Tax on profit-sharing loan arrangements


By Pieter van der Zwan

Sections 8F and 8FA contain re-characterisation rules relating to hybrid debt instruments and hybrid interest. Binding Private Ruling 263 (BPR263) deals with a scenario that section 8FA applies to. The proposed transaction is a good example of an arrangement that is subject to the hybrid interest rules. In addition, the ruling highlights a critical aspect to be considered in the determination as to whether the provision applies or not.

Arrangement and proposed transaction

The applicant, an investment bank (investor), is in the business of granting credit facilities and advances loans to its clients. The co-applicant to this ruling is a borrower who required funding for a project undertaken as the owner-developer of a shopping centre. The investor and borrower concluded senior loan and mezzanine loan agreements, both of which were interest-bearing. Part of the consideration that the investor earned for making available the funding was concluded in the form of a profit-sharing agreement. From the information available in the ruling it appears as if the focus of the profit-sharing arrangement is on gains realised upon the disposal of the property developed using the borrowed funds. The profit-sharing arrangement also applies to the sale of the shares in the co-applicant company. The profit sharing formula is not provided in the ruling. The ruling however indicates that the amount is determined based on a combination of expected future values of the property and the returns expected to be generated by the borrower using the funding from the investor.

Ruling issued by SARS

The re-characterisation rules in section 8FA apply to interest, as contemplated in section 24J, in respect of debt. With the exception of specific items that are not relevant in this instance, the definition in section 24J does not provide much further assistance as it includes gross interest without further defining this term. Broadly speaking, interest is the consideration paid for the use of another person’s funds. The ruling starts by confirming that the profit-share amount constitutes interest as defined in section 24J. As with most of the rulings the rationale is not provided, only the outcome. It is submitted that this is likely to have been a factual question relating to the connection between the funding and profit share arrangement. As the profit share, which falls within the definition of interest, is not determined with reference to a specified interest rate or the time value of money section 8FA applies.

The ruling confirms the following effects of the re-characterisation rules in section 8FA:

  • The profit share amount is deemed to be a dividend declared and paid by the borrower and received by the investor.
  • The deemed dividend is not deductible in the hands of the borrower.
  • The deemed dividend may be exempt from dividends tax if the necessary documentation is submitted to the borrower by the lender.

The investor’s treatment is complicated by the fact that it applies section 24JB, which links the tax impact of the arrangement to accounting treatment.

Broader relevance of this ruling

Borrowers should be aware of the re-characterisation rules when negotiating terms with funders. Failure to do so can result in unexpected non-deductible payment(s) , which have a significant impact on project cash flows, especially if the non-deductible payments occur regularly throughout the funding period.