Reliance on this practice by a taxpayer was recently considered in the Western Cape High Court. Due to the unique structure of the taxpayer’s employment contract as a partner at a law firm, a portion of his profit share was withheld as an obligatory interest-bearing loan to the employer, to fund ongoing working capital requirements (‘director’s loan’). While periodic distributions of interest that accrued on the director’s loan was paid to him and treated as taxable income, he was not allowed to claim repayment of the capital for as long as he was in employment. At the same time, the taxpayer would incur interest on a bank loan used to purchase an immovable property (‘bank loan’).
The court had to consider whether there is a sufficiently close link between the interest incurred by the taxpayer on the bank loan, and the interest earned by him on the outstanding balance of the director’s loan. In other words, whether the bank interest can be said to have been incurred in the production of the interest income on the director’s loan.
The taxpayer contended that it did since he would have used the proceeds of the director’s loan to repay the bank loan had it not been for the strict repayment terms, and in the process reducing the capital and interest incurred on the bank loan. He considered the portion of the bank loan equal to the director’s loan as a loan payable on which an interest deduction should be allowed. This was supported by evidence of deposits into the bank loan from distributions of profit share which could also be matched.
The court found that even assuming the funds standing in credit of the director’s loan are ‘capital’ or ‘surplus’ funds as required by PN31.2, any distributions he receives thereon are entirely in the discretion of his employer. As a result, he was not solely reliant on the distributions to maintain the bank loan and the fact that he made deposits into the bank loan from profit distributions does not distract from this fact. To have access to the bank loan, he had to maintain it from sources other than distributions on the director’s loan. Accordingly, the purpose of the bank loan was to provide him with a facility, and not to maintain the director’s loan. It cannot be said that interest paid on the bank loan brought about interest earned on the director’s loan. He would have received interest on the director’s loan, irrespective of the existence of the bank loan. Accordingly, the court disallowed the taxpayer’s appeal for deduction of the interest incurred.
An important takeaway from the judgment is the distinction the court made between the two scenarios dealt with in PN31. Firstly, PN31.1 deals with a scenario where an interest expense was incurred in the carrying on of a trade, while PN31.2 deals with a scenario where a taxpayer does not carry on a trade. The requirements of the two paragraphs should be considered separately and not treated as a single principle. It is therefore important for taxpayers that want to claim interest deductions and rely on PN31 to consider both scenarios, especially if they are not in the business of lending money.
This article is a general information sheet and should not be used or relied upon as professional advice. No liability can be accepted for any errors or omissions nor for any loss or damage arising from reliance upon any information herein. Always contact your financial adviser for specific and detailed advice. Errors and omissions excepted (E&OE)