National Treasury released a drastic proposal in the Draft Taxation Laws Amendment Bill 2011 (“the Bill”) on 2 June 2011, to wholly suspend the intra-group relief afforded in terms of section 45 of the Income Tax Act with immediate effect amidst concerns that the section was being abused by taxpayers utilising the provision as part of “debt push-downs” which, Treasury believed, generated inflated interest deductions.  There were also concerns that the section has been used to transfer assets to companies with assessed losses.

Section 45 allows the transfer of assets within a group of companies tax-free. The section gives companies “roll-over relief” and facilitates transfers between group companies.

The “suspension” of section 45 would have been affected, with retrospective effect, companies that “concluded” their section 45 transactions on or after 3 June 2011. National Treasury has now proposed a revised amendment which serves to address its concerns without suspending the section 45 relief. However, the new proposal not only affects section 45 (intra-group) transactions from 3 June 2010, but also section 44 (amalgamation transactions) and section 47 (liquidation distributions) transactions entered into after 3 August 2011.

National Treasury has proposed an approval process for transactions that make use of “excessive” debt. Legislation will be introduced to control the interest deductions associated with debt used to fund the acquisition of assets in section 44, 45 or 47 transactions. Transactions will be classified as either-

• a “green channel” transaction under which interest expenditure is automatically permissible as a tax deduction; or;
• an “amber channel” transaction which will require the approval from SARS to for the interest tax deduction to be allowed.

In the media statement released by National Treasury on Wednesday 3 August 2011, Minister Pravin Gordhan shed some light on what would be classified as “green transactions” and “amber transactions”:

“Green transactions: Sections 44, 45 and 47 reorganisations that do not involve interest-bearing debt will be able to use the relief without approval by SARS. Preference shares will also be allowed as permissible funding mechanisms for section 45 transferred assets. However, the tax cost associated with intra-group debt and preference shares will be subject to tighter restrictions.

Amber transactions: Sections 44, 45 and 47 reorganisations that utilise interest bearing debt will fall into the amber category. Amber transactions will fall within two broad groups. Firstly, if the interest-bearing debt associated with these transactions is funded within the group of companies and results in no revenue loss (or the possibility of loss), automatic pre-approval is envisioned. Secondly, a discretionary approval process will apply only if the interest-bearing debt within the arrangement may result in a revenue loss. The decision to approve or deny will depend on the impact of the interest to be incurred on the tax payable by the debtors and creditors acting as parties to the debt as well as the debt versus share features of the debt.”

At issue for obtaining this pre-approval is whether the incurral, receipt or accrual of interest will lead to a significant erosion of the tax base.

The “criteria” for the determination will be based on Ministerial regulations. At this stage, following criteria has been identified:

• the tax impact of the tax payable by the financier;
• the terms of the debt used to finance the “reorganisation” asset acquisition;
• the debt versus equity features of the debt used to finance the “reorganisation” asset acquisition -  specifically if the reorgnisation transaction:
• is financed at higher than a 1 to 1 debt to share ratio;
• results in higher debt levels for the transferee subsequent to the reorganisation transaction than the debt levels of the transferor before the reorganisation transaction;
• results in low projected coverage of interest expenses by earnings before interest, tax, depreciation and amortisation;
• or was financed by debt bearing interest at rates exceeding market rates of interest;
• the tax versus commercial purpose of the transaction; and
• the nature of the debt instrument used by the acquiring company to finance the reorganisation transaction having regard to:

•  conditions associated with the rate and amounts of interest payable:
•  the terms of repayment of the debt;
•  whether any portion of the debt is subordinated by its creditors;
• any security or guarantee provided by any person who is a connected person in relation to the acquiring company; and
• alternative financing options which were considered for the reorganisation transaction.

The media statement mentions that the approval process will be temporary and a clearer approach will be implemented in the future.

Although the suspension of section 45 has been lifted, the denial of tax deductions for interest expenditure will retain the 3 June 2011 effective date for interest-bearing debt arising from section 45 transactions.

The proposal for interest-bearing debt arising from section 44 and 47 transactions will apply from 3 August 2011.

The statement released from National Treasury accompanying the announcement that section 45 would not be suspended suggests that Treasury admits that the approach in June may have been too broad. However, it is clear that the new proposed amendments will have even more far reaching implications as the denial of tax deductions for interest will be also apply to transactions concluded in terms of section 44 and section 47 of the Income Tax Act.