Interest on money borrowed to purchase shares may not always be tax-deductible

The financial viability of many business deals depends on the interest on borrowed money being tax-deductible as this significantly reduces the real cost of borrowing.

Mark Badenhorst, corporate tax partner at PricewaterhouseCoopers SA, says that the income tax principle in this regard is straightforward. “If the taxpayer’s purpose in taking out the loan was to use the borrowed money for the purpose of producing income, then the interest is tax-deductible. If the purpose was not to produce income (or to produce income of a kind that is tax-exempt, such as dividends), then the interest is not tax-deductible.”

For example, if an individual takes out a loan in order to buy a home to live in, the interest is not deductible. But if the taxpayer borrows money in order to purchase business premises, or to purchase machinery which will generate income for a business, then the interest is tax-deductible.

Badenhorst says there is considerable scope for tax-planning in this regard. “It is tax-efficient to use one’s available funds to pay cash for items where the interest would not be tax-deductible and to borrow money to purchase items where the interest will be deductible.”

But in the case where money is borrowed in order to purchase shares, the interest will not be tax-deductible where the purpose of acquiring the shares was to produce tax-exempt dividend income. The interest on such a loan will be deductible where the shares were purchased in order to produce a non-exempt income stream such as a director who is obliged to hold qualifying shares, who purchases such shares to secure the directorship and attendant remuneration.

In the recent case of ITC1820, the taxpayer company borrowed money to purchase all the shares in another company, so that the latter became its subsidiary. The taxpayer claimed that it had purchased those shares with a view to the subsidiary paying the taxpayer company a fee for marketing the subsidiary’s products.

However, the tax court ruled that the taxpayer had failed to discharge the onus of proving that this was indeed its purpose. The court held that the probabilities were that the taxpayer had borrowed money for the purpose of acquiring the shares with a view to deriving dividend income from the subsidiary. Consequently, the interest was held not to be tax-deductible.