Unravelling tax deductibility: The transition from PN31 to Section 11G

By Dr Hendri Herbst and Dewald Pieterse

It is trite that, either in terms of section 11(a) or section 24J(2) of the Income Tax Act 58 of 1962 (‘ITA’), interest expenditure is deductible only where a taxpayer derived income from carrying on a trade and such interest expenditure is incurred in the production of income. Practice Note 31 of 1994 (‘PN31’), however, permits a deduction of expenditure where a taxpayer incurs such expenditure in the production of interest income but not in the carrying on of a trade, although such deductions are limited to the amount of interest income.

This article will delve into the specific provisions and implications of section 11G, comparing it with the previously applicable PN31. It will highlight key similarities and differences between the two, particularly focusing on the limitations and allowances for interest expenditure deductions under each of the aforesaid dispensations respectively. Through various examples, we will explore how these changes may impact different types of taxpayers. The aim is to equip taxpayers with an overview of the new framework to ensure that their affairs are in order.

During November 2022, the South African Revenue Service (‘SARS’) revealed its intention to withdraw PN31 due to concerns of taxpayers misusing the concession, and to amend the tax legislation so as not to adversely affect legitimate transactions. Such amendment took the form of the insertion of section 11G into the ITA to govern the deduction of expenses incurred in the production of interest.

Section 11G will be applicable for years of assessment commencing after 1 January 2025, and SARS announced on 8 July 2024 that PN31 will be withdrawn concurrently with section 11G coming into effect. The original proposed wording of section 11G would have resulted in wide reaching consequences for legitimate transactions, but fortunately many of the problematic aspects have since been amended. After an extended process of public consultation and changes resultant therefrom, the final wording of section 11G can be found in the Taxation Laws Amendment Act 17 of 2023, and reads as follows:

(1) For purposes of this section ‘interest’ means interest as defined in section 24J.
(2) For purposes of determining the taxable income derived by any person, there shall be allowed as a deduction from the income of that person, interest incurred by that person to the extent that the interest –
(a) is incurred in the production of interest that is included in the income of that person; and
(b) is not incurred in carrying on a trade.
(3) The amount allowed to be deducted under this section shall not exceed the amount of interest income referred to in subsection (2)(a), that is received by or accrued to a person, during the year of assessment.

There are certain similarities between PN31 and section 11G. Firstly, both are applicable not only to companies but to all persons, thus including individuals and trusts. Secondly, both limit the deductible expenditure to the amount of the related interest income received or accrued by the taxpayer such that claiming the deduction cannot give rise to a tax loss. Thirdly, with both PN31 and section 11G the interest expenditure must be directly linked to the interest income in order to be deductible. By way of example, this means that where Company A lends money to Company B and Company B on-lends that money to Company C, Company B can only deduct the interest expenditure incurred on its loan from Company A against the interest income received from Company C on the loan so on-lent, and not against other sources of income. Should Company B on-lend the full loan amount received from Company A to Company C, but at a lower interest rate, it would result in Company B’s interest expenditure deduction for the interest paid to Company A being limited to the interest income received from Company C. In other words, the difference between the interest paid and the interest received will be lost. It is important to note that the deductibility of the interest expenditure in Company B’s hands is not dependent on whether Company C is allowed to deduct the interest expenditure incurred by it in turn – in other words, Company B will be allowed to deduct its interest expenditure (not exceeding the amount of the related interest income) regardless of whether or Company C utilised the loan for a productive purpose.

Although section 11G expressly provides that interest deductions are only allowed to the extent that the interest is not incurred in carrying on a trade, one must remember that section 11G is a codification of PN31, which solidifies the concession afforded to taxpayers to still qualify for a tax deduction, even though the criteria in terms of sections 11(a) or 24J, and more specifically the trade requirement, have not been complied with. To this extent, the requirement that the interest income should not be derived in carrying on a trade merely serves to limit the application of section 11G to the circumstances for which it was intended, while redirecting the deductibility of interest in all other circumstances to the general provisions in terms of section 11(a) or section 24J. On the assumption that all other requirements are fulfilled, interest incurred in the carrying on of a trade should generally be deductible under sections 11(a) or 24J, in which case it would not be limited to related interest income.

There is, however, an important and far-reaching difference between PN31 and section 11G, namely that certain expenses which were deductible under PN31 will not be deductible in terms of section 11G, due to section 11G allowing only the deduction of ‘interest’ (as defined in section 24J) incurred in the production of interest income, whereas PN31 allowed a deduction for any expenditure incurred in the production of interest income, and not only interest expenditure. This may have significant downstream implications for certain taxpayers, which will be explored through some examples below.

Section 24J(1)(a) provides a somewhat circular definition of interest, namely the “gross amount of any interest or similar finance charges, discount or premium payable or receivable in terms of or in respect of a financial arrangement.” SARS’s Draft Interpretation Note on the meaning of “similar finance charges” published on 27 September 2024 (‘Draft IN’) notes that, given the circular reference in the above definition, the ordinary grammatical meaning of ‘interest’ must apply. Referencing dictionary definitions and relevant case law, the Draft IN states that “it can be concluded that the amount which constitutes interest is the charge for the use of money borrowed and which a person receives for giving someone the use of the money”.

Importantly, however, the Draft IN further notes that “finance charges” as referred to in the section 24J(1)(a) definition of ‘interest’ must be of the same nature as interest, which results in a narrower pool of deductible expenses than was previously allowed under PN31. For example, it is typical of holding or treasury companies to advance loans to group companies. Such a holding or treasury company, however, often does not carry on a trade, and receives only dividend and interest income. Under PN31, it was typically the case that those taxpayers would deduct other finance charges associated with securing funding for capital projects. Such administrative fees, however, do not fall within the section 24J(1)(a) definition of ‘interest’, as it cannot be said to be of a similar nature, and thus, on the assumption that such taxpayer is not otherwise carrying on a trade, these fees will no longer be deductible once section 11G comes into effect. This could result in such taxpayers experiencing adverse tax consequences when compared to the prior position. The same applies in private equity and venture capital contexts where investments are made through a special purpose vehicle which does not otherwise carry on a trade.

Turning to a different example, one often finds that a trust would borrow money and subsequently on-lend money to the trust’s beneficiaries. Under section 11G, the trust will still be able to deduct the interest expenditure on the borrowed funds, limited to the interest received from beneficiaries, but will not be able to deduct other related expenditure which fall outside of the section 24J ‘interest’ definition. This is contrary to the position under PN31, in terms of which it was typical for a trust in such a scenario to deduct expenses such as accounting fees and administrative expenses from the interest income received, which will no longer be possible.

It is clear that while both section 11G and PN31 are a departure from the normal interest deductibility requirements and provides a concession to taxpayers who do not fulfil the trade requirement under section 11(a) or section 24J, the nuances in their application can lead to significant differences in tax outcomes. Taxpayers must critically evaluate their specific circumstances and consider how the transition to section 11G might affect their tax positions. Thorough planning and consultation with tax professionals is essential in navigating these changes effectively and in mitigating potentially negative consequences. By understanding the intricate details and limitations of section 11G, taxpayers can better optimise their tax positions within the new framework.

In conclusion, although there are many similarities between PN31 and section 11G, it is incumbent upon taxpayers to consider whether section 11G may have unforeseen downstream consequences on their tax affairs, as the potential impact of section 11G extends beyond what meets the eye upon first consideration thereof.