South African Tax Rules Murky on Debt, Preference Share Funding

The tax deductibility status of debt funding or use of preference shares as funding instruments in South Africa has long been a topic of debate, especially for companies in the private capital space or those contemplating mergers or acquisitions. Expectations were that 2025 might bring some clarity on various thorny tax-related funding issues, and while there have been developments, these have not always created the certainty investors and lenders have been hoping for.

Of relevance is the question of the deductibility of raising fees, interest deduction limitation rules and recharacterization of dividend returns on preference shares.

Deductibility of Raising Fees

Raising fees (also known as arrangement fees, origination fees or booking fees) are fees imposed by a lender by a lender as part of a funding arrangement, covering administrative work and services involved in establishing a loan. These fees are typically calculated as a percentage of the total loan amount.

Provided the requirements of §24J of the Income Tax Act, 1962 (Income Tax Act) are met, interest incurred by a company will be deductible when determining its taxable income. For many years the debate has been whether raising fees incurred by a borrower under a funding arrangement qualifies as interest (as defined).

The court’s interpretation, however, does not align with that of the South African Revenue Service, which has historically held the position that for a raising fee to qualify as a “similar finance charge”, it must have the fundamental characteristics of common law interest.

In 2011, the Supreme Court of Appeals in SARS v. South African Custodial Services ((Pty) (131/10) [2011] ZASCA 233 (SACs)) favored the tax deductibility of raising fees under §24J(1)(a). This was before the amendment of the §24J(1)(a) definition of the term interest by the Tax Laws Amendment Bill 2016. Under the presiding tax law at the time, “interest” was defined as “interest or related finance charges”.

Following the SACS judgment, the South African National Treasury changed the definition of interest in the 2016 Taxation Laws Amendment Bill by replacing the word “related” with “similar”. The amendment was intended to clarify the policy position that “interest” refers to common law interest or finance charges of the same kind or nature.

In a January 2025 Tax Court case between the South African Revenue Service and a taxpayer (IT 76795), the Cape Town Tax Court ruled that raising fees incurred by the taxpayer in connection with loan funding advanced to it should be treated as tax deductible, as they are considered “interest or similar finance charges” (see the definition of “interest” in §24J(1)(a) of the Income Tax Act). The court determined that the term “interest” in §24J expressly includes “similar finance charges” and that “interest” should be interpreted more broadly than its common law or ordinary meaning.

As a matter of law, unlike judgments made by the High Court, Supreme Court of Appeal or the Constitutional Court, Tax Court judgments are only binding for the parties before the court and carry only persuasive value in other tax cases. As such, the matter cannot be considered settled unless SARS appeals the decision to a higher court following which a decision made such courts it will become binding case law. Until such time, taxpayers should tax a cautious approach in adopting a position of the deductibility of raising fees.

Interest Deductibility Limitation

Another area of uncertainty has to do with the rules limiting the deductibility of interest.

Currently, there are two sets of rules on interest deductibility for South African companies that serve different purposes.

The first set of interest deduction limitation rules under §23M of the Income Tax Act aligns with the recommendations of the Organisation for Economic Co-operation and Development (OECD). §23M limits the deduction of interest paid by a South African company (borrower) to creditors in a controlling relationship as the borrower where the interest is not taxed in the hands of the creditor. §23M contains a fixed ratio rule where the interest incurred is deductible up to 30% of taxable income, adjusted to reflect earnings before interest, tax, depreciation and amortization (EBITDA). The limitation is intended to prevent base erosion where the borrower would be entitled to a deduction of the interest and the creditor would (i) not be taxed on the interest received or (ii) be taxed at a reduced rate, for withholding tax purposes.

The second set of rules are found in §23N of the Income Tax Act and are aimed at South African companies using debt to fund group reorganization or the acquisition transactions. The intention of the section it to ensure that, in transactions relating to corporate reorganization and acquisition, excessive debt is not used to achieve tax savings that are central to the viability of the deal. Silke on South African Income Tax 2025, ¶13.39B

The deduction of interest under §23N is limited to a percentage of taxable income, adjusted to reflect 40% of EBITDA (but fluctuating in line with repo rate changes). The repo rate is the official rate of interest at which the South African Reserve Bank (SARB) lends money for deposit. Accordingly, the inclusion of the average repo rate in the formula means that the limitation percentage will adjust where there are changes in the SARB’s lending rate during a year of assessment. The amount of the interest deductible may not exceed 60% of the acquiring company’s adjusted taxable income.

Because §23M and §23N can be difficult to follow, in 2024 the National Treasury proposed amendments to these sections to align them. These amendments will come into effect starting on January 1, 2027. Clarifications include changing the definition of adjusted taxable income in §23N and replacing the existing formula with a fixed rate of 30%.

When the amendments come into effect, the deduction of interest under both sets of rules will be limited to 30% of adjusted taxable income.

Limiting §23N interest in this way seems misplaced. There is no OECD connection when it comes to South African companies using debt from local financial institutions to acquire local businesses or finance inter-group reorganizations.

It is unfortunate that we have not seen any movement on the limitation of deductibility in the Taxation Laws Amendment Bill, 2025 (2025 TLAB). Hopefully, next year will bring changes in respect of the proposed amendments.

Preference Shareholders

Except where §23N permits, if a South African company (borrower) uses debt to fund the acquisition of shares that company will, in most cases, not be entitled to a tax deduction of the interest incurred on such funds while the lender will be subject to income tax on the interest income. Using debt funding in such scenarios is may therefore be inefficient as it results in an unintended high-than-necessary tax burden for the transacting parties (commonly referred to as tax leakage).

Equity instruments such as preference shares can serve as alternative funding mechanisms. Provided the instrument does not qualify as a Hybrid Equity Instrument under §8E of the Income Tax Act or a Third-Party Backed Share under §8EA, no tax leakage arises. The issuer is not entitled to a deduction, while the preference shareholder is not subject to tax on the dividend return.

Preference share funding is commonly used in transactions where a new investor needs capital to fund the acquisition of equity. In such instances, subject to commercial considerations, the resultant tax neutrality of this funding mechanism means can be cheaper than the use debt funding.

If the hybrid equity instrument or third-party backed share rules are triggered, the dividend associated with the preference share will be reclassified to income in the hands of the preference shareholder and subject to income tax. The issuer will not be entitled to a deduction for the dividend paid, resulting in the same consequences had debt been used.

The 2025 TLAB proposed significant amendments to §8E which would overhaul the rules governing hybrid equity instruments and negatively impact existing and future transactions relying on preference shares as funding instruments.

Fortunately, following concerns raised by numerous commentators, the Minister of Finance, acting on the advice of the National Treasury and SARS, decided to withdraw these proposed amendments.

In a media release, the minister acknowledged that the proposed changes would “effectively eliminate preference shares as a viable means of financing.” The minister added that any future proposals on structural changes to the taxation of hybrid equity instruments would follow a consultative process with all stakeholders to ensure a balanced approach before draft tax legislation is published.

Parties using such instruments to fund acquisitions should note that retraction of the proposed changes may be a temporary reprieve as Treasury is likely to revisit the matter.

Some Good News

There are certain debt-related aspects of the 2025 TLAB to be welcomed.

A key one is the qualification of the practice of allowing a deduction of interest, in intra-group or back-to-back debt funding and/or refinancing structures, for companies whose primary business is not money lending.

Although not permitted by law, under general practice by SARS a deduction of expenditure incurred in the production of interest (to the extent of interest earned)t is permitted, per Practice Note 31 (PN31). PN 31 has been in place since 1994 and since its introduction its lawfulness has been under much debate.

In 2023 Treasury indicated that it was going to withdraw PN31 and, introduce §11G in the Income Tax Act to codify the principles contained in the practice note. Its effective date was deferred to allow for further consultation and, as there is no change to §11G in the 2025 TLAB, it seems likely this section will come into effect in its current form in January 2026.

While uncertainty still dogs various interest deductibility issues of importance to businesses, we hope some much-needed clarity will be provided in the future.

This article does not necessarily reflect the opinion of Bloomberg Industry Group, Inc., the publisher of Bloomberg Law, Bloomberg Tax, and Bloomberg Government, or its owners.

Author Information

Benjamin Mbana is a partner at Bowmans in South Africa.

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