1657. Interest on replacement loan
September 2008 – Issue 109
On several occasions over the past year, the tax court has awarded costs against SARS on the punitive attorney and client basis as a sign of its disapproval of the treatment of a taxpayer. This happened again in Tax case No 11691, judgment in which was delivered by Claassen J in the Johannesburg tax court on 24 April 2007.
The appellant was an incorporated medical practice consisting of three partners. They had decided on incorporation for three reasons, which were not challenged in evidence:
· the goodwill, which resided in the approximately 8 000 patients of the practice, would appear on the balance sheet of the company, which was not the case with the partnership. This would facilitate the raising of loans and the sale of shares to incoming practitioners; · the resignation and acquisition of new partners would be facilitated by the ability to buy and sell shares in the company; · the income tax payable by the company would be less than that payable by individual practitioners; · they were led to believe that, as employees of the company, they would be eligible for UIF benefits.As a result of the sale, the partners had loan accounts with the company, on which interest at 15% in 1998 and 21% in 1999 and 2000 was charged.
About four months after the incorporation, one of the partners was in financial difficulties and required repayment of his loan account. They arranged with a bank to advance the sum of R1 350 000 to the company, which was used to repay loans to the extent of R450 000 to each partner. This bank loan bore interest at 19.5% in 1998, 21% in 1999, and 14.5% in 2000 and 2001. In anticipation of receiving the advance, the company went into overdraft in order to pay the amounts to the partners immediately.
CSARS refused to allow the deduction of this interest, giving three reasons for its decision:
1. the interest had not been incurred in the production of income, as required by section 11(a), the "positive" side of the general deduction formula; 2. it had not been laid out or expended for the purposes of trade as required by section 23(g), the "negative" side of the formula; and 3. the interest incurred was capital in nature.As to the first reason, the court referred to the dictum that expenditure is said to be incurred in the production of income when it is closely related to the act that produces the income. In deciding whether the act is closely connected, the court will determine whether "it would be proper, natural and reasonable to regard the expenses as part of the cost of performing the operation". After citing several judgments and referring to an article by Professor R C Williams in which he refuted any suggestion that interest paid could be capital in nature, the court found that the interest had been incurred in consequence of a revenue producing machine and was therefore deductible. The subsequent bank loan was a "replacement loan" and bore the same characteristics as its predecessor loans from the directors. All the interest had therefore been incurred in the production of income.
As to the second reason, it would appear that counsel for CSARS did not stress this argument, which was hardly surprising. The court found that there was no basis in fact or in law for CSARS to argue that the appellant was not conducting a trade or was paying debt outside the conduct of its trade.
As to the third reason, counsel submitted that the purpose of the appellant in making the loan was not to produce income but to reduce its bank overdraft, which the payment to the directors had caused to increase extensively. The court rightly rejected this argument; the overdraft had increased because the directors had demanded repayment of their loans, which they were entitled to do. The loan from the bank was obtained to liquidate the overdraft. Counsel for CSARS had cited CIR v Drakensberg Garden Hotel (Pty) Ltd 23 SATC(1960) 251 and ITC 1126 31 SATC (1968) 111 in support of her submission, but the court correctly pointed out that these cases had not found that interest paid on money borrowed to buy shares was of a capital nature.
Therefore the appeal was upheld, whereupon counsel for the appellant asked for a punitive costs order on the grounds that the reasons advanced by CSARS were unreasonable. In considering this application the court drew attention to the weight of authority cited by the appellant and the fact that counsel for CSARS had never seriously disputed the facts in the case nor had she tendered rebutting evidence. The facts were relatively simple and the arguments of CSARS were without substance. Consequently, the punitive award was made against CSARS.
Deneys Reitz
