The revenue (as opposed to capital) nature of ‘other finance’ charges – a plausible argument

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The revenue (as opposed to capital) nature of ‘other finance’ charges – a plausible argument

• 11 April 2022
• Corporate Tax
• PWC

Introduction

Oftentimes, when taxpayers secure funding for capital projects, such funding attracts interest as well as other finance charges (e.g. raising fees, front-end fees, upfront fees, guarantee fees and commitment fees).

The circumstances under which interest and other finance charges may be deducted in the determination of taxable income is legislated in the Income Tax Act, 58 of 1952 (‘the Act’), specifically sections 11(a) and 24J, both of which must be read with section 23(g).

While sections 11(a) and 24J of the Act are generally similar in terms of the requirements which must be satisfied before an amount may be deducted, the sections differ on the capital versus revenue nature of the amount in question. Section 11(a) permits a deduction provided such amount is ‘not of a capital nature’ (i.e. it must be revenue in nature). Section 24J, on the other hand, does not require the amount in question to be revenue in nature.

Broadly speaking, section 24J deals with the deductibility of interest while section 11(a) deals with the deductibility of ‘other finance charges’. When the funding for which the other finance charges are incurred is utilised for capital projects (i.e. the income earning structure or fixed capital), the ‘not of capital nature’ requirement under section 11(a) presents a hurdle. A taxpayer may, depending on the facts and circumstances, overcome this hurdle through the application of section 24J, the mechanics of which may sometimes allow for a deduction of other finance charges.

This article focuses on the instance where ‘other finance charges’ may be treated as deductible in terms of section 11(a) even where the underlying funding was used for capital projects.

Detailed analysis

Section 11(a) read with section 23(g) is commonly referred to as the general deduction formula. It is well-known and as a result, does not warrant repetition. It contains specific requirements with which any particular expenditure can be eligible for a deduction. For the purposes of this article, we focus solely on the requirement that the expenditure ‘must not be of a capital nature’ in order for it to be deductible.

We will firstly apply this formula to interest to determine whether the ‘not of capital nature’ presents a hurdle when the expenditure in question is interest, and thereafter consider its application in the context of other finance charges, i.e., can a plausible argument be made for other finance charges to be deemed revenue in nature for purposes of claiming a deduction under section 11(a)?

Section 24J was not always a charging provision. Prior to the amendment in 2004, interest expenditure incurred fell to be deducted under section 11(a), with section 24J merely guiding the timing of the deduction.

Presently, section 24J is a charging provision, however it is not always applicable to the deductibility of interest because of the carve-out provision contained in section 24J(12). Distilled to its effect, section 24J(12) precludes the deductibility of any interest in terms of section 24J with regard to an instrument that is repayable on demand unless it provides for the payment of deferred interest. Where this is the case, the interest incurred in terms of such instrument falls to be deducted under section 11(a).

This is relevant for this article as the deductibility of interest prior to section 24J becoming a charging provision, as well as deductibility of interest under section 11(a) where section 24J(12) is applicable will shed light on how other finance charges may be considered in this context. In effect, the answer to the question ‘can interest expenditure be of capital nature?’ is relevant in this regard.

The ‘in the production of income’ test

Before addressing this question, we briefly explain the ‘in the production of income’ requirement. The requirement is set out under both section 11(a) and section 24J of the Act, and requires that the expenditure be incurred in the production of income before a deduction can be taken. While the phrase ‘in the production of income’ is not defined in the Act, there is a plethora of South African case law dealing with this requirement and the golden thread is that, in the context of interest deduction, one needs to look at the purpose for which the money was borrowed to ascertain whether the interest expenditure is in the production of income.

This begs the question whether in the context of the ‘not of a capital nature’ requirement, the purpose of the loan needs to be considered.

Can interest expenditure be of a capital nature?

Turning to the question ‘can interest expenditure be of a capital nature?’, what is the test to be applied? Does one need to look at the purpose for which the money was borrowed in ascertaining the capital versus revenue nature of interest?

The term ‘capital’ is neither defined for the purposes of section 11(a) of the Act, nor is there a definitive test for determining whether expenditure is revenue or capital in nature. Accordingly, guidance as to what constitutes capital expenditure may be sought in case law, where various tests have been laid down by the courts in order to distinguish between the two. In New State Areas Ltd v CIR, Watermeyer CJ, after citing a number of South African and English cases, stated at 170 that:

‘The conclusion to be drawn from all of these cases seems to be that the true nature of each transaction must be inquired into in order to determine whether the expenditure attached to it is capital or revenue expenditure. Its true nature is a matter of fact and the purpose of the expenditure is an important factor; if it is incurred for the purpose of acquiring a capital asset for the business it is capital expenditure even if it is paid in annual instalments; it is in truth no more than part of the cost incidental to the performance of the income producing operations, as distinguished from the equipment of the income producing machine, then it is a revenue expenditure even if it is paid in a lump sum’ [own emphasis]

In the context of interest incurred, what purpose is referred to in this regard? Does Watermeyer CJ refer to the purpose of the loan or the purpose of the interest itself? Does the interest have a purpose distinct from the purpose of the loan? Interest is generally the compensation for an amount owed to a creditor for allowing the debtor the use of the creditor’s money — isn’t this the sole purpose of interest? How then does the incurral of interest result in the creation, preservation or acquisition of a capital asset? Surely the answer to this is that it cannot.

In ITC 11265, the appellant sought to deduct interest incurred on loan to purchase shares in a company on the basis that his income as a result of the acquired shares had increased. The court held that the interest was of capital nature as the underlying loan had been used to acquire a profit-making concern and not merely to earn a salary.

The court used the purpose of the loan — being the acquisition of a capital asset — to conclude that the interest is of a capital nature. With respect, did the court not err in reaching this conclusion?

An opposing view was taken in ITC 16046. The taxpayer entered into a series of agreements which enabled him to purchase a 49 percent stake in a close corporation where he was also to be employed as a managing director. The taxpayer acquired the stake partly with cash and partly with an interest-bearing loan. It was held that the interest incurred is of a revenue nature as the acquisition of the stake in the close corporation was closely connected to earning income by way of an increased salary and substantial bonus. Importantly, it was noted that the loan liability incurred in acquiring the stake in the close corporation was of a capital nature, but the interest incurred did not improve, augment or preserve the value of the corporation or the stake acquired, nor did it add to the costs of acquiring or enhancing the value of the stake acquired.

The court in this instance seems to have severed the purpose for which the money was borrowed in performing the assessment of the capital versus revenue nature of underlying interest incurred. In effect, even though the purpose of the loan was to acquire a capital asset, the interest was still held to be of revenue nature.

In CIR v Genn & Co (Pty) Ltd, Schreiner, J.A noted the following:

‘There might of course be the further question whether or not, because of its association with the fixed capital into which the loan is turned, interest on such a loan may not properly be said to be expenditure of a capital nature.’ [own emphasis]

In Genn the court seems to have suggested tacitly that interest can be of a capital nature. However, in ITC 11249 , Trollip J (as President of the Transvaal Income Tax Special Court) relying on the Genn case held the following, which was approved by E M Grosskopf JA in Burgess v CIR:

‘Undoubtedly the loan liability incurred by the appellant company for acquiring and retaining the shareholdings in the said two private companies was of a capital nature, for it enabled the appellant company to acquire capital assets in the form of the shares and the possible enduring advantage of a constant supply of timber to the saw-milling company. But it does not necessarily follow that the interest paid on the loan must also be of a capital nature … in the present case, the interest paid was the recurrent or periodical charge or ‘rental’ payable for the continued use by the appellant company of the money lent to it. Such interest was not intended or calculated to, nor did it in fact improve, augment or preserve those aforementioned capital assets, or form part of or add to the cost of acquiring them or enhance their value. Consequently, we do not think that in the circumstances of this case the interest was so closely identified’ [own emphasis]

Trollip J clearly did not consider the purpose of the loan when assessing whether the interest itself is of a capital or revenue nature. Importantly, the crisp point made was that when one looks at the interest itself, it must be considered whether the interest improves, augments, or preserves the capital assets funded by the loan. If the answer is not in the affirmative, the interest cannot be capital in nature. This may appear to be the correct test to be applied, and is buttressed by the judgment in Australian National Hotels Limited v. FC of T. Bowen CJ and Burchett J said (at ATC 4633; ATR 1582):

‘... If the capital is raised by loan, an investment of the borrowed moneys in a business will ordinarily remain an investment of capital, and the same consequences will follow. But there is a special feature of loan capital, which flows from the ephemeral nature of a loan. The cost of securing and retaining the use of the capital sum for the business, that is to say, the interest payable in respect of the loan, will be a revenue item. It creates no enduring advantage, but on the contrary is a periodic outgoing related to the continuance of the use by the business of the borrowed capital during the term of the loan ... Rent, ... and interest are both periodic payments for the use, but not the permanent acquisition, of a capital item.’ [own emphasis]

The Australian case, even though at best has only a strong persuasive authority in South Africa, drives the point home that the interest needs to be looked at in isolation from the purpose for which the money was borrowed. Importantly, interest does not create an enduring advantage.

The following is noted in Tax Ruling 2004/414 issued by the Australian Taxation Office:

‘Outgoings of interest are a recurrent expense. The fact that borrowed funds may be used to purchase a capital asset does not mean the interest outgoings are therefore on capital account (see Steele 99 ATC 4242 at 4249; (1999) 41 ATR 139 at 148)’ [own emphasis]

Taxation Ruling 2004/10 cements the position taken in the Australian National Hotels Limited case.

RC Williams stated the following with regards to the capital nature of interest:

‘If the argument of SARS were to gain acceptance by the courts, the implications for taxpayers nationwide would be little short of “cataclysmic”. Almost every capital project is financed wholly or largely with borrowed funds and if the interest is not tax deductible, many of these capital projects would be still born… it is difficult to see how the payment of interest can ever improve or augment the capital assets of the borrower any more than the payment of rent by a lessee can ever augment or improve the leased premises … rent and interest are examples par excellence of the “fruit” (revenue) as opposed to the “tree” (capital), seen from the point of view of both incomings and outgoings.’ [own emphasis]

The remarks by RC Williams were referenced to in ITC 1827 as support for the conclusion reached by the court. In that case, a partnership sold its business to a company and the purchase price was left outstanding on an interest-bearing loan account. Subsequently, third party bank loans were obtained to discharge a portion of the shareholders’ loans. It was held that, notwithstanding the fact that the newly established company acquired capital assets, the interest incurred on the loan was still of a revenue nature.

As mentioned at the outset, prior to section 24J being a charging provision, the deductibility of interest was determined with the general deduction formula, with section 24J merely guiding the timing of the deduction. Section 24J was, however, subsequently amended such that the deductibility of interest and the timing of such deduction are now determined with reference to the provisions of section 24J read with section 23(g). The amendment to section 24J to make it a charging provision was brought about by the Revenue Laws Amendment Act, 2004 (Act No. 32 o 2004). The Explanatory Memorandum attendant thereto stated the following:

‘Currently section 24J does not provide for the inclusion in gross income of a taxpayer of interest accrued or the deduction from the income of a taxpayer of interest incurred. In order to provide certainty as to the tax treatment of interest and to introduce the principle that interest should always be treated on revenue account it is proposed that section 24J be restructured to specifically provide for the inclusion in gross income of interest deemed to have been accrued or the deduction from income of interest deemed to have been incurred in terms of that section. Section 24J(2) and (3) are to be amended to give effect to this principle. This would bring the tax treatment of interest in line with the treatment of exchange differences, which is not subject to the capital nature test. However, the deduction of interest should still be subject to the trade and production of income tests.’ [own emphasis]

No reason was provided as to why interest should always be treated on a revenue account. It is however clear that the intention of the policy is for interest to be treated on a revenue account as opposed to capital account, regardless of the purpose for which the money was borrowed. This policy intent is supported by the remarks of Trollip J as well as the Australian case referred to above.

This begs the question: what is the nature of the other finance charges (e.g. commitment fees, raising fees, participation fees, utilisation fees) incurred on loans secured by taxpayers; capital or revenue? Should one consider the purpose for which the money was borrowed in assessing whether the other finance charges are of capital or revenue nature? Clearly, in the context of interest, this may not be the case. In certain instances, the other finance charges are periodic payments similar to interest. Can the same principle and policy intent also be applied on the basis that these finance charges do not improve, augment or preserve capital assets?

When one considers the policy intent and the cases referred to above, there may be a strong case to be made that the other finance charges do not improve or preserve any capital assets, particularly when one dissociates the purpose for which the money was borrowed in performing that assessment. Each finance charge needs to be assessed on its own merits.

For example, commitment fees which generally fall to be deducted under the general deduction formula (as opposed to section 24J) is payment to a lender for the set aside of money. The moment the borrower draws on the full amount set aside, the commitment fees fall away. A case may therefore be made that the commitment fees should be dissociated from the purpose and use of the money as it ceases to exist once the borrower uses the money. Therefore, the commitment fees need to be looked at in isolation with the focus being on what it actually affects as opposed to the purpose and use for which the money was borrowed. And on the basis that it does not create or preserve any capital assets, it may be of a revenue nature.

Whilst this may be the case for commitment fees, it may be different for other finance charges. For example, raising fees. In ITC 1019, the appellant derived his income mainly from renting out four immovable properties which he had purchased with loans. The appellant incurred raising fees on a new loan used to repay the previous loan which financed one of the properties secured by a bond, and also incurred fees to secure the renewal of an existing mortgage bond upon another property. The appellant deducted these fees from its income which was disallowed by the Commissioner of SARS and, as a result, appealed to the Special Court of Natal. The court dismissed the appeal on the basis that those fees were attached to the loans which were a portion of the capital of the enterprise and, as a result, capital in nature. Here, it appears that the court linked the capital versus revenue analysis of the fees incurred to the purpose/use for which the money was borrowed without looking in isolation at what these fees actually affect. Similarly, in ITC 85, the facts of which are almost similar to those of ITC 1019, the raising fees were disallowed on the basis that they are closely identified with the raising of the loan, and therefore were expenditure connected with capital asset and consequently of a capital nature. Again, in ITC 882 and 1723, the court held the view that the raising fees incurred was closely connected to the appellant’s fixed capital, as opposed to floating capital, and was of a capital nature unlike the interest.

A careful reading of these cases seems to suggest that, as long as the purpose or use for which the money was borrowed is associated with fixed capital, the raising fees will be of a capital nature. Interestingly, although not specifically dealt with in these cases, we speculate that the interest on these loans were deductible regardless of the loans being used for capital projects (i.e. fixed capital). In the Genn case however, Schreiner, J.A observed that ‘...it should I think be observed at the outset that, whatever might be the position on other facts, it is not possible in the present case to justify a difference in treatment between the interest on the loans and the commissions [raising fees]; the circumstances mentioned above show that in each case the commission, together with the interest, formed in effect one consideration which the Company had to pay for the use of the money for the period of the loan.’ [own emphasis]. It is noteworthy to mention that in the Genn case, the raising fee was calculated with reference to the outstanding capital, as well as the term, of the loan. In effect, the raising fee was qualitatively similar to interest. Unfortunately (but in favour of the appellant), in that case, the money borrowed was applied to a floating capital (i.e. of revenue nature) and as a result, this may present a hurdle for one to rely on the Genn case to justify a deduction of the raising fee where the money borrowed was applied to a fixed capital. The presence of a hurdle notwithstanding, can this present a basis that, if the raising fee is qualitatively similar to interest, should the purpose for which the money was borrowed be dissociated from the capital versus revenue analysis of the raising fees, thereby leading to the conclusion that the raising fee is of a revenue nature? And furthermore, on the basis that the raising fee itself does not preserve, augment or create a capital asset? Can this be a plausible argument to be made?

In terms of paragraph 20(2)(a) of the Eighth Schedule to the Act, the expenditure incurred by a person in respect of an asset does not include any of the following: borrowing costs, including any interest (except as catered for in paragraph 20(1)(g)) as contemplated in section 24J, raising fees, bond registration costs or bond cancellation costs. This implies that in an instance where other finance charges are considered to be of a capital nature on the basis that they are closely associated with capital assets, they cannot be added to the base cost of such assets which in the first stance prompted the argument that they are of a capital nature. A very punitive outcome!

Key takeaway

In closing, when one considers the capital versus revenue nature of an expenditure, the purpose of the expenditure is an important factor. However, with regards to interest expenditure, it appears that the purpose of the money borrowed on which the interest is incurred should be dissociated from the capital versus revenue analysis as part of the deductibility assessment of the interest expenditure. The indispensable question raised is why the deductibility of interest should be treated differently from the other finance changes, particularly where such interest and other finance charges are qualitatively similar. We highlight a plausible argument to be made in respect of the capital versus revenue analysis of other finance charges when one considers the principles applied to another finance charge being interest. There is a strong case to be made that these finance charges do not improve, augment or preserve capital assets, particularly when one dissociates the purpose (and/or use) for which the money was borrowed in performing that analysis. Regardless of the plausibility of the argument, each finance charge needs to be assessed within the correct provisions of the Act and on its own merit as there is no standard rule. Where such a finance charge falls to be deducted under section 11(a) read with section 23(g), one may have to consider the potential application of section 23H24. Taxpayers are advised to obtain tax opinion dealing with the specific facts and circumstances in this regard.

This article first appeared on pwc.co.za.

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