COVID-19: DEFERRAL OF INTEREST PAYMENTS ON DEBT AND THE TAX IMPLICATIONS FOR LENDER AND BORROWER
The financial distress currently being endured by many South Africans as a result of the COVID-19 pandemic has been met with a positive response by some financial institutions permitting a deferral of the interest payments on borrowings.
These benefits in most instances merely defer the payment of interest, but the interest liability and the compounding effect thereof remain.
Tax implications for lenders
For lenders, in particular banks, the tax treatment of so-called ‘covered persons’ (defined to primarily include banks), is aligned with the accounting treatment for financial assets and liabilities. All amounts in respect of financial assets and financial liabilities that are recognized in the statement of comprehensive income and are measured at fair value in profit and loss in terms of IFRS 9 are included in taxable income (section 24JB of the Income Tax Act, 1962 (Act)).
This means that fair value gains and losses in respect of loans by banks recognized in the statement of comprehensive income will be included in taxable income. The effective yield on these loans will continue to accrue for accounting purposes and the tax impact will accord with the accounting treatment, regardless of the interest payment deferral.
The interest payment deferral, however, given the compounding effect on the total interest return for the bank as well as the objective factors relating to recoverability of the interest and capital, are likely to cause a credit impairment adjustment for the bank which will reduce the net increased interest income for accounting purposes.
The increase in impairment for accounting purposes, is specifically dealt with in section 11(jA) of the Act, for ‘covered persons’ which provides for a 25% deduction of the ‘loss allowance’ relating to impairment as contemplated in IFRS 9 and may be increased to between 40% and 85% depending on the greater the degree of impairment.
Tax implications for borrowers
The tax deductibility of funding costs for borrowers (particularly non-banks) is determined with reference to the effective yield or yield to maturity, which rate is applied to the debt instrument (section 24J of the Act). A yield to maturity or effective yield is calculated in terms of section 24J and has regard to the cash flows payable or receivable in respect of a debt instrument. In the context of a borrower, an amount in respect of a loan is payable if there is a liability to pay, even though the amount that is payable is in the future (Singh v C: SARS, 2003 (4) SA 520 (SCA), 65 SATC 203).
It seems that depending on how the deferral is contractually negotiated (whether interest or capital), the liability to pay will remain but will be payable later during the term of the instrument. This will mean that the yield to maturity calculation may increase, given the impact of the deferred timing of the respective payments.
The increase in yield should therefore be met with an increase in the tax deduction for the borrower. In contrast, to the extent that an interest ‘holiday’ is offered by a bank, the yield on the instrument will accordingly reduce, resulting in a lower interest obligation and accordingly a lower tax deduction. Furthermore, any reduction in liability relating to capital or interest will possibly result in negative tax consequences for borrowers.