South Africa: Deductibility Of Interest Incurred By An Investment Holding Company

At issue in Unitrans Holdings Limited v The Commissioner for the South African Revenue Service was the tax deductibility, in terms of section 24J (2) of the Income Tax Act, No. 58 of 1962 as amended ("ITA"), of interest expenditure incurred in the context of group loan funding.

Background

Unitrans Holdings Limited ("Unitrans"), an investment and holding company, provided loan funding and cash management for its group.

Unitrans borrowed funds and on-lent same to its own subsidiaries. The interest rate charged on loans to subsidiaries ranged from 0%-8% but was always lower than the rate at which Unitrans borrowed monies from related group companies.

The cash management arrangement related to the group balancing its bank accounts to zero on a daily basis with the group's banker. If the group net position was in overdraft Unitrans would borrow funds in terms of a call loan with such banker. If, on the other hand, the group net position was positive Unitrans would pay back the call loan.

In its 2011 income tax return, Unitrans declared the following:

• it earned interest income from its subsidiaries in the amount of R34 935 900
• deducted an amount of R68 133 602 being interest paid by it to its shareholder;
• surprisingly, that it did not enter into any transactions contemplated by section 24J of the ITA (which is the section of the ITA dealing with, inter alia, tax deductibility of interest).

Following an audit in 2015, SARS issued an additional assessment partially disallowing Unitrans' interest expense.

SARS's additional assessment was grounded on the following bases:

• the interest expenditure disallowed was not incurred in the conduct of any trade; and
• the interest expenditure disallowed was not incurred in the production of income.

SARS also imposed an understatement penalty of 10% (on the basis that there was substantial under declaration of income).

Unitrans' appeal to the income tax court was dismissed by Bam J. It thereafter appealed to the full bench of the Johannesburg High Court.

Submissions on appeal

Unitrans' submissions were, inter alia, as follows:

• interest was incurred by it in the course of its trade as an investment holding company (Unitrans placed reliance on SARS' averment in its pleadings that Unitrans conducts trade as an investment holding company);
• it incurred interest on funds borrowed from group companies with a view to making loans to group companies in the course of its lending trade (which it conducted);
• Unitrans' facts were akin to those in the Tiger Oats case where the Supreme Court of Appeal held authoritatively, albeit in a different context, that a holding company advancing interest free and low interest loans to its subsidiaries, in whose businesses Tiger Oats was intimately involved, was carrying on a business (hence a trade);
• similarly, Unitrans advanced low interest and interest free loans to subsidiaries in whose businesses it was intimately involved;
• it was intimately involved in the management of its subsidiary;
• Unitrans borrowed and lent funds with the overall purpose of making a profit;
• Unitrans' turnover from its interest earning and interest incurring activities yielded a profit in five of the six subsequent tax years (and in all those years if dividends are taken into account);
• dividends should be taken into account in determining profit and the existence of a profit- making purpose (because dividends constitute gross income);
• it carried on an investment business aimed predominantly at reaping dividends from subsidiaries;
• its objective was to protect, nurture and build its investments in its subsidiaries;
• its subsidiaries were wholly owned and therefore furthering their interests meant furthering its own interests; and
• its interests aligned with those of its subsidiaries.

High Court

The High Court had to consider the following requirements of section 24J(2) of the ITA:

• whether Unitrans was conducting a trade; and
• whether Unitrans' interest expenditure was incurred in the production of income.

Trade requirement

The High Court rejected the taxpayer's submissions that it was conducting a trade for, inter alia, the following reasons:

• on the evidence before the court, Unitrans did not perform any administrative, financial or secretarial services to group companies in its 2007-2011 tax years (confirmed in its financial statements and something that was conceded to by Unitrans' witness under cross examination);
• Unitrans placed no evidence before the tax court to demonstrate that Unitrans was intimately involved in the management of its subsidiaries (unlike Tiger Oats Ltd which paid fees for management services provided, on its behalf, to its subsidiaries and affiliates, out of fees earned by Tiger Oats Ltd – this latter feature demonstrated Tiger Oats Ltd's active involvement in the operations of its subsidiaries and affiliates);
• there was no factual basis, in the 2011 tax year, to demonstrate that Unitrans had a profit-making purpose in the medium term (in respect of its loan transactions). In fact, Unitrans realised interest related losses and earned exempt dividends (which do not constitute income for income tax purposes); and
• the evidence before the tax court was that Unitrans invested in its subsidiaries so as to enhance their performance and reap exempt dividend income.

In the production of income requirement

In respect of the in the production of income requirement, the High Court re-stated interest deductibility principles as follows:

• income is produced by the performance of acts (attendant upon which are expenses);
• if the purpose of the act (borrowing money in this case) is to produce taxable income, interest expenditure attendant upon such borrowing should be tax deductible. If, on the other hand, the purpose of the borrowing is not to produce taxable income, interest expenditure attendant upon such borrowing is not tax deductible;
• one must also assess:
  * the effect of the expenditure (applicable where money is borrowed and applied for a specific purpose/s); and
  * the closeness of the connection between the expense concerned and the taxpayer's income earning operations (to determine whether the expense is naturally, reasonably and properly to be regarded as part of the cost of performing such operations).

The High Court also referenced the principle that expenditure incurred to advance group interests is precluded as a deduction (in such circumstances there is usually an insufficient connection between the expense and the cost of performing the relevant income earning operation).

Applying some of these legal principles to the facts in the appeal, the High Court concluded as follows:

• Unitrans' act, to which interest expenditure attached, was borrowing money;
• Unitrans borrowed money to on-lend to group companies requiring assistance to salvage their businesses (the purpose of the borrowing was to benefit group companies improve their earning capacity instead of to earn interest income for itself – this finding was supported by the lower interest rates charged on lending than incurred by it on borrowing);
• Unitrans' loans to its subsidiaries were structured so that it would not make a profit thereon (instead it would incur interest related losses for the benefit of the group); and
• Unitrans subjugated its own self-interest in favour of benefits for group companies.

The High Court also upheld the imposition of the understatement penalty imposed.

Significance of this case

The significance of this decision is the following:

• it may be possible for an investment holding company to meet the trade requirement. Evidence will have to be produced to demonstrate that (i) the taxpayer is involved in providing loans in a business-like manner, (ii) the taxpayer is supported by appropriate resources to support active investment activity, (iii) the taxpayer earns fees from its involvement in the operations of its subsidiaries, and (iv) the taxpayer's activities are guided by self- interest;
• careful attention should be paid to the language employed when describing a taxpayer's business (in its constitutional documents, financial statements, licence applications, licences obtained, and the like);
• tax returns should be completed accurately, including to support subsequent taxpayer credibility; and
• a taxpayer's assertions must be sufficiently supported by available evidence.

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