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Subordinated Debt and Interest

31 March 2015   (0 Comments)
Posted by: Author: Louis van Manen
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Author: Louis van Manen, (Grant Thornton Johannesburg)

From 1 April 2014, interest incurred on subordinated debt is no longer deductible.

Section 8F of the Income Tax Act 58 of 1962 ("the Act”) is an anti-avoidance provision which deems interest on hybrid debt instruments to be a dividend in specie and effectively disallows the deduction of affected interest. Section 8F applies in respect of amounts incurred on or after 1 April 2014.

The disallowed interest is regarded as a dividend in specie in the hands of both the debitor and creditor with the result that dividend receipt should usually be exempt from income tax.

Where dividends tax is payable, it must be borne by the debtor (and not the creditor as is the case with dividends other than dividends in specie). If the creditor is a South African tax resident company, the entity is exempt from the dividends tax.

In its simplest form, section 8F applies to interest incurred on loans between connected persons where the loans are not repayable within 30 years and are not payable on demand. However, the section also applies to interest incurred on subordinated debt. Paragraph (b) of the definition of "hybrid debt instrument” includes an "arrangement where the obligation to pay an amount in respect of that instrument is conditional upon the market value of the assets of that company not being less than the market value of the liabilities of that company”.

Subordination Agreements are commonly used in group scenarios and typically contain the following clause:

"The Creditor hereby agrees that, until such time as the assets of the Company fairly valued exceed its liabilities, it shall not be entitled to demand or sue for or accept repayment of the whole of any part of the said amount owing to it by the company and set-off shall not operate in relation to the subordinated claim in respect of any debts owing by it now or in the future; provided that if the auditor of the Company shall report in writing that he has been furnished with evidence which reasonably satisfies him that the amount of the subordinated claim exceeds the amount by which the liabilities of the Company exceed its assets, such excess portion of the subordinated claim as is specified in the said certificate shall be released from the operation of this agreement”.

In most cases, the natural conclusion would be simply to delete the clause above from the Subordination Agreement. However, the mere deletion of the clause does not change the intrinsic legal nature and effect of a Subordination Agreement. The legal effect of a loan subordination is that repayments can only commence once the assets of the debtor, fairly valued, exceed its liabilities, also fairly valued, which places subordinated debt squarely within the parameters of par (b) of the definition of a ‘hybrid debt instrument’.

Furthermore, in the case of Ex Parte De Villiers and Another NNO: In re Carbon Developments (Pty) Ltd¹, Goldstone JA made the following remarks:

¹1993 (1) SA 493

"Save possibly in exceptional cases, the terms of a subordination agreement will have the following legal effect: the debt…continues to exist…but is enforceability is made subject to the fulfilment of a condition. Usually the condition ois that the debt may be enforced by the creditor only if and when the value of the debtor’s assets exceeds his liabilities, excluding the subordinated debt… In the event of the insolvency of the debtor, [liquidation] would normally mean tht the condition upon which the enforceability of the debt depends will have become incapable of fulfilment. The legal result of this would be that the debt dies a natural death. The result would be that the erstwhile creditor would have no claim which could be proved in insolvency…The debt would not normally survive [liquidation].”

It is quite clear that the legal nature of a Subordination Agreement cannot be changed by amending the wording contained therein. The substance and true legal intention of the agreement remains even though the words giving effect thereto may be altered.

There is accordingly a significant risk to taxpayers who have entered into Subordination Agreements that section 8F will apply. A further hindrance is that by their nature, subordinated loans cannot be repayable on demand, which could otherwise potentially place them beyond the ambit of section 8F.

It’s important to bear in mind however, that section 8F will only apply to interest bearing subordinated debt, so taxpayers with interest-free subordinated debt, so taxpayers with interest-free suborindated debt may rest assured that at this stage they do not fall within the section 8F net.

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