Interest is only deductible if incurred in the production of income and for purposes of carrying on a trade. This requires that the loan in respect of which the interest is paid and the trade/income should be closely connected. A recent case heard in the tax court illustrates that the original purpose of a loan for a specific purpose plays an important role in this regard, even in the case of a loan with flexible payment terms.
Interest would generally only be deductible in terms of section 24J of the Income Tax Act if incurred for purposes of carrying on a trade and in the production of income. In some instances a taxpayer may be deemed to meet these requirements by Practice Note 31 (PN31). In a case heard in the Cape Town Tax Court it had to be considered whether the taxpayer could demonstrate a connection between a loan initially obtained to acquire his home and interest income earned on a loan owing to him by his employer.
Facts of the case
The appellant, an attorney, was obliged by the terms of his employment to contribute to the ongoing working capital requirements of his employer by maintaining a loan to the employer until such time as he resigned. The advances on this loan were funded by the employer deducting the amounts from the appellant's remuneration. Interest accrued at the prime rate on this loan. This interest was taxable in the hands of the appellant.
Some time after his employment commenced, he obtained a loan a bank to fund the acquisition of his home. The home loan was converted to an access bond, which meant that he could access funds paid to settle the loan. As such, the loan balance could fluctuate up- or downwards. He repaid capital amounts at times but then subsequently withdrew some of those funds again for personal use.
The taxpayer claimed a deduction for the interest incurred in respect of a portion of the home loan against the interest income earned on the loan to his employer. He contended that "the retention by his employer of the amounts owing under the loan account had, as a direct consequence, the appellant being unable to repay an equivalent amount on the mortgage loan account resulting in him having to pay on the mortgage loan account a larger interest than he otherwise would have had to pay had the amount in credit on his loan been available to him".
Highlights of the judgment
PN31 applies where interest income is earned on capital or surplus funds or where funds are borrowed and then on-lent. The judge held that the funds retained on the employer loan account were never available to the taxpayer to reduce the home loan during the term of his employment. As such, the interest earned on the employer loan did not arise from surplus funds that accrued to him. The flow of the funds showed that he did not borrow on the home loan to on-lend to the employer.
The taxpayer relied heavily on the case of CIR v Standard Bank of South Africa to support the argument that the effect that had he not been required to lend the amounts to the employer, he would have been able to repay the home loan and therefore not incur the interest expense. Yekiso J concluded that the taxpayer's purpose when acquiring the home loan was to fund the acquisition of his home and there is no clear change in this intention. He failed to show that the purpose and effect of the home loan was sufficiently connected to the interest earned on the employer loan.
Broader relevance
This judgment suggests that in the case of a borrowing for a specific purpose, the purpose of the initial advance of funds rather than the reason why the loan balance remained outstanding would carry more weight. A change in purpose may require something more than a commercial netting-off argument. Similarly, the actual flow of funds appears to be more relevant than hypothetical flows when assessing the connection between interest incurred and income.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
