In a previous article we drew attention to the proposed amendments to section 10(1)(k) of the Income Tax Act, 1962 ("the Act"), in terms of which the legislature sought to tax all dividends declared on any "restricted equity instrument" for purposes of section 8C of the Act. Thankfully and due to vigorous representations made by the public, the National Treasury had an intuitive leap of understanding and section 18(1)(m) of the Taxation Laws Amendment Bill 28 of 2010 ("TLAB") was introduced to Parliament to provide that dividends declared on a "restricted equity instrument" will only be subject to income tax in the hands of the recipient if such equity instruments is not an equity share.
Just as the corporate world breathed a sigh of relief as they realised, in order to keep dividends tax-free is to ensure that the equity instruments are equity shares for purposes of the Act; National Treasury gave another bolt from the blue by amending the definition of "equity share".
The concept of an 'equity share'
In terms of the current provisions of the Act, the term 'equity share capital' means, in relation to any company, its issued share capital excluding any part thereof which, neither as respects dividends nor respects capital, carries any right to participate beyond a specified amount in a distribution. The use of the words 'neither as respects dividends nor respects capital' indicates that both the right to dividends and the right to the capital must be restricted before a shares ceases to be an equity share. Therefore, if a shareholder's right to dividends in respect of a share is restricted but that shareholder's right to the capital is unrestricted, the share will still constitute an equity share (and vice versa, i.e. if the capital is restricted but there is an unlimited right to dividends). On the other hand, if the right to receive both dividends and capital is restricted, the share will not be an 'equity share'.
There is little authority on what constitutes a restriction on a right to participate beyond a specified amount. In determining whether or not such a restriction exists, the following factors are generally taken into account:
- the participation rights of shareholders in a company consist of a bundle, complex or conglomerate of personal, and hence incorporeal, rights as against the company, principally in regard to its capital and dividends when declared;
- the participation rights attached to shares can include contingent and future rights;
- the participation rights need to be specified in absolute terms and can include tacit rights, provided these rights are determinable;
- when the participation rights are considered objectively, they must not be restricted to participate beyond a specified amount (either capital or dividends). This amount need not be specified in absolute terms, but must be defined in some way; and
- if a share is not entitled to participate beyond the specified amount, it will not form part of equity share capital.
From 1 January 2011, National Treasury has decided to define equity share as any share or similar interest in a company, excluding any share or similar interest that does not carry any right to participate beyond a specified amount in a distribution. The stated reason for this change is to align the Act with the Companies Act, 71 of 2008 ("the New Companies Act"), which is expected to come into effect in 2011, and to remove the references to the obsolete concept of share capital.
Regrettably, the new proposed definition of 'equity share' is badly worded and confusing and is further exasperated because no comments are expressed by National Treasury in the Explanatory Memorandum to the Bill on how the amendment should be interpreted. As a result, one would have to assume that, although the intention of the legislature was to bring the definition in line with the provisions of the New Companies Act, it is unlikely that it was the intention to change the philosophy behind the current 'equity capital' definition. This view is based on the fact that the words "any right" means that a shareholder must in all respects be restricted to distributions from a company before the shares would cease to constitute equity shares.
Therefore, the intention should be the same as that under the current provision, namely that it should not restrict a shareholder's right to participate beyond a specified amount of dividends or capital. Put differently, notwithstanding the proposed change to the definition of equity share, the principle remains that if a share allows the holder thereof to participate to an unlimited extent in any distributions from the company, such share would constitute an equity share.
Buy-back of shares
The new definition of "equity share" refers to a distribution. There is currently no definition of "distribution" in section 1 of the Act, nor does the TLAB introduce a new definition in section 1. There is a specific definition of "distribution" in paragraph 74 of the Eighth Schedule to the Act, but this definition only applies to the Eighth Schedule to the Act and does not necessarily extend to section 1 of the Act. There are also other indirect references to the term "distribution" in section 64B and the definition of "dividend" in section 1 of the Act. However; these sections do not find direct application to the proposed amendment.
The definition of "distribution" in section 1 of the New Companies Act, however, contemplates a number of specific events, and includes the payment of money (or other property) in consideration for a buy-back by a company of its own shares in terms of section 48. Accordingly, due to the fact that the New Companies Act specifically includes in the definition of "distribution" an amount paid in consideration for a buy-back of its shares, the question which arises is whether it could it be argued that an amount paid to a shareholder in terms of a buy-back of shares
constitutes a "distribution" for purposes of the Act and therefore, if such amount is fixed, it could have an impact on the status of an equity share.
From an interpretation point of view only, it is submitted that the definition in the New Companies Act cannot apply to a definition in the Act, unless specific reference is made to such definition. In the absence of such reference the explicit reference to the buy-back of a company of its own shares in the New Companies Act will not extend to the definition of 'equity shares' in the Act.
However, because the new definition of 'equity share' is so badly worded, and due to the wide ambit and vagueness of such wording, there is a possibility that it could be interpreted to include a buy-back. In our view such an interpretation would be fundamentally flawed, because:
- as we have stated above, the interpretation of the new definition should be the same as under the current provision, namely that it should not restrict a shareholder's right to participate beyond a specified amount of dividends or capital;
- the definition of 'dividend' in section 1 of the Act specifically includes a reduction of profits as a result of the acquisition, cancellation or redemption of shares issued by a company as a distribution by that company which, using the process of elimination, indicates that if a buy-back was not specifically included it was excluded;
- a distribution contemplates an amount which is distributed and spread amongst a number of people, whilst a buy-back is an amount paid pursuant to an agreement between the shareholder and the company, and therefore not spread amongst the shareholders.
Application of section 8E to share incentive schemes
Just as one thinks that you have successfully maneuvered through the labyrinth of changes to the Act relating to share incentive schemes, it is noted that section 8E will also be amended with effect from 1 January 2010.
Generally, when introducing a share incentive scheme, the shares are structured in such a manner that they do not constitute hybrid equity instruments for purposes of section 8E of the Act. In the event that the shares constitute hybrid equity instruments the dividends declared on such shares lose their character as dividends and are treated as interest in the hands of the shareholder.
In terms of the current provisions of the Act, section 8E applies to redeemable preference shares, as well as any ordinary shares over which the holder has a 'right of disposal' which do not rank pari passu with other ordinary shares as regards the participation in dividends. In order to align the New Companies Act with the Act, section 8E will apply from 1 January 2011 to:
- any share, other than an equity share, over which the holder has a 'right of disposal' that may be exercised within 3 years from the date of their issue; or
- any other share which does not rank pari passu with other ordinary shares as regards the participation in dividends and over which the holder has a similar 'right of disposal' of those shares.
As a result of the changes to section 8E, share incentive schemes should, in future, be structured carefully to ensure that the provisions of section 8E of the Act do not apply, failing which it would have dire consequences for the participants in the scheme.