Normally, if you borrow money in order to purchase assets that will produce income, the interest on the loan is a legitimate tax deduction. But what if you want to borrow money to buy shares from a fellow shareholder? The general advice you’re likely to receive about the tax consequences is that, because the product of shares is potential dividend income and capital growth as opposed to taxable income, any interest upon such loan is non-deductible.
This is not always true, however. In 1954, the owners of the Drakensburg Gardens Hotel Company (DGHC) sub-leased the hotel from the company and ran the hotel as a partnership. The land and buildings were owned by another company. In order to secure the leases and effect improvements, obtain control over the licences and increase rentals without having to obtain permission from third parties, the DGHC bought the shares of the land-owning company.
Money was lent and advanced to the DGHC and interest was charged upon the loan, which the company sought to deduct from its taxable income. Because the loan had in fact been entered into in order to secure the income of the company, the Appeals Court ruled in favour of the taxpayer. There were two reasons for the taxpayer’s success:
- The shares were bought to secure income, not to earn dividends.
- There was a very close connection between the earning of the income and the raising of the loan.
- These principles were confirmed in a 2001 case that came before the Cape High Court, Commissioner SARS v Van der Westhuizen.
Here, a close corporation member bought the other member’s interest by means of a bank loan, advanced to the close corporation against the security of land, and further advanced to the purchaser as a low interest loan upon which he paid tax as a ‘perk’.
Income stream
The member claimed the interest as a deduction. The High Court upheld his contention that he had bought the other member’s interest in order to gain full control of the income stream of the business. Counting in the taxpayer’s favour was the fact that his income doubled in line with his increased member’s interest. He was therefore able to show a close causal connection between the purchase of the member’s interest and the increase in income.
His sincere objective was the purchase of the full income stream by means of the acquisition of the member’s interest in the close corporation. And it should be kept in mind that he bought the member’s interest with funds he personally borrowed from the close corporation for that purpose.
Securing control
By contrast, in Natal Laeveld Boerdery (Edms) Bpk v KBI, it was found that the member in this case, who also bought the interest of his business associate, did so not with the primary view of increasing the income of the close corporation, but to gain full control of the running of the close corporation. In this case, the member didn’t personally borrow the funds that were required, but used the close corporation to borrow money with which he bought his partner’s interest, leaving him as the sole owner of the close corporation.
The taxpayer in the Natal Laeveld Boerdery case was therefore unsuccessful in obtaining a deduction in respect of interest on the loan used to buy the member’s interest. The general rule is this. The purchase of shares or members’ interest normally gives rise to dividend income. Because it’s not taxable, the interest upon a loan that’s gone into in the purchase thereof will not be deductible.The exception to the rule is one who can demonstrate that the shares or member’s interest were bought with a view to increasing or securing the income.
Peter O’Halloran is head of tax at BDO, Gaborone. Contact him on 00267 390 2779 or at [email protected]. Please state ‘Tax’ in the subject line of your email.
