The South African Revenue Service (Sars) recently issued a binding private ruling offering insights into the importance of understanding the anti-avoidance rules pertaining to the issuing and redemption of preference shares. These rules are complex and technical and can have dire consequences for taxpayers if all the nuances are not fully considered.
The ruling highlights the importance of regularly reviewing the nature of a preference share or an equity instrument, says Puleng Mothabeng, associate at Cliffe Dekker Hofmeyr, in a tax and exchange control alert.
The mischief
She warns that sections 8E and 8EA (the anti-avoidance provisions) of the Income Tax Act will apply if the share or equity instrument constitutes a “hybrid equity instrument” or “third-party-backed share”.
The anti-avoidance provisions focus on share-financing transactions – usually preference shares – that disguise taxable interest as tax-exempt dividend income.
The anti-avoidance rules eliminate a situation where, instead of granting a loan where taxable interest is received, the lender issues shares and receives tax-free dividends.
The transaction
The company that applied for the ruling is a resident company that owns a property company with some land in South Africa. The transaction entailed the issue of preference shares by the property company to the resident company, giving it a preferential right to the speculative value of the land.
The resident company and another company intended to develop the land through a joint venture. The preference shares were issued to protect the resident company against divestiture of control in the property company.
The resident company would have direct access to the land as security if the joint venture was unsuccessful and the preference shares could not be redeemed.
The transaction had specific terms relating to the redemption of the preference shares. These terms included that the shares would be redeemable on a scheduled redemption date (five years from the date of issue), or when the board decided them to be redeemable, or when a “trigger, illegality, or sanction event” arose.
The ruling
Mothabeng says the Sars ruling was comprehensive and touched on other anti-avoidance provisions in the Income Ta Act, notably the anti-dividend stripping rules. She focused on the sections relating to equity instruments and third-party-backed shares.
Sars ruled that the preference share dividends or redemption amounts would constitute dividends. The preference shares would not be considered hybrid equity instruments, and therefore the dividends would not be deemed income.
However, when there is an event that triggers the redemption within three years of the date of issue, the preference shares will be re-characterised as hybrid equity instruments and the dividend will become taxable income in the hands of the receiver.
In terms of the definition of a third-party-backed share, Sars ruled that in this case the preference shares would not constitute third-party-backed shares and therefore declared dividends would not be re-characterised as income.
The preferential rights on the land held by the resident company were exercisable against the issuer of the preference shares (the property company) and not a third party.
“I think the company would rather have had Sars say that the anti-avoidance provisions do not apply at all, notwithstanding the specific terms (set out in the transaction).”
Sars highlighted the fact that as long as the preference shares were not redeemed before the scheduled redemption date, the declared dividends would retain their nature as dividends and would not be re-characterised as taxable income.
At least the company knows what to expect if the board decides to redeem the shares before the scheduled redemption or when a trigger, illegality, or sanction event arose.
Guidance for others
Mothabeng notes that the ruling (BPR398) is binding only on Sars and the applicant. Other companies involved in share-financing transactions can use it as guidance, but it is not binding law.
Rulings rarely provide all the facts and information that was in the original application. “I do not think there are many transactions involving preference shares or third-party-backed shares where the facts will be exactly similar. One has to look at the particular set of facts to determine how sections 8E or 8EA may apply to it.”
Mothabeng says it is advisable to seek guidance if there are concerns that the structuring of a transaction may fall foul of the anti-avoidance measures and result in an unfavourable tax position.
It may be advisable to seek a binding ruling if there is uncertainty about the correctness of the tax position. This will provide comfort that when Sars does raise an assessment contrary to what the company expected, the taxpayer has a ruling on the facts underlying the transaction.
Amanda Visser is a freelance journalist who specialises in tax and has written about trade law, competition law, and regulatory issues.
Disclaimer: The views expressed in this article are those of the writer and are not necessarily shared by Moonstone Information Refinery or its sister companies. The information in this article does not constitute financial planning, legal or tax advice that is appropriate to every individual’s needs and circumstances.
