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MARCH 2011 BusinessDay
12
Business Law & Tax Review
IN PRACTICE
Tie between dividends and loans a tax issue
A
Peter Dachs &
Bernard du Plessis
SARS attempts to link loan
money to a dividend
declaration to make the
interest cost nondeductible
N OFTEN misunderstood
aspect of tax law is the
relationship between a
company borrowing
funds and declaring
dividends. This is illustrated by the
plethora of case law on this particular
topic.
The battle lines are clearly drawn
— the South African Revenue Service
(SARS) attempts to link the
borrowing of money by a company to
the dividend declaration. If it
succeeds then the interest cost is not
deductible, since it is not incurred in
order to produce income but rather
to declare the dividend.
The taxpayer company argues
that it had excess cash which it used
to declare a dividend to its
shareholders. It then subsequently
needed to borrow funds for the
purpose of running its business
operations. Therefore the interest
cost is linked to the income earned
by the company from running its
business operations and is deductible.
In the three main cases on this
topic the taxpayer is a short neck
ahead, with two cases being decided
in favour of the taxpayer. However,
various court cases have gone all the
way to the Supreme Court of Appeal
in Bloemfontein. In order to avoid a
trip to that city we illustrate below
the main principles that should be
applied when a company considers
borrowing money around the time of
declaring a dividend.
In Giuseppe Brollo Properties
(Pty) Ltd the court summarised the
principles as follows:
“In a case concerning the
deductibility or otherwise of interest
payable on money borrowed, the
enquiry relates primarily to the
purpose for which the money was
borrowed. That is often the
‘dominant’ or ‘vital’ enquiry, although
the ultimate user of the borrowed
money may sometimes be a relevant
factor. Where a taxpayer’s purpose in
borrowing money upon which it pays
interest is to obtain the means of
earning income, the interest paid on
the money so borrowed is prima facie
an expenditure incurred in the
production of income ... If on the
other hand the purpose of the
borrowing was for some other
purpose than obtaining the means of
earning income, the interest is not
deductible.”
In the Ticktin Timbers CC case it
was held that the purpose of the loan
was to enable a dividend to be paid
to Dr Ticktin, as without the loan
there would have been no dividend
and without the dividend there would
have been no loan. The court
therefore held that the interest was
not deductible in the hands of the
taxpayer.
The Supreme Court of Appeal in
this case found that the making of
the distribution and the making of
the loan were not separate and
unconnected transactions but
interdependent, and neither was
intended to exist without the other.
The Scribante case stands in
contrast with the Ticktin Timbers CC
case. In the Scribante case it was
held that the purpose of the loan
back from shareholders of money
which the company did not need was
to enhance the already healthy
position of the company by advancing
its financial profile so as to obtain
future business expediently and, in
addition, to earn interest for the
company.
In the BP case the taxpayer had
declared a dividend to its holding
company and simultaneously entered
into a loan agreement. At the time of
the declaration of the dividend the
company had cash reserves
significantly in excess of the dividend.
The court held that it seemed
conceivable that a company may be
borrowing money to fund a dividend
notwithstanding the fact that it has
resources available to enable it to
continue its income-earning activities.
The court proceeded on the basis
that it nevertheless had to be
determined whether the purpose of
the loan was to enable the dividend
to be paid or whether the purpose
was to provide BPSA with the liquid
funds required to enable it to pursue
its income-earning activities. In the
determination of the purpose of the
loan, the intention of the taxpayer
company, as evidenced by its
financial director, was critical.
The following principles can be
distilled from the case law above:
■ The purpose for which the money
was borrowed must be determined.
■ If a dividend is declared and a loan
agreement is simultaneously entered
into by a taxpayer, this does not by
itself mean that the interest on the
loan is not deductible. It is still
necessary to determine the purpose
of the loan.
In the
determination of
the purpose of the loan,
the intention of the
taxpayer company, as
evidenced by its
financial director, was
critical
■ The purpose of a company in
obtaining a loan is a question of fact
and regard will be had to the
intention of the company. The
intention of the directors, being those
who collectively represent the
directing mind and will of a
company, becomes critical.
■ In determining the purpose of the
loan our courts gave much
consideration to whether sufficient
cash was available to pay the
dividend and still be able to conduct
its normal trading activities without
the loan. However, this factor is not
decisive and it should still be
determined whether the dividend and
the loan are interdependent and
whether the intention is that they can
exist without each other.
■ Another factor that our courts
have regarded as being relevant was
whether the income-earning capacity
of the taxpayer declaring the
dividend has been increased by the
loan funding obtained.
In conclusion, if a company wants
to be sure that it will not incur the
ire of SARS it should follow the
principles set out below.
The purpose of the loan should be
to enable the company to carry on its
business operations and not to pay
the dividend.
In this regard it is important that,
from a factual perspective, it can be
demonstrated that the company has
sufficient cash available to pay the
dividend and to continue its business
operations without an immediate
need to procure finance by way of a
loan.
It should factually also be the case
that, absent the loan, the dividend
would still have been paid.
The loan should then be raised to
the extent that the company has a
need to fund its future business
operations.
■ Peter Dachs and Bernard du Plessis
are tax directors at ENS.