The South African Revenue Service (SARS) recently issued Binding Private Ruling number 173 (Ruling).
The applicant was a locally incorporated company, and tax resident in South Africa. The applicant’s majority shareholder was a foreign company. The balance of the shares in the applicant were held by its management.
The majority shareholder had previously advanced a loan to the applicant for purposes of covering operational expenditure and this loan remained outstanding.
It was proposed that the majority shareholder would subscribe for new shares in the applicant, and that the proceeds from the subscription would be used by the applicant to repay the outstanding loan owing to the majority shareholder.
In other words, the parties wished to capitalise the loan.
From a practical perspective, the majority shareholder would subscribe for ordinary shares in the applicant at par because the applicant had sufficient authorised but unissued shares to cover the amount of the loan. The majority shareholder would settle the subscription price in cash and the applicant would issue the relevant share certificates. Thereafter the applicant would settle the loan from the cash proceeds of the issue.
It would appear that the main concern of the applicant was that the subscription for new shares and the subsequent repayment of the loan would be seen as a reduction of debt for purposes of s19 of the Income Tax Act, No 58 of 1962 (Act), and that a recoupment would arise in the hands of the applicant. This is mainly so because the loan was applied towards deductible expenditure. Alternatively the concern seems to have been that the transaction would constitute a reduction of debt for purposes of paragraph 12A of the Eighth Schedule of the Act, and that a reduction of allowable expenditure for capital gains tax purposes would result.
The uncertainty whether the capitalisation of a loan triggers the debt reduction provisions stems from C:SARS V Labat 2011 ZASCA 157 where it was held that the issue of shares does not diminish a company’s assets and would therefore not constitute expenditure incurred. If a company issues shares in settlement of its loan obligations, the question then arises whether the company has in fact discharged its loan obligations.
In the Labat case the court indicated that it may be possible to structure the transaction differently so that set-off does apply. However, on the basis that there was no suggestion that the contracts were simulated, the court had to take the transaction at face value. The court therefore never decided on the issue of whether set-off may apply in the context of loan capitalisations.
SARS ruled that s19 of the Act and paragraph 12A of the Eighth Schedule to the Act would not apply to the proposed transaction.
This ruling is important in that it indicates that the capitalisation of a loan would not necessarily constitute a reduction of debt that is disguised as the issue of shares coupled with the repayment of a loan.
However, it is important to note that SARS made the ruling subject to the assumption that payment of the subscription price as well as the repayment of the loan will be settled in cash, as opposed to being settled by way of set-off.
SARS made no ruling in respect of the deductibility of the operating expenditure for which the loan was used, or the application of the transfer pricing rules to the facts.