Following the release, the draft Taxation Laws Amendment Bill (“the Bill”) on the 8 July 2016, National Treasury has focused the spot light on hybrid debt instruments.
The provisions pertaining to hybrid debt instruments are embodied in section 8F and section 8FA of the Income Tax Act 58 of 1962 (the “Act”).
In essence, in certain instances, section 8F and section 8FA of the Act reclassifies interest as a dividend in specie (i.e. a distribution in a form other than cash).
With the release of the draft Bill, National Treasury has proposed key amendments to the sections. Firstly, where a debt instrument is issued by a non-resident company, the reclassification of interest under section 8F and 8FA will apply only if:
- such non-resident company issues a debt instrument that is solely attributable to permanent establishment in South Africa; or
- if the non-resident company is a controlled foreign company whose profits are attributable to a South African resident.
This amendment aims to target specific transactions under which the parties, being non-residents, have intentionally include equity features in their debts instruments in order to taking advantage of the re-classification of interest under section 8F and 8FA.
Under the current wording, the sections apply to both residents and non-residents. When interest is reclassified in terms of either section, the interest is deemed to be a dividend in specie and taxable as such. This results in a disallowance of the deduction of the interest.
With transactions involving non-resident issuers and resident holders, the reclassification of the interest will benefit the holder who can make use of the dividends tax exemptions available. The issuer on the other hand, will not be denied the interest deduction (if it is not subject to South African tax rules), as the South African anti-hybrid rules will not apply to the non-resident. This is effectively a mismatch in treatment of the deemed dividend for tax purposes, which the proposed amendments seek to remedy.
It is proposed that this amendment to sections 8F and 8FA applies retrospectively from 24 February 2016 and will be applicable in respect of amounts incurred on or after that date.
The second amendment proposed by National Treasury will affect hybrid debt instruments which are subject to subordination agreements.
Companies generally opt to enter into subordination agreements in respect of shareholder loans in favour of third party borrowings when faced with a difficult financial year. By doing this the shareholders loans will rank second to the third party borrowings and the company is able to curb the impact of its financial instability and protect its solvency.
Where the repayment of the shareholder’s loans to a company is dependent on the solvency of the company, in terms of a subordination agreement, such dependency on solvency will fall within the ambit of section 8F. This will result in a company which is undergoing a financially trying time, being potentially placed in a tax paying position. Any interest payments made in respect of the subordinated shareholders loans will be deemed to be a dividend in specie and the company will therefore be denied the relief of an interest deduction.
In light of this the Bill seeks to limit the application of section 8F. The proposed amendment excludes the application of section 8F in situations where an issuer of the hybrid debt instrument owes an amount to a company that forms part of the same group of companies and where payments in respect of that amount owing are suspended due to the financial difficulties of the issuer.
It is proposed that the amendment to section 8F will come into effect on 1 January 2017 and will be applicable in respect of amounts incurred on or after that date.
Taxpayers should be mindful of the provisions of section 8F and 8FA when establishing or negotiating financing arrangements, as these anti-avoidance provisions have the effect of ascribing tax consequences contrary to the form of a financing arrangement.