Written by Lior Gold with Barry Garven
The alignment of the Income Tax Act, 1962 (“the Income Tax Act”) with the Companies Act, 2008 (“the new Companies Act”) required that certain concepts be amended in order to accommodate the new company law legislation from a tax perspective. The new Companies Act has discarded concepts such as ‘par value shares’ and ‘equity share capital’ and the 2010 Taxation Laws Amendment Act has given effect to some of these changes, in particular, the definition of ‘equity share capital’ in the Income Tax Act has been replaced with a new definition of ‘equity share’.
Before its amendment, the term ‘equity share capital’ was defined, in relation to a company, as “its issued share capital and shares, excluding any part thereof which, neither as respects dividends nor as respects capital, carries any right to participate beyond a specified amount in a distribution”. In contrast, the current definition of ‘equity share’ means, in relation to a company, ‘any share or similar interest in that company excluding any share or similar interest that does not carry any right to participate beyond a specified amount in a distribution’. This poses the question – when does a share cease to be an equity share?
Under the old definition, the words ‘neither as respects dividends nor as respects capital’ made it clear that a share would not be an equity share if both the right to dividends and the right to capital were restricted. If there was a ceiling on a shareholder’s right to participate in dividends but no ceiling in respect of capital distributions (and vice versa) the share remained an equity share.
The new definition of ‘equity share’ has limited the scope of the qualification ‘neither as respects dividends nor as respects capital’ and now stipulates that a share must ‘not carry any right to participate beyond a specified amount in a distribution’ in order to qualify as an equity share. This raises a further question – does the term ‘distribution’ refer only to distributions by way of dividend or only capital distributions or both?
Although in principle an amendment to the language of legislation indicates an intention to change the substantive meaning of the legislation, in this instance the re-wording of the definition of equity share capital was simply to align the Income Tax Act with the new Companies Act. The words ‘any right’ still appear in the new definition and these words imply that a shareholder must be restricted from participating in distributions from a company in all respects, namely there must be a restriction on both the right to a dividend distribution and a capital distribution, before the share will not be an equity share.
It follows that in instances where shares are specifically classified, regard must be had to the underlying rights of the shares. In certain circumstances the holder of an ‘A’ ordinary share, or a preference share, may not appear to hold an ‘equity share’ but, upon closer examination, the share may in fact be an equity share. Although a company differentiates between various shareholders, irrespective of the name attributed to classes of shares, under both the new and old definition of ‘equity share’, if a shareholder is entitled to unlimited participation in any company distributions, the share will constitute an equity share.
Although it is imperative that a shareholder has an unlimited participation right in order for a share to qualify as an equity share, regard must also be had to the requirement that the share must ‘carry any right to participate beyond a specified amount in a distribution’.
The qualification that a share must carry a right to participation suggests that, if a shareholder is unable presently to exercise its unlimited participation right, but there is certainty that the shareholder will ultimately be in a position to exercise its right and therefore, be in a position to participate in any company distributions, the shareholder will have an unlimited participation right despite that it may not be possible to predict when the participation date will occur. In this instance, the share is an equity share. The distinction between preference and ordinary shares provides an indication of which class of shares will constitute an ‘equity share’. Unlike the participation rights afforded to ordinary shareholders, there is a ceiling on a preference shareholder’s right to participation, and it is this ceiling which prevents preference shares from being classified as equity shares. As the ordinary shareholder’s participation is not capped, ordinary shares are commonly classified as equity shares.
In contrast, if a shareholder’s unlimited right to participate in any company distributions is conditional and uncertainty exists as to whether or not the shareholder’s right to participate in distributions will occur, the share will only actually carry an unlimited right to participation if and when the participation date occurs. In this situation, the share is not an equity share prior to the date of participation.
The new definition of ‘equity share’ in the Income Tax Act simplifies the concept of what constitutes an equity share. It is now clear that whether or not a share is an ‘equity share’ will not only depend on whether the shareholder has an unlimited right to participate in any company distributions but also on whether or not it is certain that the participation date will occur. The issue of whether or not a shareholder has an unconditional right to participate in distributions is sometimes difficult to determine in practice as this will depend on the practical terms of the instrument in question.