This article was contributed by Benjamin Mbana (Partner), Michael Rudnicki (Executive – Tax), and Marvin Petersen (Senior Associate) at Bowmans.
The views expressed are those of the authors and do not necessarily represent Africa Tax Review.
SARS Clarifies Interest Deduction. South Africa’s tax authority has provided fresh clarity on the treatment of interest deductions in refinancing transactions involving preference shares.
In a recent Binding Private Ruling (BPR 424), the South African Revenue Service (SARS) confirmed that companies may, under certain conditions, deduct interest on debt used to replace preference share funding.
However, the ruling also introduces important limitations—particularly regarding the treatment of accumulated dividends—highlighting potential risks for taxpayers structuring refinancing arrangements.
In this expert analysis, tax professionals from Bowmans unpack the implications of the ruling and what it means for corporate tax planning in South Africa.
Background: The “Purpose Principle” in Tax Law
A well-established principle in South African tax law provides that where new debt replaces an existing loan, the purpose of the refinancing debt is determined by the original use of the funds.
This principle—commonly referred to as the “purpose principle”—ensures continuity in assessing whether interest on such debt is deductible, even when the legal structure of the financing changes.
However, a key question has been whether this principle also applies when debt replaces equity-type instruments such as preference shares.
SARS Clarifies Interest Deduction: SARS Guidance Under Binding Private Ruling 424
In Binding Private Ruling 424 (issued 6 February 2026), SARS addressed the tax treatment of interest where debt is used to redeem preference shares.
The ruling considered whether the purpose of capital principle applies when the original funding instrument differs in legal form from the refinancing instrument.
SARS accepted that where preference share funding was initially used for productive, income-generating purposes—such as construction and start-up costs—the new debt raised to redeem those shares may inherit that same purpose.
This means that, in principle, interest on such refinancing debt may be deductible.
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Key Limitation: Treatment of Rolled-Up Dividends
A critical aspect of the ruling relates to the treatment of accumulated (or “rolled-up”) preference share dividends.
In the case considered, the refinancing debt was used to settle both:
- The original preference share capital; and
- Accrued preference share dividends
SARS clarified that while interest on the portion of the debt used to redeem the original capital may be deductible, interest relating to the portion used to settle dividends will not qualify for deduction.
Why Dividends Are Not Deductible
The ruling reinforces three key tax principles:
- Dividends are not “interest” under section 24J of the Income Tax Act
- Dividends are appropriations of profit, not expenses incurred in generating income
- Dividends are capital in nature, and therefore not deductible under general deduction rules
As a result, any debt used to settle accumulated dividends is not considered to serve a productive purpose, and the associated interest is not deductible.
Apportionment Becomes Critical
Where refinancing debt is used to settle both capital and dividends, taxpayers must carefully allocate (apportion) the debt between:
- The original productive capital (potentially deductible), and
- Non-deductible dividend-related amounts
Failure to properly distinguish between these components could result in disallowed deductions and increased tax exposure.
Interaction with Anti-Avoidance Rules (Sections 8E and 8EA)
Although not directly addressed in BPR 424, the interaction with South Africa’s anti-avoidance provisions remains critical.
Sections 8E and 8EA of the Income Tax Act apply to “hybrid equity instruments” and “third-party backed shares,” particularly where preference shares exhibit debt-like characteristics.
If these provisions apply:
- Dividends may be recharacterised as income in the hands of investors
- The tax treatment of the financing structure may change significantly
The original classification and purpose of the preference shares will therefore influence the tax outcome of any refinancing.
Impact of “Qualifying Purpose” Rules
In some cases, preference shares may have been issued for a “qualifying purpose,” such as acquiring equity shares.
However, such investments often generate exempt dividend income, meaning they are not considered productive for tax purposes.
Where this is the case:
- Refinancing such preference shares with debt may result in non-deductible interest
- This could disrupt the intended tax efficiency of the financing structure
Section 24O: Limited Relief in Refinancing Cases
Section 24O of the Income Tax Act provides for interest deductibility in certain share acquisition transactions.
However, the provision is unlikely to apply in pure refinancing scenarios where:
- No new equity acquisition occurs
- Debt simply replaces existing preference share funding
Taxpayers should therefore not rely on section 24O as a fallback for interest deductibility in refinancing structures.
Key Takeaways for Taxpayers
The ruling provides important guidance for businesses considering refinancing preference share arrangements:
- Interest on refinancing debt may be deductible if the original funding was used for productive purposes
- Interest relating to debt used to settle accumulated dividends is not deductible
- Proper apportionment between capital and dividend components is essential
- Anti-avoidance rules under sections 8E and 8EA must be carefully considered
- Section 24O is unlikely to apply in most refinancing scenarios
Conclusion
Binding Private Ruling 424 provides useful clarity on the tax treatment of refinancing arrangements involving preference shares.
However, it also highlights the complexity of such transactions and the need for careful structuring.
Taxpayers are advised to assess the original purpose of funding, the composition of refinancing debt, and the potential interaction with anti-avoidance provisions before proceeding.
