Interest on money borrowed

In this series of articles, Cameron Kotze – the Tax Partner at Ernst and Young – discusses some topical tax issues for our readers.

ONE aspect that the tax courts have expressed a view on numerous occasions is the deductibility of interest incurred on money borrowed. In order for interest to be deductible for tax purposes, it must qualify for deduction under the general deduction formula and also meet the requirements that it must be incurred for purposes of the taxpayer’s trade.The only specific provision our Income Tax Act contains with regard to the deductibility of interest paid is interest incurred which relates to the acquisition of moveable assets on which the taxpayer is entitled to a wear and tear deduction.Interest is usually considered to be of a revenue nature on the basis that it is considered to be paid for the use of money and is similar to rental paid for use of a good.If money is borrowed and is used for a purpose that does not produce income, the interest paid on the money borrowed is not expenditure that is incurred in the production of income and is accordingly not tax deductible.In case heard by the Supreme Court of Appeal in South Africa in 1985 the following principles were laid down by the Court regarding interest expenditure and the deductibility thereof for tax purposes: * The closeness of the connection between the expenditure and the income earning operations has to be assessed to decide whether the expenditure is incurred in the production of income.* If a specific sum of money is borrowed for an identifiable purpose, the purpose of the expenditure and what it actually affects can be determined and identified – a clear and causal connection can be traced and both of these factors are important considerations in determining the deductibility of the expenditure.* If a taxpayer borrows generally upon a large scale to raise floating capital for use in the business, it is not easy to identify the causal connection and you cannot say that the expenditure was incurred to achieve a particular effect.You can however say that the expenditure is incurred to provide the business with capital to run with.From the judgement it is clear that the purpose for which you borrow money and the way you apply the borrowed funds is an important factor in determining whether you can deduct the interest paid on the money borrowed for tax purposes.So for example, if you borrow money to buy shares and you cannot satisfy the Receiver of Revenue that the purpose for the borrowing was to earn income other than dividends, the interest expense will not be tax deductible.Interest incurred relating to an asset before it is brought into use in your trade is not tax deductible because it is regarded as being of a preliminary nature and incurred in the acquisition or an asset that is a source of future income.The tax courts have also debated the issue of the tax deductibility of interest charged in respect of borrowings arising from the crediting of dividends to members’ or shareholders’ loan accounts.The issue that has been considered is whether the interest is incurred in the production of the taxpayer’s income.Every case has its own particular facts but it seems as if the tax courts have generally decided that interest incurred on moneys borrowed to pay dividends is not incurred in the production of the taxpayer’s income and is therefore not tax deductible.* Should readers have queries, they are invited to send them to cameron.kotze@za.ey.com.In order for interest to be deductible for tax purposes, it must qualify for deduction under the general deduction formula and also meet the requirements that it must be incurred for purposes of the taxpayer’s trade.The only specific provision our Income Tax Act contains with regard to the deductibility of interest paid is interest incurred which relates to the acquisition of moveable assets on which the taxpayer is entitled to a wear and tear deduction.Interest is usually considered to be of a revenue nature on the basis that it is considered to be paid for the use of money and is similar to rental paid for use of a good.If money is borrowed and is used for a purpose that does not produce income, the interest paid on the money borrowed is not expenditure that is incurred in the production of income and is accordingly not tax deductible.In case heard by the Supreme Court of Appeal in South Africa in 1985 the following principles were laid down by the Court regarding interest expenditure and the deductibility thereof for tax purposes: * The closeness of the connection between the expenditure and the income earning operations has to be assessed to decide whether the expenditure is incurred in the production of income.* If a specific sum of money is borrowed for an identifiable purpose, the purpose of the expenditure and what it actually affects can be determined and identified – a clear and causal connection can be traced and both of these factors are important considerations in determining the deductibility of the expenditure.* If a taxpayer borrows generally upon a large scale to raise floating capital for use in the business, it is not easy to identify the causal connection and you cannot say that the expenditure was incurred to achieve a particular effect.You can however say that the expenditure is incurred to provide the business with capital to run with.From the judgement it is clear that the purpose for which you borrow money and the way you apply the borrowed funds is an important factor in determining whether you can deduct the interest paid on the money borrowed for tax purposes.So for example, if you borrow money to buy shares and you cannot satisfy the Receiver of Revenue that the purpose for the borrowing was to earn income other than dividends, the interest expense will not be tax deductible.Interest incurred relating to an asset before it is brought into use in your trade is not tax deductible because it is regarded as being of a preliminary nature and incurred in the acquisition or an asset that is a source of future income.The tax courts have also debated the issue of the tax deductibility of interest charged in respect of borrowings arising from the crediting of dividends to members’ or shareholders’ loan accounts.The issue that has been considered is whether the interest is incurred in the production of the taxpayer’s income.Every case has its own particular facts but it seems as if the tax courts have generally decided that interest incurred on moneys borrowed to pay dividends is not incurred in the production of the taxpayer’s income and is therefore not tax deductible.* Should readers have queries, they are invited to send them to cameron.kotze@za.ey.com.