Change to legislation creates some uncertainty and could increase the cost of debt.

Words like ‘relevant’ and ‘similar’ may seem very close in meaning, but the difference between them in a tax context has the potential to cause taxpayers pain.

The word ‘relevant’ was changed to ‘similar’ in the Taxation Laws Amendment Act in 2016 and took effect in 2017. This change appears to have narrowed the scope of finance charges that can be deducted for tax purposes.

Jackie Arendse, professor of taxation at Academy One and presenter of The Tax Faculty’s monthly tax update, analysed a case where the court did allow the deduction of related finance charges incurred during the raising of debt.

The outcome of a similar case under the new wording is unclear since there is no case law that will guide taxpayers on which debt costs they can or cannot deduct for tax purposes.

Arendse referred to a case in 2016 where a company involved in property investment and management, including the letting of property for rental income, raised funds for the purpose of property development.

Related finance charges

It incurred interest costs, but also raising fees, debt origination fees and certain structuring fees on the loans. It deducted interest and the related finance charges during the 2016 year of assessment.

The South African Revenue Service (Sars) disallowed the related costs amounting to R19.5 million and imposed an understatement penalty at 50% of the tax owed.

The matter went to court and Sars argued that the fees did not amount to related finance charges because they were payable upfront, they constituted once-off payments and they were not linked to the duration of the loans.

The court considered existing case law from a case in 1955 and another in 2012, and found that the deductions must be allowed. The matter was remitted back to the Sars commissioner to raise a new assessment. The understatement penalty also fell away.

In the 2016 case the ‘pure’ interest was not in dispute as it is defined in the act. However, related finance charges were not defined. The ordinary dictionary meaning defines it as the borrower’s total cost of credit, including loan interest, commitment fees or prepaid interest in consumer loans.

Arendse notes that there has to be a factual causal link between the borrower’s obligation to pay the amount in question and the lender’s extension of credit to the borrower.

In the 2012 case, which went all the way to the Supreme Court of Appeal, the court took a broad view and found that these fees were part and parcel of raising loan finances and therefore fell within the realm of related finance charges.

Similar finance charges

But the law was changed in 2017. The reason given was to clarify the policy position that the deduction applies to finance charges of the same kind or nature as interest, Arendse explains.

She says the general view is that the change has narrowed the scope of which finance charges will be deductible.

In terms of the common law meaning of ‘similar’, one thing is similar to another if, without being identical, there is a resemblance in some aspect.

“So, if we look at finance charges that are similar to interest it will have to be that they have a resemblance in appearance, character or quantity without being identical.”

Some guidance

Arendse mentioned the master’s degree research study by Chantelle Haines in 2017 on the tax deductibility of interest and finance charges and the real cost of credit. Although it offers helpful guidance, it remains a view, as it has not been tested in a court of law.

In terms of the guidelines, the fees would have to be paid as compensation for the use of money; payments must be recurring (because interest is typically recurring) and the fees must be calculated with reference to the time value of money and the amount outstanding as opposed to a fixed fee.

According to the study, upfront raising fees would not ordinarily constitute similar finance charges as they are paid once and are not calculated with reference to the time value of money for the loan amount outstanding.

In terms of the guidelines guarantee fees or commitment fees may qualify as similar finance charges and could be deductible, whereas service fees are not similar to interest and may not be deductible.

If the fees are not deductible in terms of Section 24J of the Income Tax Act, there is the option under Section 11A. However, if they fall outside the realm of Section 11A it will form part of the base cost of the asset, says Arendse.

“That means taxpayers must properly understand what is meant by the term interest and similar finance charges.

“Perhaps somewhere in the not-too-distant future we will have some case law that looks at the interpretation of these words.”

Source: MoneyWeb – Amanda Visser.