It is often said in South Africa today that there are three partners in most businesses the members or shareholders, the taxman and the bank.
The bank is cited because of the high cost of borrowing in this country. Although the shareholders and the taxman take their share of the business's profits out of after-tax income and from taxable income respectively, the bank may take its share before tax.
It is vital that any interest paid by the business is deductible for tax purposes, effectively reducing the cost of borrowing by the amount of the tax rate.
Surely this is elementary, you may be saying. In theory yes, but in practice, it is not unusual to find a borrowing arrangement that results in the interest not being deductible.
For example, if you are looking at buying a business which is operating successfully (it is generating taxable profits) but the purchase price is more than the cash you have available, you will need to borrow some money from the bank.
The business is currently being operated in a company and you have been given the option to buy the assets of the business from the company as a going concern, or buying the shares of the company.
If you borrow from the bank and buy the assets of the business as a going concern, the interest you pay to the bank on the borrowing will be deductible against the income of the business. If, on the other hand, you buy the shares with money borrowed from the bank, the interest will not be deductible.
This is the first of two articles which explains when interest is not deductible and how loans should be structured to ensure that, where possible, the interest will be deductible.
For interest to be deductible it must, generally, satisfy the normal tax rules for deduction of expenditure. Thus, it must be, among other things, incurred for the purposes of trade and in the production of taxable income.
The courts have ruled that the passive generation of investment income, which means interest income, is not viewed as trading.
Until recently, it could have been argued that if you borrowed money and re-invested it to generate income, the cost of the interest paid on the borrowing would not be deductible against the taxable interest income.
The South African Revenue Services has, however, issued a practice note advising that, despite this argument, it will allow interest to be deducted to the extent that interest is earned.
If you earn R10 000 interest, of which R2 000 is exempt not taxable for an individual and you have paid interest of R9 000 on the funds borrowed to re-invest, you will be able to deduct R8 000 of your interest cost against the taxable interest income. You will not be able to create a loss to set-off against other income with the remaining R1 000 interest paid.
The main pitfall generally arises from the second requirement that the interest paid must be in the production of taxable income. It is this requirement that prohibited the deduction of the interest on the purchase of the shares of the company in the first example set out above. The income which arises as a consequence of the purchase of the shares is dividends. Dividends are exempt from tax.
Consequently, the interest paid to invest in the shares will not have been incurred in the production of taxable income, and will not be deductible.
If the business itself is purchased with its assets and liabilities, the income derived from that business will be considered taxable profits. The interest you paid on the funds borrowed to buy the business will be deductible.
I will discuss further problems in the production-of-income requirement and how to overcome the hurdles next week.