Section 8EA of the Income Tax Act, No 58 of 1962 (Act) constitutes an anti-avoidance provision which, if applicable, has the effect that the amount of any dividend or foreign dividend received or accrued to the holder of a preference share, is deemed to be an amount of income as opposed to exempt income for tax purposes. In order for the provisions of s8EA of the Act to apply, the preference share in question must be regarded as a ‘third-party backed share’.
A third-party backed share means any preference share in respect of which an enforcement right is exercisable by the holder of that preference share or an enforcement obligation is enforceable as a result of any amount of any specified dividend, foreign dividend, return of capital or foreign return of capital attributable to that share not being received by, or accruing to the person entitled thereto.
It should however be noted that one of the important requirements that must be satisfied in order for the preference share in question to be regarded as a third-party backed share, is that the funds derived on the issue of the preference share must be applied for a purpose other than a ‘qualifying purpose’, as defined in s8EA(1) of the Act. Accordingly, where the funds derived from the issue of the preference share are applied for a ‘qualifying purpose’, the provisions of s8EA of the Act will not apply, provided that the enforcement rights or obligations are only exercisable or enforceable against certain persons listed in s8EA(3)(b) of the Act.
For purposes of this article, subparagraph b(i)(aa) of the definition of ‘qualifying purpose’ in s8EA(1) of the Act states that a qualifying purpose in relation to the application of the funds derived from the issue of a preference share, means the partial or the full settlement by any person of any debt incurred for the direct or indirect acquisition of an equity share by any person in an operating company. However, this excludes a direct or indirect acquisition of any equity share from a company that, immediately before that acquisition, formed part of the same group of companies as the person acquiring that equity share.
It is therefore not enough to merely have applied the funds derived from the issue of the preference share for a ‘qualifying purpose’, to escape the application of the aforementioned provisions to the preference share.
On 22 December 2015, the South African Revenue Service (SARS) issued Binding Private Ruling 214 (BPR 214), which deals with the interpretation and application of the provisions of s8EA of the Act. In particular, BPR 214 determines whether, in terms of the proposed transaction, cumulative redeemable preference shares constitute ‘third-party backed shares’.
The parties to the proposed transaction is the Applicant, a company incorporated in and a resident of South Africa, which is a wholly owned subsidiary of a private company incorporated in and resident of South Africa (Company B). Company B in turn is a wholly owned subsidiary of a listed company incorporated in and resident of South Africa (Company A). A private company incorporated in and resident of South Africa (Company C), is a wholly owned subsidiary of the Applicant.
In terms of the proposed transaction, Company C borrowed an amount from Company B with the sole purpose of acquiring shares in a special purpose, non-operating company (Company D). Company D was created solely to hold equity shares in an operating company (Company E). The loan was subsequently delegated by Company C to the Applicant, resulting in the Applicant being indebted to Company B. The Applicant required funds to partially settle the loan and accordingly issued cumulative redeemable preference shares (shares) to a resident listed company, acting through its Corporate and Investment Banking Division (Company F).
In addition to the share subscription, the respective parties agreed that the following arrangements will apply:
- the Applicant will, inter alia, indemnify Company F in the event of non-payment relating to the shares and will enter into a pledge and cession agreement with Company F, in respect of certain rights it holds;
- company B will subordinate all of its claims against the Applicant, in favour of Company F;
- company A will extend a guarantee to Company F for all the post redemption obligations of the Applicant; and
- either Company A or Company B, or both of them, may extend guarantees to Company F in respect of the non-payments of the shares.
Further, in accordance with the calculation in terms of the share subscription agreement, three classes of dividends are to be payable in respect of the shares.
SARS made the following ruling in connection with the proposed transaction:
- by virtue of the shares being issued for the indirect acquisition of an equity share in an operating company, the shares were applied for a ‘qualifying purpose’, as contemplated in s8EA(3), read with subparagraph (b)(i)(aa) of the definition of ‘qualifying purpose’ in s8EA(1) of the Act. Accordingly, the shares do not constitute ‘third-party backed shares’, as defined in s8EA(1) of the Act; and
- by virtue of Company A and Company B forming part of the same group of companies as the Applicant, no regard must be had to the enforcement right exercisable by Company F, where the security provider is Company A or Company B.