<p>
      There is no real definition in the income tax of unproductive interest. For tax purposes a certain amount of the interest you pay in the production of income results in a valid tax deduction
      e.g. interest paid on bond repayments for a property that is let for business purposes. Any interest paid for private or nonbusiness activities is regarded as unproductive interest.
    </p>

Sep / Oct 2009

Professional Accountant

Income Tax Act 58 of 1962 #v5

The tax professional cpd points 30 min Unproductive interest Don t assume interest expenses are tax deductible! What is unproductive interest? There is no real definition in the income tax of unproductive interest. For tax purposes a certain amount of the interest you pay in the production of income results in a valid tax deduction e.g. interest paid on bond repayments for a property that is let for business purposes. Any interest paid for private or nonbusiness activities is regarded as unproductive interest. Only interest incurred in the production of income is an allowable deduction (Section 11(a) of the Income Tax Act). Some common examples of unproductive interest: income. However, where pro-rating was not done, SARS could disallow the entire expense where such expense was not mainly used for trade and income producing activities. Unproductive assets: What about the interest you pay to finance assets that don t generate income? These are assets that do not generate income, for example: l A building not utilised for business purposes l Interest-free loans to associated companies or parties (e.g. company makes a loan from a director which bares no interest) l Loans you use to cover private expenses l Loans you use to finance drawings or member salaries l Revaluation of fixed assets (mainly property) the asset value increases but it does not generate further income l Money you borrow to buy out another member of a CC (or partner) l The capital account of the owner or partner of a business with an interest-free debit balance. l Loans by a company to pay dividends The interest you pay to finance unproductive assets is not deductible e.g. share investments (dividends received are not taxable). l Unproductive interest expense for rental income l Money borrowed to acquire an investment which yields no income. When determining the deductibility of interest expenses consider the three main questions asked by SARS: When SARS calculates unproductive interest, they will identify the source of finance for the asset. Where there is uncertainty, the original purpose of the loan will be determined. Rental income and unproductive interest l What is the general purpose of the loan? l Are you using the funds for private or business purposes? If you let out a property you are entitled to claim the interest paid on the bond of the property (Section 11(a)), as you are carrying on a trade. l What is the nature of your trade or business? Interest paid won t be allowed as a deduction for: l Private and domestic expenses (Section 23(b)) l Expenses incurred for receipts or accruals which don t constitute income (Section 23(f)) l Moneys claimed as a deduction . to the extent to which such moneys were not laid out or expended for the purposes of trade (Section 23(g)). Remember that the Income Tax Act allows for the prorating of expenses which were incurred for both business and private purposes. When expenses are pro-rated the business portion of the expense is allowed as a tax deduction, while the private-use portion is not. SARS will not disallow the expense outright but rather concede that some of the expense was incurred in the production of 22 The Professional Accountant However, if you use this capital to finance private or nontrade expenses the deduction will not be allowed. What has been decided in court on unproductive interest? l ITC 1602 (58 SATC 205) A CC borrowed money to enable a member to buy out the other 4 retiring members interest and loan accounts. Ruling: The interest was not deductible because the loan did not increase the taxpayer s income-producing capacity and only achieved at change in control. l ITC 484 (11 SATC 351) To finance the operations of a private company, the shareholders and directors borrowed money from a bank The tax professional (a certain rent-producing property owned jointly by them serving as security). They then lent this money (free of interest) to the company. They tried to deduct the interest incurred on the loan from their directors fees and from the rent received from the rental property. wanted to deduct interest paid on the loan as an expense incurred in the production of this remuneration. Ruling: It was held that the interest paid did not constitute expenses in the production of their income. Ruling: This was disallowed by SARS and upheld by the court, which ruled that his salary/commission/housing allowance were not the result of his shareholding in the company, but due to the services rendered by him in his duties as MD. l ITC 678 (16 SATC 348) l SATC 468 Different interest rates In this case a company borrowed money to pay a dividend to shareholders. As the interest on this loan wasn t spent in the production of income and was not allowable. A company had large loans owing to shareholders and directors at 6% interest per annum. These loans were used as part of this trading company. At the end of the year of assessment the company also had building society deposits earning interest at 4% per annum. On assessment a portion was added back due to the loss (the difference between 6% and 4%). l ITC 1500 (53 SATC 272) A company revalued its fixed assets. Using the unrealised profit on the asset, together with other reserves, it declared a dividend to its shareholder to convert its reserves to a loan account due to the shareholder. The company paid interest on the resulting loan. This was allowed as a deduction. Court cases on which SARS bases their decisions on unproductive interest: l CIR v Standard Bank of SA Ltd 1985 SA 428 (A) (47 SATC 179) General purpose of funds borrowed: Ruling: It was held that SARS could not merely add back because of the difference in the interest rates. If it could be shown that the loans had been arranged to benefit the directors or to reduce the profits of the company then Section 103 (Schemes) could be applied successfully. A direct connection should exist between funds borrowed and loaned out, to add back unproductive interest. l SATC 261 Interest i.r.o. a business that ceases to trade: The bank used a small portion of its borrowed funds to invest in redeemable preference shares (a type of share that yields dividends). SARS disallowed the deduction of a portion of the interest paid by the bank because the preference shares yielded dividends which were tax free. SARS didn t regard the raising of these shares as producing income. Ruling: The court held that the general purpose of the funds borrowed should be considered (a holistic view should be taken). The funds were generally raised by the bank to produce income; therefore the interest paid on all the funds borrowed was deductible. l Financier v COT (17 SATC 34)(SR) investment: A private company carried on business as a steel mill. It had a loan payable to its holding company. They paid interest of approximately R3.3 million and claimed it as a deduction. A portion of the interest levied at 29.25% was disallowed as being excessive. SARS argued that a reasonable rate of 22% interest would be acceptable in terms of the Usury Act. SARS argued that the expense was not exclusively laid out for the purposes of trade, but inspired by another motive. The company argued that the interest rate was high due to the high risk nature of the industry and because the loan was an unsecured inter-group loan. The holding company was technically insolvent. The borrower was also controlled by the lender. Part of the loan was for a dividend declared to the holding company. Non-productive Where money borrowed for the general purposes of a business (as opposed to a specific purpose), is used to acquire an investment which yields no income, the portion of the interest paid allocated to the non-productive investment may not be allowed as a deduction. l CIR v Shapiro (1921 NPD 436)(4 SATC 29) In terms of an agreement with a company, Shapiro borrowed money to acquire enough shares to qualify for the position of Managing Director. In this position he would receive a salary, housing allowance and commission. He Ruling: The court held that interest payable on funds applied for a business which has ceased to trade is not deductible (Section 11(a)). l ITC 301 Purchasing shareholding: To extend its business operations a trader purchased all the shareholding in another company carrying on similar trade. He had to borrow funds to do this and attempted to claim the interest payable on the loan. Ruling: It was held that this interest was expenditure on a capital liability and was not directly connected with the production of income from a trade. ER The Professional Accountant 23 

Unproductive interest : the tax professional