The Draft Taxation Laws Amendment Bill, 2011 (“the Bill”) released for public comment on 2 June 2011, introduced two significant anti-avoidance measures:

• a significant extension of the redemption time period required for an equity instrument not to be regarded as a “hybrid” under section 8E of the Income Tax Act (“the Act”); and

• the drastic tax treatment of dividends declared on third party backed shares (proposed section 8EA of the Act).

Section 8E of the Act, in its present form, acts as an anti-avoidance mechanism in circumstances where dividends are issued on so-called “hybrid equity instruments”, typically preference shares which exhibit elements of both equity shares and loans. Dividends declared on these instruments are taxed as if they are interest in the hands of the holder but no deduction is allowed for the issuer.

Currently, in simple terms, a redeemable preference share will constitute a “hybrid equity instrument” if either the issuer is obliged to redeem the share, or the holder has the right to require that the share be redeemed in whole or in part within a period of three years from date of issue.

It is proposed that with effect from 1 April 2012, the three year redemption period will be extended to 10 years. This means that, in order to avoid the re-characterisation of preference share dividends as taxable interest income, such preference shares may not be redeemed or be capable of being redeemed for a period of at least 10 years from the date of issue. Many funding structures will, as a result, no longer be feasible.

National Treasury has further proposed the introduction of section 8EA, also aimed at curbing transactions involving the use of shares (usually preference shares) as funding mechanisms. The attack is now centred on circumstances where the holder has obtained the “backing” of a third party (typically a group company) which in one way or the other guarantees the redemption of the instrument.

It is proposed that dividends declared on these types of instruments, will be treated for tax purposes as ordinary revenue in the hands of the holder.

Many transactions, especially BEE transactions, involve a sale of shares, often because of the commercial difficulties in selling a business or assets held by a company or transferring important contracts to the purchaser. These transactions are usually financed by way of an issue of preference shares, often to a bank. Usually the bank requires security for taking up the issue.

Alternatively, some transactions are funded using debt funding raised in the context of a so-called “debt push-down structure”. Both the preference share funding and the debt push-down structures are required because South Africa, unlike many other tax systems, does not allow tax deductions for interest incurred on a loan used to acquire shares.

In the past, SARS seems to have accepted the need for such arrangements although it has treated preference share structures with suspicion for many years. Now that there appears to be an open attack on both preference shares and on debt push-down structures (by suspending the operation of section 45 of the Income Tax Act), the funding of many commercial transactions will be difficult and unless a workable solution can be found, many such transactions will no longer be feasible.

We are currently considering various funding alternatives but whether or not these are workable will depend on the facts of each transaction. In the light of these issues and the soon to be introduced Dividends Tax, one of the issues that needs to be examined is whether funding from a foreign financier would now be more attractive.

The Bowmans Tax Team