Treasury proposes new rules dealing with the tax treatment of the conversion of debt into equity

An overview of the new rules for the tax treatment of conversions of debt into equity within the same group of companies under the Taxation Laws Amendment Bill 2017.
  • Submitted 23 August 2017
  • Applicable Law Africa , South Africa
  • Topic Tax

This article was first published by Conor Mcfadden of Fasken Martineau, Johannesburg, who has agreed to Simmons & Simmons making it available on elexica.

National Treasury has proposed the introduction of new rules for the tax treatment of conversions of debt into equity within the same group of companies. These proposals in the Taxation Laws Amendment Bill 2017 released on 19 July 2017 come on the back of concerns that taxpayers are entering into short term shareholding structures which seek to thwart the debt reduction rules.

The Income Tax Act contains provisions that deal with the way in which a taxpayer has to account for any benefit resulting from a waiver, cancellation or reduction of a debt that they owe. These provisions apply only where the debt was used to fund deductible expenditure or capital assets and the amount of debt reduced exceeds any consideration received by the creditor for the reduction.

This may benefit the debtor. Depending upon what the funding was used for, the debtor may have a recoupment for income tax purposes or a reduction in base cost for capital gains tax purposes.

Over recent years, and owing to difficult market conditions, taxpayers have "capitalised" their loans in their subsidiary companies, effectively converting debt into equity which results in a healthier looking balance sheet for the subsidiary.

Although it is not technically possible to convert debt into equity under our law, what occurs in practice is that the creditor (holding company) subscribes for shares in the debtor (the subsidiary) for an amount equivalent to the debt outstanding at that point. The debtor then uses the subscription proceeds to settle the outstanding debt or the parties set off the two claims.

This results in no debt reduction and consequently no adverse tax consequences for the parties. SARS has issued a number of binding private rulings on the issue and has released an interpretation note confirming that the debt reduction provisions would not apply in these cases.

The latest proposals apply only where the debtor and creditor form part of the same group of companies (70% or more shareholding). Treasury is proposing that where a debt owing is settled, directly or indirectly, by means of shares issued by that company to another company in the group then the debt reduction provisions will not apply. This is the case under the current law.

However, should the debtor and creditor no longer form part of the same group of companies within at least five years from the date of conversion and the market value of the shares issued is less than the debt, the difference will be recouped in the debtor’s hands.

The market value of the shares must be measured at the stage of the de-grouping and not at the time the shares were issued. This is an important consideration if one is purchasing shares in a company which has capitalised any of its debt in the preceding five years. The purchaser will need to assess if the sale will trigger this provision by assessing the market value of the shares on disposal against the face value of the old debt, then determining whether or not the seller will be exiting the same group of companies by virtue of the sale.

Where the debt reduction provisions do not apply, Treasury has proposed that any interest previously deducted by the debtor that is subsequently converted into equity must then be treated as a recoupment in the hands of the debtor to the extent that the interest was not subject to normal tax in the hands of the creditor.

This is crucial as under certain multinational structures the parent company will not always be subject to tax in South Africa on the interest accrued as a result of the application of a double tax treaty. The local company will then recoup all such interest. Such a recoupment is to be used firstly to reduce any assessed loss of the debtor and then a third of any balance remaining must then be treated as a recoupment in each of the three immediately succeeding years of assessment.

The proposed date of operation of these proposals is set at 01 January 2018.

This document (and any information accessed through links in this document) is provided for information purposes only and does not constitute legal advice. Professional legal advice should be obtained before taking or refraining from any action as a result of the contents of this document.