Loan Replacements

• Published date: 01 June 2021
• Author: Michael Rudnicki Rudnicki
• Pages: 19-26
• DOI: 10.10520/ejc-btclq_v12_n2_a4
• Date: 01 June 2021

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© Siber ink

Loan Replacements:

INTEREST DEDUCTION FLOW-THROUGH

MICHAEL RUDNICKI*

AbstrAct

Many taxpayers in every circle of the economy have battled immeasur-

ably since the start of Covid19. Businesses have battled to stay solvent and

liquidity constraints have caused many a business to either close or resize. We

keep praying that this horrible pandemic will end. The vaccination roll-out

is the only light and our government needs to step up and ensure that the

supply of the vaccines is accelerated.

Financial institution engagement with borrowers is at an all-time high.

Borrowers are refinancing loans with new loans obtained from different finan-

cial institutions, and materially changing the rights and terms on existing

loans, such as deferred repayment profiles.

This article examines the deductibility of interest on such replacement

or refinance loan arrangements. The article starts with an assessment of the

critical pillars for interest deductibility. The provisions of section 24J of the

Income Tax Act 58 of 1962, impose the application of the well-known ‘in

production of income’ test. The key themes in the case law relating to this

test are: (i) the purpose of the Act entailing expenditure and (ii) the link to

the business operation. The deductibility of interest expenditure has regard

primarily to the purpose of the loan. If the application of the loan capital is

‘productively’ employed for the purpose of generating taxable income, the

interest on the loan will meet the ‘in production of income’ test. Interest is

a cost of borrowing. The courts propose that the cost of borrowing is inex-

tricably linked to the purpose of the borrowing. And so, if the borrowing is

applied for a ‘productive’ purpose, the interest will be regarded as incurred in

the production of income.

Decided case law in South Africa, restricted to lower court decisions, has

laid down a very simple test to establish the deductibility of interest in respect

of refinanced or replacement loans. The test is simply to ascertain the purpose

of the old loan and if the old loan is ‘productively’ employed, the new loan

mirrors the old loan for tax purposes. The interest deductibility on the new

loan is a so-called ‘flow-through’ from the old loan, provided the old loan was

used for the purpose of earning taxable income.

Establishing the use of the original loan is important and often compli-

cated; in particular, where loan agreements may not be available or the appli-

cation of the funds is not evidenced. Accordingly, it is recommended that

appropriate audit trails are maintained by taxpayers in respect of the source

and the application of loan funds so as to be able to motivate the purpose of

the original loan.

* Tax Executive, Bowmans Attorneys.