Beware: The characterisation of foreign exchange differences as “interest” under section 23M will have far-reaching implications

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Beware: The characterisation of foreign exchange differences as “interest” under section 23M will have far-reaching implications

• 22 February 2024
• Accounting
• PWC

Background

Section 23M of Income Tax Act No. 58 of 1962 (“the Act”) has been in place for a number of years and historically acts to limit the deduction of interest for taxpayers in respect of certain debts owed to persons that are not subject to tax in South Africa (“SA”). Most recently, significant amendments were made to section 23M as part of the corporate income tax (“CIT”) base-broadening measures. These measures were introduced by the Taxation Laws Amendment Act, 2021 and came into effect for years of assessment ending on or after 31 March 2023. The practical implications of these amendments may not be apparent yet may have dire consequences for companies if over-looked. In addition, there are a number of uncertainties and potentially unintended consequences which have arisen as a result of the amendments.

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Whilst PwC issued previous publications relating to section 23M in February and September 2022 following on the amendments introduced by the Taxation Laws Amendment Act, 2021, practical difficulties and challenges in the implementation of these amendments became apparent for taxpayers with financial years ending on or after 31 March 2023 having to submit their annual income tax returns to the South African Revenue Service (“SARS”). In this article we highlight some of the noteworthy practical consequences of the amendments to be considered by taxpayers, specifically focusing on the characterisation of foreign exchange differences as “interest” under section 23M.

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Definition of interest under section 23M ““interest” means interest as defined in section 24J, and includes:

1. amounts incurred or accrued under any “interest rate agreement” as defined in section 24K(1);
2. any finance cost element recognised for purposes of IFRS in respect of any lease arrangement that constitutes a finance lease as defined in IFRS16;
3. amounts taken into account in determining taxable income in terms of section 24I(3) and (10A); and
4. any amount deemed to be interest under section 24JA,

but excludes any amount that is deemed to be a dividend in specie as contemplated in sections 8F and 8FA;”

According to the amended definition of interest in section 23M, it includes foreign exchange gains and losses which are taken into account in determining taxable income in terms of section 24I(3) and section 24I(10A) of the Act.

Section 24I(3) deals with the tax treatment of foreign exchange gains and losses arising in respect of an exchange item. Section 24I(10A) provides for the deferral of foreign exchange gains and losses in certain instances for transactions between companies that form part of the same group of companies or are connected persons in relation to each other.

An exchange item is a unit of foreign currency, a debt in foreign currency, a foreign currency forward exchange contract or a foreign currency option contract.

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Notable practical implications of foreign exchange differences being included in the definition of “interest” for purposes of section 23M:

• A trade receivable or trade payable balance that is receivable from or owed to a foreign person that is in a controlling relationship with the taxpayer constitutes an exchange item. For purposes of section 23M, any foreign exchange difference arising on such a trade balance and which is taken into account in the determination of taxable income in terms of section 24I(3) and (10A) would be regarded as “interest” as defined in this section. This implies that any foreign exchange loss that arises on a trade payable balance should be subject to the interest limitation in terms of section 23M. This position complicates matters for taxpayers, as it results in the application of the interest limitation rules even in instances where the taxpayer has not incurred any “interest” in terms of sections 24J, 24K and 24JA of the Act or any finance cost is recognised in terms of IFRS 16.
• The issue of foreign exchange differences that arise on trade balances becomes even more complex when one considers a scenario where the taxpayer has a trade receivable balance that has given rise to a foreign exchange loss. A question arises as to whether this foreign exchange loss should be subjected to the interest limitation rules. The answer, surprisingly, is yes. This position is confirmed by the term “creditor” being defined in section 23M as a person to whom a debtor owes a debt (see further below for details on this new definition). Accordingly, in terms of this definition the foreign person would qualify as a “creditor” as defined in section 23M since:
  • the resident taxpayer is a “debtor” in relation to the foreign person. In this regard the term “debtor” is defined in section 23M as inter alia a person that incurs an amount of interest and is a resident; and
  • the trade balance that is receivable from the foreign person is characterised as “debt” in section 23M on the basis that it is an amount in respect of which interest has beenincurred. This balance is therefore regarded as an amount that is owed.

It is not clear whether the above outcome was intended by the legislators. But its impact is far-reaching, as it means that taxpayers with trade receivable balances could end up suffering from adverse section 23M implications.

• Foreign exchange gains that arise on both trade receivables and trade payables are required to be taken into account as interest received for purposes of computing “adjusted taxable income” and in the determination of the interest amount that is allowed to be deducted.
• However, any foreign exchange gains and losses that were deferred during a year of assessment in terms of section 24I(10A) are excluded in the determination of “adjusted taxable income”. This is because these foreign exchange gains and losses would not have been included in or deducted from taxable income, respectively, in the income tax computation, i.e. the taxation of the foreign exchange gains or the deduction of the foreign exchange losses would be deferred to a subsequent year of assessment and would not be taken into account in the determination of taxable income in the year of deferment.
• Furthermore, foreign exchange gains and losses deferred in a prior year of assessment must be taken into account in determining the taxable income of a person in a subsequent year when section 24I(10A) no longer applies or when the debt is realised. These foreign exchange gains and losses taken into account in the determination of taxable income in the subsequent year of assessment will also constitute “interest” for the purposes of section 23M in that subsequent year. As a result, such foreign exchange gains and losses should be included in the computation of “adjusted taxable income” and in the determination of the amount of interest that may be deductible in that subsequent year.

Whilst taxpayers still grapple with the changes highlighted above, further amendments to section 23M have become effective for years of assessment commencing on or after 1 January 2024. This follows the promulgation of Taxation Laws Amendment Act 17 of 2023.

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Overview of amendments effective for years of assessment commencing on or after 1 January 2024:

• The starting point of “adjusted taxable income” has been amended to start with taxable income before applying section 23M and before setting off any balance of assessed loss. The meaning of “adjusted taxable income” has also been amended to remove the addition of “assessed loss or balance of assessed loss” in the computation of “adjusted taxable income”.
• A definition has been inserted of the term “creditor” which clarifies that a creditor is a person to whom a debtor owes a debt.
• A clarification has been added explaining that exchange gains as contemplated in section 24I(3) and section 24I(10A) should be classified as interest received or accrued for the purposes of section 23M.
• The exemption applicable in certain specific circumstances where a creditor funded debt with funding obtained from a lending institution that is not in a controlling relationship with the debtor has been extended to funding obtained by the creditor from South African (“SA”) banks.

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The Takeaway

The amendments have certainly cast a wider net over “debt” that may be subject to the provisions of section 23M. Notably, the significant expansion of the definition of “interest” for purposes of section 23M specifically to include foreign exchange differences has given rise to practical implications that could be easily overlooked by taxpayers. It is therefore critical for taxpayers to carefully examine the components of “interest” for the purposes of section 23M to identify amounts that could potentially be subject to the limitation provisions, noting that this could even include amounts that are receivable by the taxpayer.

SOURCE: PWC

• Stevie Coetzee
• Keshmee Maharaj

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