The High Court recently handed down judgment in an appeal from the Tax Court in the matter Unitrans Holdings Limited v CSARS. Unitrans Holdings Limited (Unitrans), is an investment holding company that performs a treasury function to group companies, including providing loan funding and cash management.

Unitrans’s wholly owned subsidiaries had a cash management arrangement with Standard Bank, where the group’s bank accounts were balanced to zero on a daily basis. If the group’s net position ended up in overdraft, Unitrans would borrow funds from the bank on a call loan and if the group was in a positive cash position, Unitrans would pay back the call loan.

In its 2011 income tax return Unitrans declared that it had earned R34 million in interest income from its subsidiaries. It further claimed that it had deducted R68 million in interest paid by it to its shareholder Steinhoff Africa Holdings (Pty) Ltd (Steinhoff).

SARS disallowed the interest claimed in terms of section 24J(2) of the Income Tax Act because the expenditure incurred was not in the conduct of any trade, nor was it incurred in the production of income. SARS contended that the interest expenditure was not closely linked to Unitrans income earning operations. According to SARS the purpose of the expenditure was not to produce income but to further the interest of the Unitrans subsidiaries. Unitrans, on the other hand, contended that the Court should recognize that the relevant trade was its trade as an investment and holding company.

The Court observed that Unitrans conducted two related ventures. The first was an investment business where it received dividends from its subsidiaries engaged in the logistics trade. The second part to the business was that it borrowed funds with a view to on-lending such funds to its subsidiaries. The Court noted that the interest rate charged on the loans to subsidiaries ranged from 0% to 8% and was always lower than the rate of interest at which the taxpayer borrowed the monies from its group companies.

The overriding question was – what was the trade which produced the income conducted by Unitrans and how does it entitle it to deduct interest expenditure. The Court said it was clear from the financial statements that Unitrans earned unproductive interest. Therefore, even if its investment business is a trade, it yielded unproductive interest that cannot be allowed as a deduction. The Court further held that the Unitrans argument that it performed a treasury function on behalf of the group is not supported by the facts. Evidence showed that it invested in its subsidiaries so that it can enhance their performance and in turn reap the benefits in the form of dividends.

The Court held that SARS was correct in its finding that Unitrans conducted an investment trade, such investment trade yielding exempt dividend income that it was not entitled to deduct under section 24J(2). Furthermore, the loan in the investment activities produced unproductive interest and exempt income in the form of dividends. It further loaned money to its subsidiaries at a reduced rate of interest whenever the interests of the subsidiaries concerned required that to be done, irrespective of the attendant disadvantage to Unitrans.

For interest to be deductible it must have been incurred in the production of income. The most important fact in the inquiry is the purpose of borrowing money. If the purpose is to apply the funding to produce taxable income, the interest expenditure incurred should be deductible. However, if the purpose is not to produce taxable income, then the interest expenditure is not deductible.

Usually, one must determine whether the interest expense incurred will qualify for a deduction considering:

• The purpose of the loan; and
• Whether the expenditure is linked closely enough to the production of income.

Previously Courts have emphasized the fact that interest will not be deductible if a specific sum of monies is borrowed, and that amount is used for the purpose of unproductive income and not directly connected to the income earning business operations of the taxpayer.

Applying the above principles, the Court stated that it cannot be said with any conviction that the interest expenditure was incurred in the production of the income whilst Unitrans conducted its trade as an investment holding company. The intention was not for Unitrans to earn an income but to assist the group companies to increase their earning capacity. This, the Court said, was evident from the fact that Unitrans charged interest at less than the interest paid on borrowed funds from Steinhoff.

Therefore, the Court held that SARS was correct in disallowing the interest expenditure as a deduction.

Telephone: +27 31 570 5496, Email: graeme.palmer@gb.co.za.