When the Draft Taxation Laws Amendment Bill of 2011 (“Draft Bill”) was released on 3 June, it contained proposed amendments to section 8E of the Income Tax Act (“the Act”) and also contained a proposal to introduce section 8EA into the Act. 

One of the proposed amendments was intended to increase the redemption period central to the application of section 8E from 3 years to 10 years.  If the proposal became law, it would have meant that in order to avoid the application of section 8E, an investor would have had to hold a share for at least 10 years and a day before redemption, which usually would not be feasible.  Another proposal relating to section 8E was intended to extend the application of section 8E to foreign dividends, with the consequence that both domestic and foreign dividends received or accrued in respect of a hybrid equity instrument would be deemed to be interest in relation to their recipient.  The reaction to the proposal to increase the redemption period was that it would place many funding structures at risk. 

Treasury has now withdrawn the proposal to increase the redemption period from 3 years to 10 years.  Therefore, the minimum redemption period for the purposes of section 8E will remain at three years and a day. The reason given for the revised proposal is that preference share funding is often used to acquire controlling share interests in an operating company or as a tool for black economic empowerment transactions.  When used in this fashion, it seeks merely to preserve tax neutrality and not to create tax losses. 

In addition, Treasury proposes to extend the application of section 8E to shares which entitle their holder to dividends that are calculated with reference to a specified interest rate or the amount of capital subscribed for the share and which are derived mainly from interest as defined in section 24J of the Act.  This proposal is intended to target preference shares which entitle their holder to dividends derived from interest bearing instruments/notes. 

Section 8EA targets third party backed shares and will treat dividends in respect of those shares as ordinary income.  In terms of the original proposal, the section would apply in specific circumstances, for instance where the holder of a share had a put option in respect of the share which was exercisable against a third party. 

Treasury has modified its proposal with regard to section 8EA. In its modified form, section 8EA will also apply in respect of foreign dividends and will treat both domestic and foreign dividends received in respect third party backed shares as ordinary income.  Treasury also seeks to amend the definition of third party backed shares.  The consequence of the proposal is that section 8EA will apply in more limited circumstances and in particular, where as a result of the lack of a dividend:

• the holder of the share or a connected person in relation to the holder has a put option in respect of the share against a third party;
• a third party has undertaken to make any payment in  respect of the share;
• a third party has undertaken to procure, facilitate or assist with the exercise of the put option or the making of any payment referred to above. 

Section 8EA will not apply where the issuer applies the subscription amount paid for the shares to fund the acquisition of shares in a South African resident company (“Target Company”) and the rights or obligations referred to above are against the Target Company or any company which forms part of the same group of companies as the Target Company or the issuer.  The reason provided for this exception is that the use of preference shares to fund share acquisitions is commonly used to fund black economic empowerment and is generally neutral to the fiscus.