By: Mark Linington - Executive Tax, Bowmans

Government efforts to stimulate private sector investment in major infrastructure projects could be stymied by the unintended consequences of limiting the interest that certain project companies can deduct on their debt.

Of particular concern is where an infrastructure fund, which is structured as a limited partnership, is partly funded by tax exempt investors such as pension funds.

It is likely that the project companies in which the infrastructure fund invests may not get a tax deduction for the interest incurred on all the debt required to develop the project. The problem is the current definition of a ‘connected person’ read with section 23M of the Income Tax Act.

According to this definition, any partner in a partnership is a connected person in relation to the other partners. This includes limited partnerships where the partners come together for a specific purpose, such as to invest in companies that develop infrastructure projects.

If the shareholdings of all the connected persons in such a partnership add up at 50% or more in the project company, the project company suddenly becomes subject to the section 23M limitation on the amount of interest that it can deduct for income tax purposes. This is because they are supposedly in a controlling relationship with the project company – even if the exempt investor has a stake significantly below the 50% level.

All the shareholders of the project company are hurt by the disallowance of the interest deduction, including the black economic empowerment shareholders. This puts financial strain on the project company, as the cash it must now pay to the South African Revenue Service (SARS) is not available to settle the debt, and its effective rate of income tax becomes higher than the normal 27%.

Collateral damage

It is unlikely this was the intention behind the ‘connected persons’ concept and the 30% interest deductibility limitation. In a sense, there is collateral damage where infrastructure funds are structured as limited partnerships, and the partners include pension funds.

The original targets of the 30% limitation on interest deductibility were foreign-owned companies whose immediate holding companies were in tax havens. These companies have been known to levy big interest income on shareholder loans to their subsidiaries in South Africa and strip the tax base here by deducting the interest on all the debt.

The Minister of Finance acknowledged in the 2024 budget review that partners in limited partnerships were being affected by the ‘wide ambit’ of the connected persons net. As a solution, he proposed that the status of connected persons in relation to a ‘qualifying investor’ be reviewed in the definition of connected person in the Income Tax Act.

The South African Revenue Service (SARS) did duly introduce a change to the connected persons definition. However, this change was negligible and has made little, if any, difference to the situation of pension funds participating in infrastructure funds in the form of limited partnerships.

The tax implications are serious and may very well deter other investors from investing in infrastructure project companies.

With South Africa in desperate need of infrastructure development, the time has come to effect a proper change to the 'connected person' definition in section 1, or to section 23M of the Income Tax Act – a change that will relieve infrastructure project companies of the additional, unwarranted tax burden they are currently carrying.