Just because it’s related, does not mean it’s the same

A brief history of the ‘interest’ definition

‘Interest’, for tax purposes, is tax deductible or taxable in terms of the rules set out in section 24J of the IT Act, generally on a yield-to-maturity basis over the period of the relevant financial instrument, such as a loan. Prior to 19 January 2017, ‘interest’ was defined in section 24J of the IT Act to include “…the gross amount of any interest or related finance charges, discount or premium payable or receivable in terms of or in respect of a financial arrangement …” (our emphasis).

 While not a defined term, some clarity was provided on the term ‘related finance charges’¹ in C:SARS v South African Custodial Services (Pty) Ltd (131/11) [2011] ZASCA 233 (30 November 2011) (“SACS”). In this case, SACS (the taxpayer) had borrowed monies for the construction of a prison, and had sought to deduct as ‘interest’ (in the form of ‘related finance charges’) a number of additional fees incurred in relation to the borrowed monies:

• Guarantee fees: Paid to another company and to SACS’ financial advisor during the bid phase for guarantees provided over and above the bank loans obtained;
• Introduction fees: Paid to a joint venture partner for a loan advanced to SACS;
• Financial advisory fees: Paid to SACS’ financial advisor;
• Margin fees: Paid to SACS’ financial advisor in respect of its negotiations for bank loans obtained;
• Commitment fees: Paid to the banks for the loans advanced;
• Initial fees: Paid to the banks for the loans advanced;
• Administration fees: Paid to the banks for the loans advanced; and
• Legal fees: Paid to SACS’ attorneys.

In essence, these fees were all incurred by the taxpayer in order to obtain or maintain access to the debt advanced. ‘Related’ in this instance was interpreted to mean bearing a “close connection to the obtaining of the loans”. SACS was permitted by the judge to deduct these fees as ‘interest’ for tax purposes, in that they constituted ‘related finance charges’.

This list of fees in the above case also provided useful examples of the various types of fees incurred by taxpayers when obtaining project or business funding, which do not constitute pure interest. Another common fee is a raising or originating fee, often paid by the borrower to the lender in order to obtain access to the borrowed funds. This is dealt with in more detail below.

The 2017 amendment – ‘similar finance charges’

With effect from 19 January 2017², the ‘interest’ definition in section 24J of the IT Act was amended to replace the term ‘related finance charges’ with the term ‘similar finance charges’. While this may have seemed an innocuous amendment, in reality it had significant consequences. Taxpayers could no longer place reliance on the very helpful laundry list of fees seen to be included in the ‘interest’ definition in terms of the SACS case.

Given the limited commentary from National Treasury that accompanied this amendment³, taxpayers were essentially left to their own devices in interpreting the meaning of the word ‘similar’ in this context. The Merriam-Webster dictionary defines ‘similar’ to include “having characteristics in common”, and “alike in substance or essentials”. This definition, along with National Treasury’s cursory comments, gave the impression that this was a very intentional narrowing of the definition of ‘interest’ for tax purposes.

Due to the lack of guidance on the meaning of this new definition, there has been little to no consistency in the treatment by taxpayers of these types of costs and fees.

The draft interpretation note

On 27 September 2024, SARS broke its seven-year silence and published the Draft IN on ‘similar finance charges’. The Draft IN is quite thorough in defining in detail various terms relating to financing and interest, and provides an illustrative example. We have highlighted selected take-aways below:

• In order for ‘similar finance charges’ to fall within the ‘interest’ definition for tax purposes, SARS makes it clear on page 7 of the Draft IN that these charges “…must have analogous or matching characteristics to that of ‘interest’… there must be almost no difference in character between the finance charges and the interest incurred… the phrase ‘similar finance charges’ does not include all forms of costs associated with acquiring and executing a loan and should not be interpreted and applied too widely” (our emphasis).
•  An entire section of the Draft IN is dedicated to an analysis of raising fees (also called originating fees or front-end fees), generally paid to the lender or the person arranging the loan for the provision of the debt funding. SARS makes a very important distinction here between costs incurred in raising, obtaining, or gaining access to capital (funding), and costs incurred as payment for the use of that capital. In SARS’ view, costs incurred to raise, obtain, or gain access to capital cannotbe seen to be similar to interest, the latter being incurred for the use of borrowed funds.
• If these types of fees do not fall within the definition of ‘interest’ set out in section 24J, one is left to determine whether they may still be deductible in terms of section 11(a) of the IT Act, read with section 23(g). A key challenge here, given these fees are generally incurred in relation to establishing the ‘income-earning structure’ of a taxpayer’s business, is that they are more often than not seen to be capital in nature. Therefore, these fees might not be tax deductible in terms of section 11(a). This means that the costs cannot be deducted at all for tax purposes.  

While the Draft IN does not address every conceivable type of finance charge, it does provide some very useful guidance and insights into how SARS may seek to determine the nature of such charges.

While each case will be determined on its own merits, facts and circumstances, some useful questions to consider when determining whether a finance charge could be seen as being ‘similar’ to interest are:

• Is the charge incurred in raising, obtaining, or gaining access to capital, or is it incurred for the use of that capital?
• Is the charge a once-off payment, or a recurring payment?
• Is the charge calculated with reference to the time value of money?
• Is the charge calculated on the total available capital, or the outstanding balance of capital actually owing to the lender?
• Is the charge a fixed amount or is it determined with reference to a percentage?

 The takeaway

The Draft IN and the guiding principles provided therein are certainly welcome. Its publication, however, may indicate renewed focus and scrutiny from SARS on the types of charges that taxpayers may seek to deduct for tax purposes under the guise of ‘interest’.

‘Similar finance charges’ must display the same nature and characteristics as interest, and in SARS’ words, “there must be almost no difference in character between the finance charges and the interest incurred”.⁴ This is certainly a narrow interpretation, and in our experience, other finance charges incurred on financing arrangements are very rarely almost identical to pure interest in every aspect. 

Given the potential plethora of fees involved in financing arrangements and the lack of consistency in the naming conventions of these fees, it is crucial that taxpayers apply their minds to each of these charges to determine their true nature. This will require reviewing the terms and conditions of financing agreements, and ensuring that adequate evidence is on hand to support the view that these charges bear practically no difference to interest. This task is made even more complex by the subjective nature of the tests provided in the Draft IN – it is a question of degree (how close, how similar, how identical), rather than being black and white.

^{1 Albeit in the context of the now repealed section 11(bA) of the IT Act, and not section 24J – nonetheless, the same term was used in both of these sections, and in practice, the SCA’s interpretation in this case was generally applied by taxpayers to ‘related finance charges’ in the context of section 24J as well.}

^{2 Per section 45 of the Taxation Laws Amendment Act, No. 15 of 2016.}

^{3 Clause 45 at page 90 of the Explanatory Memorandum to the Taxation Laws Amendment Act No. 15 of 2016 simply stated that this amendment was to clarify “…the policy position that this applies to finance charges of the same kind or nature.”}

Authors;

Greg Boy, Senior Manager

Graham Molyneux, Partner