borrower entity and then on-lent to other companies within the same group as the borrower, the question is whether the interest incurred by the borrower entity is deductible in terms of section 24J(2) of the Income Tax Act No 58 of 1962 (the Tax Act)?

This question was once again considered in Taxpayer H v Commissioner of the South African Revenue Service (IT 14213) (9 February 2022).

Facts

The taxpayer was a private investment holding company whose assets comprised, in the main, shares in unlisted subsidiary entities, loans advanced to those subsidiaries, and cash.

The taxpayer contended that during its 2011 year of assessment, in addition to being an investment holding company, it undertook a trade in money lending with the specific purpose of making a profit from on-lending borrowed funds to its subsidiaries.  It therefore sought to claim a deduction for interest incurred on borrowed funds in the amount of R68 133 602.

SARS saw things differently, and was of the view that interest was not incurred by the taxpayer whilst carrying on a trade, nor was it incurred in the production of income, therefore the requirements of section 24J(2) of the Tax Act had not been met.

SARS therefore disallowed the deduction of the full interest amount.

However, owing to a practice adopted by SARS (set out in Practice Note 31 read with Section 51 of the Tax Administration Act 28 of 2011), it allowed a partial deduction of the interest expenditure limited to the amount of interest income of R34 936 000 received by the taxpayer.

SARS disallowed the full interest deduction for the following reasons:

• The taxpayer borrowed at interest rate of 8.29% per annum, yet it extended loans to its subsidiaries at interest rates ranging between 0%, 5.29%, 6.22% and at times, 8.29% per annum.
• The interest rates imposed by the taxpayer demonstrated the taxpayer’s intention as nothing more than furthering the group’s interests, by enhancing the earning capacity of the subsidiaries.
• The transactions related to the funding of unproductive loans, in that the taxpayer’s borrowings were less than its receivables, and its lending transactions extended only to its subsidiaries.
• The taxpayer had structured its lending transactions so that it could earn neither income nor profit.

SARS also imposed a 10% understatements penalty in accordance with Section 223 of the Tax Administration Act No 28 of 2011.

The taxpayer disputed SARS’ conclusion on the basis that (i) it was carrying on a money lending trade, and (ii) it incurred the interest expense in the production of income as required under Section 24J(2).

This article considers only the court’s findings in relation to the deductibility of the interest incurred by the taxpayer in terms of section 24J of the Tax Act.

Judgement

Was the taxpayer carrying on a trade in money lending?

The court first considered whether the taxpayer was carrying on trade as a moneylender in its 2011 year of assessment.  In this regard the court referred to guidelines set out in Solaglass Finance Co. (Pty) Ltd v Commissioner for Inland Revenue [1991] 257 (A) (also cited by the taxpayer in its submissions).

The court highlighted the following findings from this case:

• The lending had to be done pursuant to a system or plan which disclosed a degree of continuity in laying out, and getting back the capital for further use and which involved a frequent turnover of the capital.
• The obtaining of security was a usual, though not essential, feature of a loan made in the course of a money lending business.
• The fact that money had on several occasions been lent at remunerative rates of interest was not enough to show that the business of money lending was being carried on. There had to be a certain degree of continuity about the transactions.
• As to the proportion of the income from loans to the total income, the smallness of the proportion could not necessarily be decisive if the other essential elements of a money lending business existed.

The Court also referred to ITC 1771 66 SATC 205 and ITC 812 20 SATC 469 in which the following was stated:  “A long-term loan without any repayment terms, in my view, lacks the essential characteristics of floating capital which, if it becomes irrecoverable, constitutes a loss of a capital nature.”

and

“The main difference between an investor and a money lender appears to consist in the fact that the latter aims at the frequency of the turnover of his money and for that purpose usually requires borrowers to make regular payments on account of the principal. This has been described as a system or plan in laying out and getting in his money…”

The court noted that throughout the taxpayer’s correspondence with SARS, it argued that the interest expense was deductible in full because it was incurred whilst carrying on a trade in money lending with the purpose of producing income, specifically from interest generated from its on-lending activities.

However, when faced with the reality that it would fall short in meeting the tests outlined in the case law, the taxpayer discontinued this argument, arguing instead that its trade activities consisted of “interest earning and interest earning activities”.

Based on the evidence presented by the taxpayer, the court found that the taxpayer could not justify its claims that it was engaged in the trade of money lending, which was further apparent from the fact that the taxpayer had declared, in its 2011 tax return, that it had not concluded any transaction in terms of Section 24J.

In considering whether a taxpayer has a profit-making motive, the court stated that

• money lenders demonstrate their profit-making purpose by charging remunerative interest rates and fixing terms when lending;
• money lenders use a plan or system of laying out and getting back their capital to demonstrate continuity. For this reason, they usually require the borrower to make periodic repayments on account of their capital; and
• money lenders do not borrow at high interest rates and lend at either nil or substantially low interest rates or at the very same interest they incurred, and look to the fiscus to finance the growth of the borrower and enhance its profitability, in the comfort that they will reap lofty dividends.

Accordingly, in light of the above, the court found that the taxpayer’s lending transactions were not concluded with the intention of making a profit; instead, they were about funding unproductive loans for the taxpayer to reap exempt income.

Was the interest expense incurred in the production of income?

The court highlighted that one of the most important and sometimes over-riding factors in determining whether expenditure is incurred in the production of income is the purpose for which the expenditure was incurred.  In this regard, the court was obliged to consider the closeness of the connection between the expenditure and the income earning operations of the taxpayer.

The taxpayer submitted that the “in production of income” requirements of section 24J(2) had been met on that basis that:

• the mere fact that interest earned on the loans made to its subsidiaries in 2011 did not exceed the interest incurred does not mean that the interest was not incurred in the production of income, and
• that the interest it earned from its subsidiaries constituted income as none of it was exempt.

SARS, on the other hand, argued that the purpose of the borrowing was to provide the taxpayer’s subsidiaries with advantageous loans to benefit the group by increasing their earning capacity.

The court found on the facts that it was apparent from the manner in which the taxpayer structured the loans to the subsidiaries that the taxpayer’s purpose was not to generate income from the loans, nor could it be shown that the taxpayer had a profit-making purpose in advancing the loans.

Conclusion

Although the matter of interest deductibility has been considered in numerous cases, this judgement is a reminder that clear distinctions can be made between a money lender and an investor and that these differences lie primarily in the structure and terms associated with the loans.

In particular, in determining whether interest incurred by a taxpayer is incurred in the production of income and therefore deductible for tax purposes, a distinction may have to be drawn between a taxpayer who borrows a specific sum of money and applies it to an identifiable purpose (as in the instance of Taxpayer H), and a taxpayer who borrows money generally and in a large scale in order to raise floating capital for use in its business.

In the former type of case, both the purpose of the expenditure (being interest) and what it actually effects can readily be determined and identified and where there is a direct link between the money borrowed by a taxpayer and the money lent to its subsidiaries, the taxpayer will be precluded from relying on income received from other sources in order to prove that the taxpayer’s intention is one of profit-making (as in the instance of Taxpayer H).

Had the taxpayer, instead, applied the approach of placing all borrowed funds into a common pool which constitutes a general fund used for all purposes, the taxpayer may have been able to argue that the general sense of its expenditure (being interest) was incurred in order to provide the taxpayer with funds to raise floating capital for use in its business and thus incurred in the production of income.

Written by BENJAMIN MBANA

This article is a general information sheet and should not be used or relied on as legal or other professional advice. No liability can be accepted for any errors or omissions nor for any loss or damage arising from reliance upon any information herein. Always contact your legal adviser for specific and detailed advice. Errors and omissions excepted (E&OE)