An interest(ing) case: Section 11(a) of the Income Tax Act and the deductibility of interest expenses on home loans

Facts

Mr X, the taxpayer, is a qualified solicitor in England and Wales, currently in the employ of Y Attorneys, an incorporated firm of attorneys. Although he is not an equity partner with the law firm as he has not been admitted as an attorney in South Africa, he enjoys the same remuneration as an equity partner and therefore has to assist with on-going working capital requirements of the firm. He does this by maintaining a credit balance on his loan account (Firm Loan Account) for which he is then remunerated by his employer at the prime rate of interest. The amount that must be kept in the Firm Loan Account is deducted proportionately from the taxpayer’s monthly remuneration, meaning that the source of the funds paid towards the Firm Loan Account is his remuneration. The interest on the Firm Loan Account accrues to him and therefore constitutes taxable income in his hands. Occasionally, the firm would make a distribution in the form of interest to loan account holders. However, the taxpayer is not entitled to withdraw the outstanding balance on the Firm Loan Account unless he resigns.

The other important fact is that the taxpayer purchased property, which he uses as his residence and is secured by a mortgage bond access facility (Home Loan) which he had drawn on to fund a variety of his expenses. The taxpayer claimed in his income tax returns for the 2010, 2011 and 2012 years of assessment that certain interest incurred on the mortgage bond was incurred in the production of interest income received from the law firm, but the South African Revenue Service (SARS) disallowed these deductions to which the taxpayer then objected.

Issue

The key issue was whether the taxpayer is entitled to deduct from the interest income earned on the Firm Loan Account, a portion of the interest incurred on the Home Loan. This would depend on whether the interest was incurred in the production of income, in terms of s11(a) of the Income Tax Act, No 58 of 1962 (Act).

Judgment

One of the requirements to claim an expense as a deduction, is that the expense must be incurred in the production of income in terms of s11(a) of the Act. The taxpayer’s case largely relied on Practice Note 31 (PN 31), which states that even if a person does not carry on a trade as a moneylender and that any expenditure incurred in the production of such interest cannot be allowed as a deduction, it is nevertheless SARS’s practice to allow expenditure incurred in the production of the interest to the extent that it does not exceed such income. PN 31 states that the “…practice will also be applied in cases where funds are borrowed at a certain rate of interest and invested at a lower rate. Although, strictly in terms of the law, there is no justification for the deduction, this practice has developed over the years and will be followed…”

In the court’s view, interest earned on capital or surplus funds invested, as contemplated in paragraph 2 of Practice Note 31, contemplates interest earned on capital or surplus funds which would have accrued to the investor. However, once such capital or surplus funds are received, the investor, of his own volition, invests such capital or surplus funds on interest and, any interest incurred as a consequence of investment of such capital or surplus funds, is incurred in the production of interest income from the capital or surplus funds so invested. The court referred to the judgment in PE Electric Tramway Company Limited v CIR 1936 CPD 241, where it was held that expenditure has been incurred in the production of income, if the expenditure is so closely related to the trade that it can be said that it is part of the costs of running the business. It also referred to the judgment in CIR v Genn & Company (Pty) Ltd 1955 (3) SA 293 (A), where it was held that one must look at the purpose of the expenditure and to what it actually effects to determine whether the expense was incurred in the production of income. Lastly, the court referred to the judgment in Commissioner for Inland Revenue v Standard Bank of South Africa Ltd 1985 (4) SA 485 (A), which the taxpayer relied on to argue that a portion of the interest on the Home Loan was deductible. In the latter case, the court found in favour of Standard Bank, but also stated that to determine whether interest was deductible, “…a distinction may in certain instances have to be drawn between the case where a taxpayer borrows a specific sum of money and applies it to identifiable purpose, and the case where, the taxpayer borrows money generally and upon a large scale in order to raise floating capital for use in his (or its) business.”

On the facts of the current matter, the court held that the taxpayer acquired the Home Loan for purposes of purchasing his residence and that this was an instance where the money was borrowed for an identifiable purpose, as stated in the Standard Bank judgment. The proceeds of the Home Loan were utilised for the payment of the purchase price. That was the taxpayer’s intention in acquiring the Home Loan and there is no indication on the record of evidence of a change of intention or, if his initial intention had changed at some point, at what point there was a change of intention. Therefore, the interest paid on the Home Loan was incurred in the acquisition of a capital asset and, as such, the expenditure thus incurred was expenditure of a capital nature as it was not borrowed for the purpose of earning interest income. The expenditure also did not have the effect of earning interest income. The court pointed out that although the taxpayer changed the Home Loan from a bond account into an access facility over time, he could not prove that the purpose of the Home Loan was to earn interest from the Firm Loan Account.