Anti-avoidance provisions limiting interest deductions: a comparative analysis between the OECD and South Africa

Abstract

Companies have two options to finance their operations: equity injections from their shareholders or loans (SARS, 2013, p. 3). The cash outflows as a result of these two methods of financing are dividends and interest respectively (SARS, 2013, p. 3). Since dividends are not allowed as a tax deduction in South Africa, it is clear that companies would benefit by financing their businesses with debt rather than equity since the interest expense on a loan is deductible for tax purposes under s 24J of the Income Tax Act 58 of 1962 (the Act)(SARS, 2013, p. 3). A study completed by de Mooij, R. & Hebous, S. suggests that debt/asset ratios increase by at least 0.14% -0.46% for corporations every time there is a 1% increase in the tax rate, which proves company tax bias towards debt (Hebous & de Mooij, 2017). Using debt rather than equity also allows for the existing owners in a company to raise funding without the possibility of losing control of the company, which may be the case when equity instead of debt funding is utilised (Halka, et al., 2017, pp. 182-183).For multinational enterprises, it may be easier to raise debt funding from a company within the same group of companies versus debt obtained from external parties such as banks as they can take advantage of internal synergies (Reynolds & Wier, 2016, p. 4) this creates a problem for tax authorities in certain instances. The reason for concern is that some multinational enterprises choose to engage in excessive debt financing particularly from companies within their group to charge high interest rates to those branches situated in high tax jurisdictions (Palanský, 2019). Some groups issue loans from a company based in a low-tax jurisdiction allowing the borrower to deduct their interest costs in the high tax jurisdiction resulting in large interest deductions that lower not just the net tax bill for the group but also erodes the tax base in the high-tax jurisdiction (OECD, 2017a, p. 23). This research report will review how multinational enterprises use debt funding as an opportunity to avoid tax and what the regulations are in South Africa to protect the tax base in comparison with the recommendations from the Organisation for Economic Co-operation and Development. Section24J of the Act governs the fundamentals of interest deductibility. Section 31(2) of the Act limits interest deductions to the arm’s length amount of cross-border debt and interest. Section 23N of the Act limits interest deductions by a company on debt obtained to purchase assets or shares in reorganisation and acquisition transactions. Section 23M limits the deductibility of interest on debt from a foreign person that is not subject to tax in South Africa and is in a controlling relationship with the resident borrower