Tax Implications Of Certain Company Distributions
02 September 2013
Posted by: Author: Ben Strauss
Author: Ben Strauss (CliffeDekkerHofmeyr)
The interaction between the tax law and company law rules relating to corporate distributions gives rise to interesting issues.
Consider the following example:
The simplified balance sheet of Company A is the following:
|Share Capital||R 1 000|
|Retained Income||R 100|
|R 1 100|
|Cash in Bank||R 1 100|
|R 1 100|
The sole shareholder of Company A is Company B. Both companies are tax residents in South Africa. Company A wishes to make a distribution to Company B in the amount of R250.
Now, if Company A funded the distribution out of share capital, Company B would need to account for capital gains tax (CGT) – see below. However, if Company A funded the distribution out of retained income, the distribution would be a dividend and would be free of income tax or dividends tax in the hands of Company B – see below.
If Company A funded the distribution out of retained income, the simplified balance sheet of Company A after the distribution would be the following:
|Share Capital||R 1 000|
|Retained Income||(R 150)|
|Cash in Bank||R 850|
In other words, Company A will have negative retained income after the distribution.
The question that I address here is whether that course of action is possible. In other words, is it workable for a company to fund a distribution out of retained income if it does not have sufficient retained income but does have sufficient share capital?
The term dividend is defined in s1 of the Income Tax Act, No 58 of 1962 (Income Tax Act), to the extent that it is relevant, as –
"any amount transferred or applied by a company that is resident for the benefit or on behalf of any person in respect of any share of that company, whether that amount is transferred or applied –
(a) by way of a distribution made by;
that company, but does not include any amount so transferred or applied to the extent that the amount so transferred or applied –
(i) results in a reduction of contributed tax capital of the company;…"
The term 'distribution' is not defined in the Income Tax Act. I submit that, as the term is used in relation to a company, one should have regard to the definition of 'distribution' in the Companies Act, No 71 of 2008. The definition of the term 'contributed tax capital' in the Income Tax Act is complex. For present purposes, the contributed tax capital (CTC) of a company is its share capital or stated capital.
Until the end of the previous century, under the capital maintenance rule, a company was only allowed to distribute funds to shareholders from distributable profits. However, now a company is allowed to make any distribution, including a distribution from its share capital, as long as it meets certain requirements, notably the solvency and liquidity test. Put simply, under that test a company may make a distribution if its assets exceed its liabilities and if it will in the near future be able to pay its debts as they arise.
To return to our example above, from a company law perspective(unless its memorandum of incorporation prohibits this) the directors of Company A would be able to make a distribution funded from retained income as opposed to share capital as long as the company meets the solvency and liquidity test. From a tax perspective, unless the directors determine that the amount of the distribution is funded from CTC, the distribution will not result in a reduction of CTC and will be considered to be a dividend.
In terms of s10(1)(k) of the Income Tax Act a dividend is exempt from income tax, subject to exceptions. In terms of s64F(1)(a) of the Income Tax Act a dividend paid to a tax resident company is also free of the dividends tax. Accordingly, Company B will suffer no tax if the distribution is funded out of retained income. However, had the directors determined that the distribution was funded from CTC then, while the distribution will not have had immediate CGT consequences, it will have consequences for Company B in future: it will have to add the amount of the distribution to the proceeds when it disposes of the shares in Company A.
Does the above course of action constitute an impermissible scheme to avoid tax? In my view, the answer is no. One of the requirements of the general anti-avoidance provision contained in s80A of the Income Tax Act and further is that the sole or main purpose of the arrangement must be to obtain a tax benefit. If the company is simply making a distribution to shareholders and choosing to do so otherwise than from CTC, the purpose of the arrangement would not be to obtain a tax benefit – it would be to make a distribution.
However, the position may well be different in the case where such a distribution is done in conjunction with other arrangements such as a sale of shares. In this context, the following principles and provisions should also be borne in mind.
It is trite that if a company borrows money to pay a distribution to shareholders, the interest on the loan will not be tax deductible as the funds will not be applied in the production of income. Section 22B of the Income Tax Act and paragraph 43A of the Eighth Schedule to the Income Tax Act attempt to prevent so-called 'dividend stripping'. Put simply, the provisions state that if the shares in a company are being sold; and if that company as part of the sale arrangement borrows money from the purchaser of the shares; and if that company then declares a dividend which is free of taxes in the hands of the seller – then the dividend will have income tax or CGT consequences, as the case may be, for the seller.
Paragraph 19 of the Eighth Schedule is aimed, among other things, at preventing losses that arise on the disposal of shares if the seller received extraordinary exempt dividends (that is, dividends exceeding 15% of the proceeds of the disposal) within an 18-month period preceding the disposal. It is apparent that making a distribution is not a simple affair, both from a tax law and company law perspective. In particular, companies and their shareholders should obtain advice when a distribution is made in conjunction with another transaction such as a sale of shares.
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