Issue of Shares As Consideration
01 October 2013
Posted by: Author: Natalie Napier
Author: Natalie Napier (ENS)
In order for the ownership of assets to pass from a seller to a buyer it is necessary that the parties agree three essential elements: price, terms and structure. These three elements are interdependent in any transaction. For instance, after agreeing the price of a transaction, i.e. the number of rands or rand value of other consideration the seller will receive, the parties will need to agree the terms such as whether the price will be paid by means cash, debt and/or shares as well as the timing of these payments.
Commercial transactions can be structured on the basis that instead of a cash payment for the acquisition of an asset, shares are issued by the purchaser in favour of the seller, usually referred to as an "asset for share” transaction. The issue of shares as consideration will give rise to a number of tax consequences which should be considered carefully before implementing the proposed transaction. Thus, after agreeing the price and the terms the parties will need to agree the structure of the transaction, namely, whether it should be structured as a taxable or a tax-deferred transaction. That careful consideration should be given to these matters is particularly the case given the ever changing tax legislative provisions.
Of particular relevance in a taxable transaction where shares are issued as consideration for the acquisition of assets are the anti-avoidance provisions addressing value mismatches. Complex tax systems such as South Africa’s invite taxpayers to carry our certain transactions by according them special tax advantages. Yet, attempts to access these advantages might be susceptible to challenges under the general anti-avoidance rule because the transaction was motivated, at least in part, by the desire to access the tax advantage, or legislative amendments might be enacted to block such tax advantages.
According to National Treasury, schemes which allowed for shares to be issued in exchange for assets where there is a mismatch in their respective values did not trigger the appropriate amount of tax. The Income Tax Act contains a number of provisions stipulating that in specific circumstances the disposal of assets will be deemed to take place at market value. For example, paragraph 38 of the Eighth Schedule contains a deemed market value provision in circumstances where an asset is disposed of by means of a donation, for a consideration not measurable in money or for a price that is not arm’s length between connected persons. Where a formal connected person relationship is absent the buyer and seller could easily structure their transaction to fall outside the paragraph 38 market value deeming provisions.
Therefore, the anti-avoidance provisions are not limited to the Eighth Schedule. Additional anti-avoidance provisions have been inserted in the Income Tax Act to address circumstances where value is transferred without triggering the appropriate tax, specifically where the parties concerned are not "connected persons”.
- Section 40CA provides that if a person acquires an asset in exchange for shares, that person is deemed to have incurred expenditure in relation to the acquisition of the asset equal to the market value of the shares issued as consideration immediately after the acquisition.
- Section 24BA applies where a company acquires an asset in exchange for the issue of shares by that company and the consideration differs from the consideration that would have applied between independent persons dealing at arm’s length. If there is any mismatch in market values of the assets disposed of and the shares issued as consideration for the acquisition of the assets, then section 24BA addresses any such mismatch on the basis set out below.
- Where the market value of the assets immediately before the disposal exceeds the market value of the shares issued in consideration immediately after their issue the amount of the excess must be deemed to be a capital gain.
- Where the market value of the shares issued in consideration immediately after that issue exceeds the market value of the assets immediately before the disposal the amount of the excess must be deemed to be a section 64D dividend that consists of a distribution of an asset in specie.
A number of questions arise from the application of the above sections in practice.
How is the market value determined?
The Income Tax Act does not define market value in any general provision. Instead there is a definition of market value for the specific purpose of capital gains tax. That provision defines market value as the price which could have been obtained upon a sale of the asset between a willing buyer and a willing seller dealing at arm’s length in an open market. The South African Revenue Service has indicated that the open market value of an asset is the best price at which an interest in the asset would have been sold unconditionally for a cash consideration assuming, amongst others, that there is no duress, that a period has elapsed for the marketing of the interest and for the sale to be concluded and that both parties to the transaction acted knowledgeably, prudently and without compulsion.
The Income Tax Act does not prescribe which valuation methodology is the most appropriate when valuing unlisted shares. It is nevertheless likely that the South African Revenue Service will expect that a number of factors that may affect the shares’ market value be taken into account -
- the use of a valuation method will have to be explained and demonstrated why it is an appropriate method;
- adjustments for factors such as liquidity (at the holdings level) and degree of control and to show that these adjustments are appropriate (for instance it might be possible to benchmark a minority interest in an unlisted company against a listed company operating in a similar environment); and
- the rights of other equity and debt holders (which may influence the market value of an ordinary share).
When will the market value be determined?
Interestingly, section 24BA refers to the market value immediately before the disposal of the asset and section 40CA refers to the market value immediately after the acquisition. The taxpayer should therefore appreciate that the timing for determining the market value may be different depending on the relevant section concerned.
Is there any order of preference in the application of the relevant sections?
The latest draft amendments to the Income Tax Act clarify that if paragraph 38 is applicable, then section 24BA will not be applicable. The taxpayer concerned will therefore have to consider both provisions to determine which will be applicable to the transaction in question.
Taxpayers will be well advised to perform a tax due diligence to ascertain the implications of entering into a transaction of this nature. The taxpayer’s commercial requirements will have to be reconciled with the tax consequences. For instance, the taxpayer may seek to minimise any capital gains tax payable or ensure that the base cost of any assets acquired is as high as possible. However, these tax requirements may not always be easily achievable given the surrounding factual circumstances when considered in conjunction with the anti-avoidance provisions contained in the Income Tax Act.
This article was first published on ens.co.za