Reconsider the Tax implications of Loan capitalisations
05 October 2015
Posted by: Authors: Erich Bell and Gardner van Niekerk
Authors: Erich Bell and Gardner van Niekerk (BDO South Africa)
Given the current economic conditions and the increased focus on transfer pricing and the introduction of withholding tax on interest, an increased number of companies are exploring conversion of long outstanding loans into equity share capital.
The capitalisation of loans through the issue of share capital is currently a heavily debated topic among tax professionals in South Africa. The increased focus on the capitalisation of loans as opposed to waiver (apart from valid commercial reasons) can partly be attributed to the fact that a loan could be converted to share capital with neither the debtor company issuing the shares nor the creditor incurring a tax liability.
Loan capitalisations are primarily encountered in groups of companies - normally between a holding company and a wholly owned subsidiary. Various commercial reasons may give rise to loan capitalisation, mostly where the debtor company is in financial distress and unable to repay a loan or to service the interest on the loan, and the recapitalisation is done to strengthen the debtor's balance sheet.
A loan can be capitalised by using one of three approaches.
Physical transfer of cash to extinguish or reduce the loan
Under this option the debtor company issues share capital to the creditor in exchange for a cash subscription price. The cash is then applied to repay the loan.
Issuing of shares on a subscription loan to be set-off against the existing loan
Under this option the debtor company issues share capital to the creditor for a cash subscription price on the loan account. This results in two loans existing: a loan by the debtor company to the creditor (the loan to be capitalised) and the subscription loan by the creditor to the debtor company (for the share capital issued). The loans are then set-off and extinguished through confusio, assuming the face value of the loans to be the same. The set-off results in the creditor having additional share capital in the debtor company and the debtor company having extinguished the loan owing to the creditor.
Issuing of shares directly in settlement of debt
Under this option share capital is issued by the debtor company to the creditor directly in settlement of the loan. As a result, there is no quid pro quo from the creditor for the issue of the share capital under this option, as opposed to where the creditor paid cash for the share capital or the creditor acquired the share capital on a loan account.
Debt reduction provisions as applicable to loan capitalisations
It is critical that the transactions undertaken do not fall foul of the debt reduction provisions contained in the Income Tax Act (the Act).
Simply stated, the debt reduction provisions would in most circumstances be invoked
when the face value of a debt is reduced by a greater amount than the amount applied by the debtor as consideration for the reduction. This excess amount is referred to as a 'reduction amount'. The table below indicates the usual instances in which the debt reduction provisions would be invoked.
Instance in which debt reduction provisions can be invoked
|1. Cash transfer||If the face value of the debt is reduced by a greater amount than the cash paid by the debtor company to the creditor.|
|2. Loan set-off||If the subscription loan created through the issue of share capital is less than the face value of the loan owing by the debtor company (assuming no other consideration passes from the debtor company to the creditor as consideration for the loan capitalisation).|
|3. Share payment|
If the market value of the shares issued by the debtor company in satisfaction of the debt is less than the amount by which the face value of the debt is reduced (assuming no other consideration passes from the debtor company to the creditor as part of the loan capitalisation)
The debt reduction provisions, in essence, provide that if the loan was used to fund:
- Deductible expenditure or trading stock not on hand at the time of the debt reduction:
A recoupment equal to the reduction amount would have to be included in the debtor company's gross income, subject to income tax at 28% if the company is in a tax paying position
- Trading stock on hand at the time of the debt reduction:
The reduction amount needs to be applied to reduce the amount taken into account for opening and closing stock, thereby effectively reducing the deduction allowed on the trading stock with any excess having to be included in the company's gross income as a recoupment
- A capital asset on hand at the time the debt reduction takes place:
The base cost of that capital asset must be reduced by the reduction amount. This would either increase the capital gain or decrease the capital loss on the subsequent disposal of that asset. Alternatively, if the capital asset is not on hand when the debt reduction takes place, the reduction amount would have to be applied to reduce any assessed capital loss that the debtor company may have. Should the debtor company not have any assessed capital loss, there would be no further capital gains tax implications.
The biggest challenge that companies face with loan account capitalisation is to ensure that it does not result in a reduction amount. As illustrated above, it is a straightforward exercise to determine if a share capitalisation through a cash transfer gives rise to a reduction amount, as one must merely ensure that the face value of the loan is not reduced by a greater amount than the cash flowing from the debtor company to the creditor. The capitalisation of a loan through set-off would also not result in a debt reduction if the face value of the two loans are of equal value, irrespective of the value of the share capital issued on the loan account.
Various risks are attached to the capitalisation of loans through the issue of equity shares, namely:
- A loan capitalisation may be seen as a sham where a debt reduction has, in substance, taken place. The Act, in certain instances, exempts debt reductions as part of liquidations, windings up or de-registrations.
- In CSARS v Labat, the court held that the issuing of its own shares by a company does not constitute 'expenditure'. SARS may attempt to apply this judgment to loan capitalisations.
Substance over form
The maxim plus valet quod agitur quam quod simulate concipitur is a common law doctrine also known as the 'substance over form' doctrine. This doctrine translates to 'what is actually done is more important than that which seems to have been done' and allows the courts to give effect to the legal substance of the transaction over the form.
To mitigate the risk, it is important to ensure that a commercial rationale for the loan capitalisation exists and that a 'tax avoidance arrangement' does not exist or that the transaction is not seen as a sham.
Companies in financial distress that wish to capitalise loans owing to their holding companies may face additional challenges. The loan could be subordinated in favour of other creditors to ensure that the subsidiary can continue trading on a going concern basis.
Numerous pitfalls can be encountered when attempting to capitalise a loan and every loan conversion has a unique set of facts. Application of the tax principles to the facts should be considered carefully before implementing a loan capitalisation.
This article first appeared on bdo.co.za.