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Time to consider the terms of company loans carefully

28 January 2014   (0 Comments)
Posted by: Author: Pieter van der Zwan
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Author: Pieter van der Zwan

The 2013 tax amendments contain a number of provisions dealing with the deductibility of interest. This includes the introduction of ss 23M and 23N that limit the amount of interest that can be deducted in respect of loans to connected persons in whose hands the interest is not subject to tax and in respect of loans to fund certain acquisition transactions. The application of these two sections is likely to be limited to entities that enter into transactions falling within the narrow definitions. The amendments also include a revamp of s 8F and the introduction of s 8FA, both dealing with hybrid debt reclassification. The scope of ss 8F and 8FA is rather wide. As a result it would be wise for all companies that are funded by loans to be aware of this amendment and to consider the effect on such loan agreements. This article aims to provide an overview of the amendments relating to hybrid debt instruments and hybrid interest as well as an initial discussion of certain aspects of these sections that taxpayers need to pay careful attention to.

Background to the developments 

Interest incurred in respect of a loan is generally deductible, provided that the requirements of s 24J(2) are met. The interest that accrues to the lender is included in its gross income under s 24J(3) and may in some cases be exempt. Dividends on the other hand are not deductible when paid by the company and may be subject to dividends tax at a rate of 15% in the hands of the recipient. An exception to these principles is hybrid debt instruments. Section 8F effectively requires a re-characterization of interest incurred by stating that no deduction is allowed in respect of these instruments (similar to the treatment of dividends paid in respect of equity instruments),  Instruments currently affected by this section (prior to its amendment) are those that have the form of debt but contain certain equity conversion features.

These conversion features have to however be exercisable within three years from the date of issue for a reclassification to be required. There are some instances when the tax treatment of a loan may be more favourable than the treatment resulting from an equity instrument. This includes cases where the interest would be deductible in the hands of the borrower (where the dividends would not) and may not be taxed (or at least not fully taxed) in the hands of the lender. This situation could arise if the lender is exempt from tax (entities such as pension funds whose receipts and accruals are exempt (s 10(1)(d (i)), where interest accrues to natural persons (directly or via trust distributions) that is partially exempt under section 10(1)(i) or where interest accrues to a non-resident that is exempt under section 10(1) (h). It may also be that the lender is in an assessed loss position and an interest deduction in the hands of the borrower effectively moves otherwise taxable profits to the lender that possesses the loss where those profits will not be subject to tax immediately. Lastly, there may be cases where interest would be tax neutral, as a result of the deduction in the hands of the borrower and inclusion in the hands of the lender, where dividends may not be neutral as a result of being subject to dividends tax.

The purpose of section 8F is to counteract the misuse of instruments that have the form of a loan (to obtain the favourable treatment of interest as discussed above) but contain certain equity features. The equity features under the current section are limited to conversion features. The key weakness of this section is probably the fact that its application can be circumvented rather easily by ensuring that the conversion rights are only exercisable after a period of three years from the date of issue of the instrument.

The revised s 8F and newly introduced s 8FA deal with the concern relating to equity instruments disguised as loans by considering the features of the instrument as whole (s 8F) as well as the yield on the instrument (s 8FA) more comprehensively. These sections take effect from 1 April 2014 and apply in respect of amounts (interest) incurred on or after that date. As the sections apply to interest incurred after this date, as opposed to instruments entered into after that date, it would also apply to instrument issued prior to 1 April 2014. This may require a careful evaluation of the terms of existing debt instruments.

Consequences of classification as a hybrid debt instrument or hybrid interest

The treatment of interest under both ss 8F and 8FA is similar. Unlike its predecessor, these sections require re-characterization in the hands of both parties to the affected instrument. In the hands of the borrower (according to the legal form of the interest-bearing arrangement), no deduction is allowed in respect of interest. As the interest resembles a dividend, both these sections deem the interest to be a dividend in specie paid by the company. As such, the issuer will be liable for dividends tax (if any) under s 64G. Dividends in specie may however qualify for an exemption from dividends tax in the instances listed in s 64FA, provided that the requirements of s 64G(2) are met. These sections lastly also deem the interest accrued to be a dividend in specie that accrues to the lender. This opens up the dividend exemption in s 10(1) (k), which would mean that unlike interest, the amount is not included in the lender’s taxable income.

Classification as hybrid debt instrument or hybrid interest 

The following diagram illustrates the aspects of the definitions in ss 8F and 8FA to be considered to determine whether the interest on a loan is affected by these sections: (if an instrument meets any of the requirements in A – E, the interest will be re-characterized as discussed above). 


A number of observations can be made from the definitions depicted in the diagram. Firstly, the provisions of both sections only apply in respect of debt owing by a company. Loans owing by other forms of taxpayer, for example trusts, would not be affected. It should furthermore be noted that, except for the 30 year period mentioned in requirement C in the diagram, none of the features are linked to timeframes that can be manipulated. The assessment as to whether an instrument meets any of these criteria is a continuous assessment. The 30 year redemption period mentioned is also a rolling 30 year period that is reconsidered from the end of every year of assessment that the loan is outstanding. Any structuring of an instrument to avoid hybrid debt instrument or hybrid interest classification would therefore require the substance of the terms of the loan, rather than merely the timing of the exercise of rights, to be reconsidered.

Conversion rights (Requirement A)

Convertible loans or bonds are likely to fall into this category. These instruments may be used for a number of reasons other than disguising equity instruments as loans for tax purposes. These purposes include lower interest rates compared to vanilla bonds or loans as well as providing a company with some flexibility in raising finance. Para (a) of the definition of ‘hybrid debt instrument’ contains an important conversion feature not covered by the definition in s 8F that should be noted when structuring these instruments. This paragraph refers to a conversion feature in terms of which market value of the shares to be issued at the time of conversion is equal to the amount owing in terms of the instrument. This means that a conversion feature which allows settlement in shares to the equivalent value of the outstanding debt, rather than conversion to a fixed number of shares which is not linked to the debt amount, should not result in a reclassification of the instrument.

30-year redemption rule (Requirement C)

This criterion is based on the view that a loan which is unlikely to be repaid after a substantial period of time assumes the nature of the equity, in particular when it is advanced to a company by a connected person (in most cases a shareholder who already holds an equity stake in the company). Shareholder or related party loans that have been advanced without the parties agreeing on any detailed terms (including repayment terms) may pose a specific reclassification risk here. An exception to this requirement, which is likely to save most of these loans from reclassification, is that the 30-year rule does not apply to instruments that are payable on demand.

It is a well-established principle in common law that a loan where no specific repayment terms have been agreed is repayable as soon as it has been incurred (see amongst other Praesidium Capital Management (Pty) Ltd v Kay-Davidson (17332/2010) [2010] ZAWCHC 531)). It is therefore submitted that the 30-year rule will only apply to loans that explicitly allows for repayment after a period of longer than 30 years, rather than loans with no explicit repayment terms as this is considered to be repayable on demand. An aspect on which the legislation is less clear is what the impact of a possible extension of the repayment period would be. As the classification is based on the fact that the company "is not obliged to redeem the instrument within 30 years”, there may be grounds to argue that the possible existence of an obligation to redeem within the 30 year period, should the extension not be granted, may be sufficient to fall outside the scope of s 8F. This would however depend on the exact terms and conditions of the extension clause.

Conditional repayment (Requirement B)

An essential characteristic of equity, as compared to debt, is that debt must be serviced irrespective of the performance of the company while this is normally not the case with equity. It is submitted that requirement B is based on this premise. Despite the principle that a loan without specific repayment terms is repayable on demand under common law (as discussed above), it was held in the case of Stockdale & Another v Stockdale 2004(1) SA 68 (C) that the obligation to make repayment in a case where no payment terms have been agreed must be considered in light of the circumstances of the particular case. In that case, which dealt with prescription of a debt, it was held that a debt without specific repayment dates could not be considered due under the circumstances as the lender could not reasonably have expected to demand payment as she was aware of the fact that the borrower would not have been able to perform.

This would suggest that repayment of a loan by a person to a company which is not in the position to repay such a loan at the time of advancing it, may in certain circumstances by implication be conditional upon the ability of the company to repay the loan. This consideration does however not necessarily imply a condition that a company must be solvent before repayment can be demanded. It is therefore submitted that in many cases, the circumstances under which a loan is advanced may not imply a condition as specific as the one in Requirement B as this may only be one of the factors that impact on the borrower’s ability to repay a loan.

Nature of the yield (Requirements D and E)

The wording of the definition of ‘hybrid interest’ in s 8FA leaves room for interpretation and could possibly result in some uncertainty in practice. The section states that hybrid interest means:

"(a) any interest where the amount of that interest is—

i) not determined with reference to a specified rate of interest; or

(ii) not determined with reference to the time value of money.”

The uncertainty involves the phrase ‘any interest’. It could be argued that the definition refers to any amount of interest which is not determined with any reference to a specified interest rate or the time value of money. As the definition does not state that the interest must be determined solely with reference to these two aspects, it can be contended that where a total amount of interest based on a specified rate as well as some other basis, this interest would not be hybrid interest. Alternatively, it could however be interpreted that any part of the total interest amount which is not determined with reference to a specified rate or the time value of money would constitute hybrid interest. The question essentially comes down to whether the definition quoted above requires interest to be split into the components in its calculation or not. Unfortunately no further guidance is provided in the explanatory memorandum; it may however be wise to be aware of both interpretations and take this into account when structuring a loan that bears interest which is partly determined with reference to an underlying basis other than an interest rate or time value.

Exceptions to the rule

Sections 8F and 8FA contain similar exclusions in s 8F(3) and 8FA(3) respectively. These exclusions relate to regulated capital of banks and insurers as well as a temporary exclusion for linked units in certain property companies held by significant investors. Other companies are only excluded from the regime if the company that owes the amount in  respect of the debt is a small business corporation, as defined in section 12E(4)(a). At first glance this exclusion appears to provide relief to entities based on their size, as the title of section 12E would suggest. To some extent this is true as section 12E(4)(a)(i) considers an entity’s turnover (which is likely to be an indication of size) as a criteria. It must however be realised that a number of other factors that do not necessarily relate to the size of an entity, but which were rather included in the definition of a small business corporation to avoid misuse of the concession, could cause a small entity (based on assets or turnover) not to be a small business corporation and consequently having to consider s 8F and 8FA.

This includes the nature of its income (a small business corporation may not earn more than 20% of its income from personal service or investment income, a term which is defined in a relatively wide manner), the nature of the shareholders as well as the classification of the company as a personal service provider. It is therefore submitted that a small company with one or two shareholders would not necessarily be outside the scope of the provisions of s 8F and 8FA as a result of this exclusion.

Concluding thoughts

The above discussion suggests that companies, large and small, may be affected by ss 8F and 8FA. It would be wise to consider the impact of these provisions before 1 April 2014 when it comes into effect as a revision of the terms of loans, in particular shareholder loans, may be required where the terms of a loan arrangement were driven by commercial reasons without it being the intention of the parties to advance an equity type of loan.

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This article first appeared on the Jan/Feb edition of Tax Talk. 


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