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News & Press: Corporate Tax

The re-characterisation of debt

16 July 2012   (0 Comments)
Posted by: SAIT Technical
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 By Alastair Morphet (DLA Cliffe Dekker Hofmeyr Tax Alert 13 July 2012)

The introduction to this discussion needs to start with the fact that the National Treasury (Treasury) intends to insert a definition of 'debt' in s1 of the Income Tax Act, No 58 of 1962 (Act) with effect from 1 January 2013. While there has been a lot of legal authority as to what constitutes a debt, the Treasury has decided to deal with this expressly by defining it as "any amount owing to or by a person". This is an incredibly broad definition and I have struggled to understand why they felt this was necessary.

The reasons given for the change is that various provisions of the Act deal with the concept and seek to encompass the various ways in which a debtor/creditor relationship may be created. Because the Treasury feels that the Act has become burdened with cumbersome formulations, they decided to insert this definition. However, given such a broad definition, the fact that I am late in paying an account, means a debt in terms of the Act has come about. However, this can be a simple account with no provision for interest to accrue. The very fact that one person has an IOU from another person will fall within this definition. There is now no need to advance an amount or provide goods on credit.

The insertion of this definition seems to be linked to the expansion of the hybrid debt re-characterisation rule in s8F. That provision says that if a debt instrument is convertible into shares in the debtor within three years of the date of issue; or can be repaid within three years by the issue of shares in the debtor; or within three years the issuer can compel the creditor to subscribe for shares, then the Act will disallow the interest deduction on those debt instruments from the date on which they became or are 'hybrid' in terms of this Section.

The Explanatory Memorandum (EM) then sets out that the proposed change to "reduce the scope for the creation of equity that is artificially disguised as debt" will be based on a twofold test – rules to analyse the nature of the instrument itself and a second set of rules to focus on the nature of the yield on the instrument. It states that the proposal is aimed at domestic companies that issue debt instruments so as to artificially generate interest deductions.

Section 8F has been totally rewritten to come into operation on 1 January 2014. So the definition of 'hybrid debt' will now mean any debt if the issuer of the debt is not entitled to repay that debt in full within 30 years of the date of issue; or is entitled to exercise any option by reason of which the issuer will be obliged to convert or exchange that debt for shares in the issuer in the company or any company which forms part of the same group of companies. Or, if the holder of the debt is obliged to convert or exchange that debt or receive repayment of that debt in the form of shares in the issuer (or any company in the same group of companies). If on a balance of probabilities the debt will not be repaid in full within 30 years of its date of issue or the obligation to make payment of the debt is conditional on the solvency of liquidity of the issuer, it will still fall within hybrid unless the market value of all of the assets do not exceed R10 million (that's the small business relief provision) or the company is a bank as defined in the Banks Act (SARS are concerned about these provisions impacting the raising of Tier 2 Capital in terms of the Basel Standards).

Any hybrid debt issued by a domestic company is in relation to the issuer deemed to be a share (other than an equity share), and for the holder of the hybrid debt it is deemed to be a share as well. In terms of s8F(3) any amount paid or incurred by the issuer of the hybrid debt is deemed to be an amount paid or incurred by the issuer or any amount received or accrued by the holder of such debt is deemed to be an amount received or accrued by that holder in respect of a share other than an equity share. Sub section (4) provides that for the purposes of the definition of 'contributed tax capital' the amount referred to above is an amount equal to the amount outstanding in respect of that debt at the time that the debt becomes a hybrid debt as defined.

Where the instrument is re-characterised by reason of its lack of redemption features, the Act will now seek to treat the distribution in the hands of the issuer as well as the recipient as a distribution. Accordingly there will be no deduction for the issuer and no inclusion in the hands of the recipient if the distribution is similar to a dividend. Repayments or disposals in respect of these instruments will be treated as repayments or disposals in respect of shares (non equity shares).

Now s8F will need to be read in conjunction with the new s8FA, which will come into effect on 1 January 2014. This provision defines 'hybrid interest' as interest paid by the issuer of a debt if the amount of the interest is not determined with reference to the time value of money; the obligation to pay that interest is conditional upon the solvency or liquidity of the issuer; or the issuer is obliged or entitled to exercise any option to make payment of the interest in the form of shares in the issuer or any company in the same group of companies. Effectively, the instrument re-characterisation provisions will be contained in the s8F, and the yield re-characterisation provisions will be contained in s8FA. If what the issuer pays falls within thisdefinition of 'hybrid interest', the yield is deemed to be a dividend. In this case, the issuer may not deduct the yield, and the dividend is exempt from normal tax in the hands of the recipient.

But in the case of s8FA the instrument itself retains its characterisation as debt (unless it falls within the hybrid debt provisions) and other payments would need to be tested separately for their characterisation. One needs to note that where the yield is re-characterised, it is deemed to be a dividend in specie, where in terms of s64F the obligation to pay the dividends tax is on the company paying the dividend. Also, in terms of s8FA(2)(b)(i) the dividend is deemed to have been paid on the earlier of the date on which the amount is received by or accrues to the holder of the hybrid debt.

SARS do say in their EM that where investors effectively sacrifice some of their yield in exchange for an upside stake in the growth of the company that convertible feature is not seen as an anti avoidance technique or as a non commercial transaction.



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