In South Africa the cost of borrowing is high, so if you need to borrow funds to buy shares, you should be aware of the tax implications as these may affect whether you consider the purchase viable or not.
For any expense to be deductible for tax purposes, it must be incurred "in the production of income" (where income means what is taxable).
Tax legislation specifically prohibits the deduction of any expense that is incurred in the production of tax-free income. This applies equally to interest.
So, how do these rules apply in relation to interest paid on funds borrowed to buy shares?
Let's say you are considering using borrowed money to buy some shares on the Johannesburg Stock Exchange. The question you need to answer to decide whether the interest you will pay on the borrowed money will be tax deductible, is: what will you do with the shares?
If you intend to hold the shares as an investment in order to derive dividends, the interest on the borrowed funds will not be tax deductible because it will not satisfy the requirements set out.
The effect of the tax will be that the dividends you will receive will be exempt from tax ie tax free.
Because you hold the shares as a capital asset, that is, an investment from which you will derive dividend income, when you sell the shares, unless you have changed your intentions, the proceeds will be capital in nature and therefore tax-free.
If you intend to treat the shares as trading stock, that is, you have bought the shares to sell them in the future for a profit, the interest you will pay on the borrowed funds will be tax deductible. This is because the proceeds from the sale of the shares will be taxable. If the interest you pay is more than the proceeds from trading in shares in any particular year and you make a loss, you will be entitled to deduct the balance of the interest costs against other income you may have.
Generally, when you buy shares as trading stock, however, you will also receive dividends during the time that you hold them. Because the dividends will be tax free, the interest deduction will be apportioned between the taxable trading income and the tax-free dividend income, based on the relative portion of each, and interest will only be deductible to the extent that it relates to the taxable income.
What about a share incentive scheme when your employer lends you funds to buy the shares? Since such shares will probably be treated as capital assets in your hands (your intention, however, is always a determining factor) and you will receive tax-free dividends, any interest your employer charges you on the loan will not be tax deductible.
It will not help if your employer gives you an interest-free loan, as you will be taxed on an amount of deemed interest under the fringe benefits legislation.