Unveiling the intricacies of Section 24O: Not every loophole is a noose to the fiscus

By Dewald Pieterse and Dr Hendri Herbst

Introduction

It is well-known that for interest expenditure to be deductible, whether in terms of section 11(a) or section 24J of the Income Tax Act 58 of 1962 (‘ITA’), such interest expenditure has to be incurred “in the production of income”, namely, that there must be a close connection between the expenditure and the income-earning operations of the taxpayer considering both the purpose of the expenditure and what it actually effects. It is also trite that shares produce dividend income for the shareholder, which, dividend income being exempt from normal tax, means that interest incurred in financing share acquisitions is generally not deductible for taxpayers who do not hold shares as “trading stock”.

Introduction of Sections 23K, 23N, and 24O

After various complex stratagems were devised by taxpayers under the corporate rollover provisions, to nonetheless enable deductions of such interest, sections 23K, 23N and 24O of the ITA were introduced to discourage the use of multiple-step debt push-down structures. As will be pointed out below with a specific focus on section 24O, however, there is still a modicum of uncertainty in certain instances on how these provisions are to be applied.

Purpose of Section 24O

The aim of section 24O is to grant the purchaser company a deduction of interest incurred for the purpose of acquiring equity shares in a target ‘operating company’ (or equity shares in the ‘controlling group company’ in relation to a target ‘operating company’) without the purchaser having to employ section 45 or 47 interest deduction strategies to acquire the underlying assets out of the target company.

The effect of Section 24O

In essence, the application of section 24O(2) allows a purchaser company to deduct interest incurred for purposes of acquiring shares in an “operating company” (or “controlling group company” in relation to an “operating company”) by deeming such interest on “qualifying debt” to be in the production of income and expended for the purposes of trade. However, the interest deduction limitations such as section 23N applies directly to section 24O in that the allowable deduction is limited to an amount calculated by applying the specific formula to the “adjusted taxable income” of the purchaser.

Definition of an “operating company”

Section 24O(1) defines an “operating company” as a company of which at least 80% of amounts received by or accrued to that company in a year of assessment constitutes income which is derived from business carried on continuously by that company and in the course or furtherance of which goods or services are provided or supplied by that company for consideration.

Conditions for deeming provision in section 24O(2) to apply

In order for the deeming provision in section 24O(2) to apply, the financing which gives rise to the interest in question must relate to an “acquisition transaction” as defined in subsection (1). An “acquisition transaction” is defined to mean any transaction in terms of which a purchaser company acquires an equity share in another company from a person that does not form part of the same group of companies as that purchaser company if that other company is an operating company on the date of acquisition of that share, and as a result of which, at the end of the day of that transaction, (i) that purchaser company is a controlling group company in relation to that other company, and (ii) both form part of the same group of companies as defined in section 41(1). (Similarly, acquiring the shares in a “controlling group company” which holds the requisite shares in an operating company also qualifies.) It should be noted that, after the acquisition, there must be a change in control in order to rely on section 24O of the ITA. In other words, the provision is not applicable to companies that already form part of the same group of companies.

Interest deemed in the production of income

Section 24O(2), however, provides that interest is deemed to be in the production of income where during any year of assessment the interest is incurred in respect of a debt used for financing an acquisition in terms of an “acquisition transaction” to the extent that (i) the purchaser held the equity shares in the operating company and (ii) that the equity shares constituted a “qualifying interest” in an operating company at the end of the purchaser’s year of assessment. Subsection (3), on the other hand, defines an equity share in a company to constitute a “qualifying interest” in an operating company where the equity share, on the date referred to in subsection (2), namely the purchaser’s year-end, is held in a company that qualifies as an operating company “in its latest year of assessment” that ended prior to or on the date of the purchaser’s year-end.

Possible loophole in section 24O

This means that technically, on the wording of the section, it may be possible to incorporate a start-up company which commences operations and qualifies as an operating company on the acquisition date and at its own year-end, and ensure that the start-up company’s year of assessment ends before or on the date of the purchaser company’s year-end, thereby resulting in the shares held in the start-up “operating company” constituting a “qualifying interest” acquired in terms of an “acquisition transaction” at the time of the purchaser’s year-end. All the requirements having been met, the interest so incurred would then be deductible. It follows that the interplay between the wording used possibly creates an opportunity for schemes where section 24O is used to obtain interest deductions in the funding of start-ups.

Explanatory Memorandum

This loophole was pointed out in the Explanatory Memorandum on the Taxation Laws Amendment Bill, 2019, which further states that the “special interest deduction is meant to provide for a deduction where interest bearing debt is used to acquire shares in established companies with income-producing assets that already generate high levels of income”, proposing that the loophole be closed in that “further clarification will be made in the definition of an “acquisition transaction” in order to ensure that the company must have traded for at least one year prior to the date of acquisition.” To date, however, no such amendment has been made.

Comments and responses

In the Final Response Document on the Taxation Laws Amendment Bill, 2018 and Tax Administration Laws Amendment Bill, 2018, the Standing Committee on Finance noted this request and states that “[i]t was never intended to grant a deduction for all share acquisitions and particularly, not start-ups.” Although the Committee is not of the view that the current provisions allow for the special interest deduction in respect of “newly established companies that later qualify as operating companies”, it is submitted that an argument can be made that the correct interpretation of section 24O nonetheless allows for the deduction provided that the requirements of the section are complied with in the manner outlined above, which accords with the Committee’s remark that “the practical application of these provisions will be further reviewed in the following legislative cycle to ensure that they are not abused.” However, any such scheme will still be subject to the substance over form and general anti-avoidance rules.

Possible unbusinesslike results and example scenario

The above notwithstanding, and if one accepts that the special interest deduction should indeed be disallowed in relation to the funding of start-ups, there are certain scenarios wherein amending the definition of an “operating company” to require it to have been in operation for more than one year (as proposed by the above Explanatory Memorandum) would have unbusinesslike results. This may explain why no amendment has been made to date to address the shortcoming identified. Consider the following example:

Company C is a holding company which holds the shares of both Company A and Company B, which are both operating companies and which are interdependent on each other for manufacturing their products. Both are large operating companies which have been successfully operating for many years. Company X wishes to acquire both Company A and B from Company C and wishes to consolidate their operations. For commercial reasons, Company X makes it a precondition for the acquisition that Company A and B are amalgamated into Company D under the guidance of the current shareholders, after which Company D will be acquired by Company X. In this scenario, the provision as it currently stands should allow for the special interest deduction in relation to the acquisition of Company D (as long as its year-end falls on or before that of Company X) but amending the definition of “operating company” to require at least one year of operation would preclude Company X from claiming the special interest deduction for the first year. As there is essentially no practical difference from the perspective of the fiscus between the abovementioned approach and an approach where Company X purchases both Company A and B separately, it would not make sense for the special interest deduction to be allowed in one instance and not the other, and a disallowance in the prior instance would arguably go against the policy rationale underlying section 24O, as it would force Company X to revert to the very structuring mechanisms section 24O was enacted to discourage.

Future amendments and conclusion

It would thus be interesting to see whether an amendment will be made to section 24O going forward to address this anomaly and what form such amendment may take to close the unintended loophole without simultaneously producing unbusinesslike results. For now, taxpayers should take note that, according to Government, the intention behind section 24O is not to allow for interest deductibility for the funding of start-ups, although a taxpayer could be forgiven for coming to the opposite conclusion on the ordinary wording of section 24O.

In conclusion, while the current wording of section 24O does provide an opportunity for interest deductions in the acquisition of start-ups, it is clear that the legislative intent was to facilitate such deductions primarily for established, income-generating companies. The potential for misuse of this provision remains a concern, and it is incumbent upon the lawmakers to consider refining the statute both to clarify the intention and to prevent abuse. Taxpayers are advised to obtain professional tax advice in order to make efficient structuring decisions which do not fall foul of Section 24O or the anti-avoidance provisions. As we await possible amendments, it is crucial for taxpayers to stay informed of the evolving developments of section 24O to ensure compliance and optimal tax planning.