Tax Considerations for Secured and Unsecured Term Loans in South Africa
In the complex landscape of South African tax law, understanding the implications of different financial arrangements is crucial for both financiers and borrowers. This article delves into the tax considerations for secured and unsecured term loans, highlighting key aspects of income tax and VAT, as well as relevant legislation.
Understanding Secured and Unsecured Term Loans
Secured and Unsecured Loans Defined:
A secured term loan involves the borrower providing collateral to the lender. This collateral might include assets like shares, immovable property, or even a third-party guarantee. Importantly, the security provided might not necessarily be the asset being financed.
An unsecured term loan does not involve any collateral from the borrower. If the borrower defaults, the financier has no right to repossess any specific assets financed by the loan.
Financier's Perspective: The financier provides what is often referred to as a "vanilla" loan. This means the financier does not acquire and subsequently sell the underlying asset. Instead, the financier simply lends money, which the customer then uses to acquire an asset from a supplier.
Tax Considerations for the Financier
Income Tax
Interest Income:
The financier is subject to income tax on the interest received from both secured and unsecured loans.
Substance Over Form Legislation: Sections 8F and 8FA (see addendum) may apply, which can recharacterise certain arrangements and affect the taxation of interest income.
Other Fees:
The financier is also subject to income tax on various fees, including guarantee fees, facility fees, and raising fees.
VAT
Interest Income:
Local Interest: Exempt from VAT. This exemption means the financier cannot claim input VAT on the costs incurred to generate this income.
Foreign Interest: Subject to VAT at 0%. The financier may claim input VAT on the costs incurred to generate this foreign interest income.
Fees:
Fees like raising fees, guarantee fees, facility fees, and other bank charges generally attract VAT. The financier can claim input VAT on the costs incurred to earn these fees.
Input VAT Apportionment:
A major challenge for financiers is the apportionment of input VAT when their activities involve both taxable and exempt supplies.
Tax Considerations for the Borrower
Income Tax
Interest Deductibility:
Governed by Section 24J, the deductibility of interest depends on the use of the loan. Interest on loans used for trade purposes is generally deductible.
If the loan funds activities that generate exempt income, deductions for interest may not be allowed.
Specific Provisions:
Section 11G: Starting January 1, 2025, this section allows for the deduction of expenses incurred in the production of interest, with certain conditions.
Section 24O: Related to the deductibility of interest incurred to purchase shares.
Anti-Avoidance Rules: Sections 23M and 23N, along with Sections 8F and 8FA, are critical in preventing tax avoidance.
Fees:
The treatment of fees like raising fees and guarantee fees requires careful tax consideration. The outcome of cases like the Consol Glass case indicates that refinancing and the treatment of such fees can be contentious.
VAT
The VAT treatment of fees associated with loans is contentious, especially following specific case law. The deductibility and treatment of such fees must be examined in light of current rulings and precedents.
Legislation to Consider
Sections 8F and 8FA: These sections consider certain interest on hybrid debt instruments and hybrid interest as dividends in specie.
Sections 23M and 23N: These limit interest deductions related to debts owed to non-taxable entities and in specific reorganization and acquisition transactions.
Section 24O: Focuses on the deductibility of interest for certain debts deemed to be in the production of income.
Section 11G: Starting in 2025, this will be a key section for deducting expenses related to the production of interest.
Conclusion
For both financiers and borrowers, navigating the tax implications of secured and unsecured term loans requires a thorough understanding of various tax provisions and legislative guidelines. By carefully considering these aspects, stakeholders can optimize their tax positions and comply with South African tax law.
Addendum: Simplified explanation of Section 8F and 8FA of the Income Tax Act
In our main article, we touched on how some tax rules, like Section 8F, change the way interest from certain loans is taxed. This guide will help you understand Section 8F in easier terms, especially how it affects loans where payments are delayed, known as subordinated debt, and other similar types of loans.
What is Section 8F All About?
Section 8F is a rule in South African tax law that tries to stop people from avoiding taxes through tricky financial setups, particularly with certain types of loans or debt.
Key Points about Section 8F:
When It Started: This rule has been in place for amounts incurred since April 1, 2014.
Main Impact: Section 8F can change the interest you pay on some loans from being a usual business expense into something called a "dividend in specie." This basically means you can't deduct this interest to reduce your taxes like you usually would.
Tax on These Dividends: Normally, these dividends (the changed interest) won't be taxed in the hands of the person who pays or receives them. But if a special tax on dividends needs to be paid, the person who borrowed the money has to pay it, not the lender (which is the opposite of what usually happens with dividends).
How Does This Affect Delayed Payment Loans (Subordinated Debt)?
What is Subordinated Debt?
This type of debt or loan is where the person who lent the money agrees to wait longer than other creditors before being paid back. This waiting happens until the borrower has enough money to first pay off other debts.
Interest on These Loans:
No Deductions After April 2014: You can't reduce your taxable income with the interest you pay on these loans anymore because of Section 8F. This rule sees this type of debt as fitting into a special category under the law.
Interest Treated as Dividends: The interest that you can't deduct will be treated like a dividend. This usually means it's not taxed as income.
Who Pays Dividend Tax? If there is tax to be paid on these dividends, the person who borrowed the money (the debtor) has to pay it. If the lender is a company in South Africa, they might not have to pay this tax.
When Does Section 8F Apply?
Section 8F mostly looks at situations where it's hard to tell if something should be treated like debt (something you owe) or equity (something you own). For the loans we're talking about:
Who's Involved: The rule looks at loans between connected people or businesses.
How Long Until You Pay Back: The loan isn't meant to be paid back within 30 years, or it doesn't have a set time when it must be paid.
Based on Financial Health: The rule kicks in for loans where you only have to pay back if your business is doing well enough (like if your assets are worth more than what you owe).
Examples and Legal Points
Typical Agreements:
In many businesses, especially within groups of connected companies, there are agreements where a company won’t ask for its money back until the borrowing company is financially healthy enough. Here’s what one of these agreements might say:
"The lender won't ask for repayment until the borrower’s total value of things it owns is more than what it owes. If an auditor says that the borrower is doing well enough, some of the debt might be released from this agreement."
What Does This Really Mean?
Legally, these agreements mean you can't just ask for your money back anytime. You have to wait until the conditions are met (like the borrower having enough assets). This makes these loans fall under Section 8F.
Court's View:
A court case (Ex Parte De Villiers and Another NNO: In re Carbon Developments) explained that these types of debts continue to exist, but you can't enforce them unless certain conditions are met, like the borrower having enough assets to cover its debts. If the borrower goes bankrupt, the debt might become unenforceable and just disappear.
Conclusion: What to Watch Out For
Important Points:
Changing the words of your loan agreement won’t change its real nature; the original intention and substance behind the agreement remain. This means Section 8F could still apply.
There’s a big risk that Section 8F will apply to these agreements, especially because these loans can’t just be paid back anytime.
However, if your loan doesn’t involve interest (it’s interest-free), then you don't have to worry about falling under the Section 8F rule right now.
If you have a loan where you're paying interest, and the repayment is delayed under certain conditions, be careful. You need to think about Section 8F because it could change how you handle your taxes. Adjusting how your loan agreement is set up could be very important to manage your tax responsibilities properly.
Special Rules for Some Types of Loans (Sections 8F and 8FA)
There are rules about when interest (the extra money you pay back when you borrow money) on certain loans doesn’t get the usual tax treatment. Instead, it’s treated like a dividend (which can change how it’s taxed).
What Are Hybrid Debt Instruments and Interest?
The Basics: These are special types of loans or interest that don’t follow the usual rules. The government says, "Hey, this isn’t just regular interest; it’s more like a dividend." So, they tax it differently.
Why It Matters: This is important for companies because it can change how much tax they owe.
What About Section 24J?
Interest Over Time: This rule says we need to spread out how we record interest for tax purposes over the time we have the loan or investment. It’s like saying, "Let’s not just look at what we pay or get each year; let’s spread it out over the whole time."
The Problem: There’s confusion because it’s not clear if the rules about turning interest into dividends (from Sections 8F and 8FA) should use the simple interest stated in the loan agreement or the spread-out interest from Section 24J.
What Does This Mean for You?
For Investors and Businesses: If you have investments or loans that these rules might affect, you could see changes in how much tax you owe. It’s like the rules of the game have changed a bit, especially for specific kinds of loans or situations with dividends.
For Accountants: It’s important to look closely at any loans or investments that might fall under these rules. Make sure you’re using the right numbers and understand the new clarifications to avoid surprises in your or your clients’ taxes.
Key Points to Remember
Dividends: Not always tax-free if tied to certain types of cost reductions or if involved in long and short share positions.
Special Loan Rules: Interest might be taxed like a dividend if the loan is a special kind, changing how much tax needs to be paid.
Confusing Areas: The rules aren’t super clear on some points, especially about how to calculate interest for these special cases, so stay alert and maybe get some advice if you’re in this situation.
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