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Converting debt into equity: Beware the taxman

Friday, 16 November 2012   (0 Comments)
Posted by: SAIT Technical
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By PKF/Moneywebtax

Executive summary (SAIT Technical)

PKF looks at the tax consequences of converting debt into equity. Assessed losses must be reduced by the value of any benefit derived from a compromise or concession with a creditor.

Full article

In the current strained economic environment, the possibility of default by a debtor is a stark reality. One way of assisting companies through these uncertain times is for shareholders or creditors to convert loan claims against the company into shares.

The conversion or capitalisation of debt into shares has various potential tax consequences. For companies with assessed losses, this may result in a reduction of the assessed loss. The reason for this is that the Income Tax Actprovides that a taxpayer's assessed loss must be reduced by the value of any benefit derived by it in consequence of a compromise or concession made with any creditor.

In a matter before the Appellate Division (as it then was) between Sars and a taxpayer, the court was required to adjudicate on whether the capitalisation of debt through the issue of redeemable preference shares by the taxpayer amounted to a compromise with a creditor. The shareholders of the taxpayer in that case, which was a company, received preference shares in the taxpayer and as consideration for the preference shares, waived their loan claims against the company. The court held that this transaction resulted in a concession with a creditor and the taxpayer's assessed loss was accordingly reduced.

Sars, however, ruled on a matter recently dealing with a similar question but with slightly different facts. The distinguishing factor between the facts in the current ruling and the facts before the court in the case referred to above, it seems, revolves around the fact that the shareholders of the taxpayer in the ruling application settled the subscription price of the redeemable preference shares in cash after which the taxpayer used the cash to settle the shareholders loans. Sars ruled in favour of the taxpayer stating that the capitalisation of the debt does not constitute a compromise with a creditor.

The ruling issued by Sars is a binding private ruling which is only enforceable against Sars by the applicant of that ruling and does not establish any precedent for future cases. It nevertheless does give an indication, albeit vague, of how Sars may interpret the application of these provisions of the Income Tax Act.

The ruling in question also dealt with other matters which we have not addressed in this alert.

We urge you to assess the potential tax consequences when considering whether or not to convert or capitalise debt into shares as the specific facts and circumstances of each case and the manner in which the capitalisation is effected may impact on the associated tax consequences.



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