The 2013 Taxation Laws Amendment Act introduced section 23M into the Income Tax Act. This was around the time of the OECD BEPS project and its Action 4, which deals with limitations on interest deductibility. Most early commentary placed it alongside thin capitalisation, transfer pricing, and the withholding tax on interest, all of which are cross-border matters. This provision does not, however, necessarily apply only in a cross-border context. In this article, I consider three key aspects to consider when assessing whether the limitation in section 23M affects a taxpayer.
A lender in a controlling relationship
The provision applies when a lender is in, or part of, a controlling relationship with the borrower. In the context of section 23M, such a relationship exists where a lender holds at least 50% of the equity shares or 50% of the voting rights in the borrower. That is the direct case. Section 23M(2) does not stop there. The subsection lists the further debts and relationships the provision covers. It includes indirect controlling relationships, funding that reaches the borrower indirectly from a controlling person, and funding from entities in the same group as that person. The lender, therefore, need not be the controlling shareholder itself.
A section 23M analysis therefore starts with understanding the group structure. Key questions are who controls the borrower, and where and how the funding arrives at it.
Interest is not subject to tax.
The second requirement is that the interest must not be subject to South African tax in the lender’s hands. This refers to South African tax.
Cross-border interest often attracts the withholding tax on interest. The ITA sets the rate at 15%, but many tax treaties reduce it. Section 23M contains a deeming provision that applies where a tax treaty reduces the rate. Where the withholding tax applies at less than 15%, section 23M deems a portion of the interest not to be subject to tax. Interest that appears taxed at face value may therefore fall partly within section 23M.
The requirement is not limited to foreign lenders. Two examples illustrate how it could apply in a domestic context. Interest that accrues in respect of a loan by a retirement fund that is in a controlling relationship with a borrower is exempt income for the fund. A public benefit organisation (PBO) that ring-fences for-profit activities in a subsidiary and lends to that subsidiary may receive exempt interest, because this interest is not trading or business income. In both cases, the interest is not subject to tax. The provision then applies if the controlling relationship requirement is also met.
Section 23M limits more than contractual interest
Section 23M limits the deduction of interest on a debt owed to a lender in a controlling relationship with the borrower, where the interest is not subject to tax in the hands of the lender. The limit is roughly based on a formula tied to 30% of a tax version of the borrower’s EBITDA. If section 23M applies, it is necessary to consider the details of the formula as defined in legislation.
A key aspect of applying the restriction is determining what counts as interest. Section 23M defines interest more widely than just the contractual charge on a loan. For example, foreign exchange losses fall within the definition. So does the interest component of a lease under IFRS 16 by a lessee. If deductible lease payments carry an IFRS 16 interest charge for accounting purposes, a portion of the deduction arguably falls under section 23M. This could broaden the provision’s impact considerably once it is established that it applies.
Take-home message
Section 23M is not confined to cross-border loans as it is often believed. It applies wherever a lender in a direct or indirect controlling relationship receives interest that is not subject to South African tax. This may be the case because of a reduced withholding rate or exemptions available to retirement funds or PBOs. The amount affected includes foreign exchange losses and IFRS 16 interest, not only contractual interest.
I discuss section 23M in this episode of my podcast, Tax Break. Click the link below to listen:
