February 23, 2012 · 0 Comments
Interaction between company law and income tax law
Emil Brincker, Director, National Practice Head, Tax
It seems that the legislative authorities have at last appreciated that a number of issues have arisen pursuant to the introduction of the new Companies Act 2008 on 1 May 2011. The introduction of the Companies Act has given rise to a number of anomalies and new concepts which have not been dealt with in the context of tax law to date. For instance, the Companies Act deals with a concept called “distributions”, whereas the fiscal laws still refers to “a dividend” distributed to shareholders.
One of the issues that has not been addressed to date, relates to the ability of a company to issue so-called “sweat equity” to shareholders in circumstances where the initial subscription price is not paid for such subscription on day one. In terms of section 40 of the Companies Act, the subscription price can be delayed or can be settled through means of the rendering of future services, future benefits or future payment by the shareholder. Unfortunately the ability to receive the shares immediately, results in an upfront tax liability for the subscriber to the extent that it is acknowledged that the shares are acquired for future services. Also it is not clear at this point in time whether the issue of shares by a company would actually constitute expenditure actually incurred by the company should these shares be issued for future services.
In the tax proposals issued by National Treasury it is indicated that an immediate focus area will also relate to company reorganisations and other share restructurings. Share-for-share recapitalisations of a single company will enjoy an immediate focus. Currently share-for-share transactions are dealt with in terms of section 42 of the Income Tax Act on the basis that rollover relief is afforded to shareholders to the extent that a shareholder acquires a 20% equity shareholding in the acquiror company pursuant to the disposal of assets to the acquiror company. The amalgamation provisions of the Companies Act are also not consistent with those incorporated in section 44 of the Income Tax Act, especially given the fact that section 44 of the Income Tax Act does not deal with the transfer of liabilities whereas the amalgamation provisions in the Companies Act deal specifically with the merging of assets as well as liabilities of the merging companies.
Transfer pricing and the use of quasi equity loans
It has often been a bone of contention between taxpayers and the revenue authorities as to whether a shareholders’ loan should attract interest at market‑related rates in circumstances where the shareholders’ loan has been intended to provide subordinated funding to the offshore company. More often than not such shareholders’ loan is used to fund the start-up operations of the offshore entity and it is not expected that the loan will be serviced for the foreseeable future.
It has now been recognised by National Treasury that these types of loans more often than not function as additional share capital and that the purpose is to provide for a more flexible use of capital. One should therefore not automatically insist upon a market‑related interest rate that applies to these types of loans. In particular, it has been proposed that these types of loans should be treated as share capital in line with the decision to treat certain forms of debt as shares.
Contingent liabilities revisited
Natalie Napier, Director, Tax
In the tax proposals for 2012, the issue of contingent liabilities has once again been the subject of reconsideration. In the 2011 budget it was proposed that new explicit rules would be introduced to clarify circumstances in which a deduction may be claimed in the case of the transfer of contingent liabilities pursuant to a sale of business. This proposal followed the judgment delivered in the Ackermans Limited/Pep Stores (SA) Limited v the Commissioner case delivered on 1 October 2010. The Supreme Court of Appeal considered if the expenditure had been actually incurred and concluded that no liability had been actually incurred by Ackermans having regard to the particular facts of the case.
On 10 May 2011, the South African Revenue Service issued a binding class ruling BCR29 concerning the deductibility of contingent liabilities taken over when buying the assets and liabilities of another company within the same group of companies. The context in which the ruling was issued was where two companies formed part of the same group of companies and that proposed transaction was to be implemented in accordance with the amalgamation provisions contained in section 44 of the Income Tax Act.
The nature of the contingent liabilities included both employment related obligations such as leave pay and bonuses, sales related obligations such as warranty obligations and contract cost overruns. If the contingent liabilities were to materialise, they would ordinarily have been deductible. It was confirmed in the ruling that the purchaser will be entitled to deduct expenditure actually incurred in respect of the contingent liabilities transferred. The seller of the assets and liabilities will correspondingly not be entitled to a deduction of the contingent liabilities.
The approach in the ruling is consistent with the Ackermans case in that there is the necessity that the expenditure be actually incurred by the purchaser in order to qualify for the deduction of the contingent liabilities. There is the necessity of considering whether there has been an “undertaking of an obligation to pay” or “actual incurring of a liability” in order to satisfy the requirements of section 11(a) read together with section 23(g) of the Income Tax Act.
In the tax proposals for 2012 it is now indicated that after much debate no legislative provisions will be enacted. Rather, it is indicated that an interpretative approach will be favoured. Interpretative guidance, with legislative refinements, is expected later in the year. The question will be the form of such interpretative guidance and how the existing interpretation adopted in the Ackermans case and the ruling will be applied. It is of concern that there remains such degree of uncertainty with what appears to be an issue which is not uncommon.
In line with current economic trends of there being a weaker economic climate, National Treasury recognises that some taxpayers are at risk of becoming insolvent and will seek to reduce or restructure their debt. In the budget proposals for 2011, National Treasury announced its intention to consider the elimination of unintended tax consequences of debt reductions in circumstances where there is a debt work-out.
Legislative amendments were subsequently proposed to amend the definition of “gross income”. However, the proposals were withdrawn following comments received that there was no co-ordination with recoupment rules. It was accepted that the isolated amendment was not appropriate.
In the 2012 budget proposals, the issue of debt cancellation is highlighted as one of the tax amendments for the forthcoming year. It is indicated specifically that –
“The goal would be to create a simplified regime to determine the tax impact on the debtor when debt unilaterally reduced or cancel without full consideration, and to eliminate adverse tax consequences when the debt relief merely restores the debtor to solvency.”
No specific indication is provided as to how this goal will be achieved, although it is noted in the 2012 budget proposals that specific rules will be required to regulate the situations where creditors agree to convert their debt interests into an equity stake as partial compensation. It remains unclear as to what form these rules will take as well as what other matters will be addressed in any legislative amendments required to eliminate the so-called unintended tax impact of debt reductions.
Continued focus on excessive debt in business operations
Emil Brincker, Director, National Practice Head, Tax
Since the suspension of the application of section 45 (intra-group transactions) and section 47 (liquidations) to corporate restructuring rules during June and July 2011 there has been a continued focus on the use of excessive debt in corporate restructuring transactions. It has now been mentioned that the main problem is the erroneous classification of certain instruments as debt to generate interest deductions for the debtor, where these types of instruments more accurately represent equity. This would for instance be the case with reference to so-called subordinated shareholders loans or so-called junior loans that are made available to companies. It has also been indicated that, should the creditor be a non-resident, there is currently a tax mismatch given the fact that the debtor can deduct the interest whereas the creditor would not be subject to tax. One of the consequences is the introduction of a withholding tax on interest at the rate of 15% on 1 January 2013.
It has also been indicated that, in 2013, National Treasury will consider a so-called “across-the-board” percentage ceiling on interest deductions, relative to earnings before interest and depreciation. This will limit excessive debt financing.
Related to the aforegoing, it has long been a bone of contention that no interest deduction is afforded to taxpayers in circumstances where debt is raised to acquire shares. The reason is that the shares are only expected to render exempt returns in the form of dividends thus prohibiting the interest deduction.
Pursuant to the introduction of section 23K to the Income Tax Act in circumstances where taxpayers had to make application to have transactions approved, including the level of debt, it has now been announced that the use of debt to acquire controlling share interests of at least 70% be allowed. The interest associated with this form debt acquisition is still subject to the same controls applied to section 45 acquisitions. In other words, even though there may be an interest deduction pursuant to the acquisition of shares, one will still have to make application to the Revenue Authorities so as to have the level of debt and equity approved, the rate of interest, the identity of the debtor and the fact that non-South African residents will effectively not be able to fund these types of transactions.
The question as to whether debt can be used to fund share acquisitions, has been the subject matter of much debate between taxpayers and the Revenue Authorities over the years. To the extent that an interest deduction will now be allowed, it is interesting to establish whether dividends will also become taxable in these circumstances so as to provide for reciprocity. Ultimately, however, taxpayers will have to realise that these types of transactions will be subject to a pre-approval process, apart from the fact that they will have to be reported to the Revenue Authorities. Apart from the fact that certain shareholders loans may in future be treated as equity, especially if they are subordinated in favour of senior lenders, the actual rate applicable to loans will also be closely scrutinised. The moment a premium is attached to an interest rate in view of the fact that the loan is subordinated in favour of other lenders, it may well at some stage be treated as equity, resulting in a non-deduction of interest by the debtor.
The focus of SARS shifts to insurance companies
It seems that the focus of the legislator and the revenue authorities has shifted from financial institutions to insurance companies. Apart from the elimination of so-called captive cell arrangements, it has also been mentioned that specific focus will be given on scenarios where premiums are paid by a parent company at increased rates on the basis that the excess so paid back to the company by way of tax-free preference share dividends, will be specifically addressed.
However, pursuant to a number of assessments issued to insurance companies over the last few months, it has been indicated that the solvency requirements applicable to insurance companies are not currently consistent with the tax treatment thereof. In the case of short-term insurance companies, it has been specifically indicated that the recognition of certain reserves have had both a positive and negative effect for short-term insurers.
In the context of long-term insurance companies, it seems that the so-called forefront trustee system of taxation is to be reconsidered. Essentially the business of a long-term insurance company is divided into an untaxed policyholder fund, a company policyholder fund, an individual policyholder fund and a corporate fund. Different tax principles apply to each fund and the assets accounted for by each fund. For instance, the untaxed policyholder fund is not subject to any tax. The different treatment has also given rise to mismatches from an account perspective. For instance, at one stage reinsurance liabilities were not recognised even though reinsurance assets were recognised for tax purposes, resulting in substantial anomalies.
It has been indicated that the tax system for calculating short-term insurance reserves will be addressed during 2012, with the long-term insurance industry being considered during 2013. One can expect far-reaching amendments, especially given the aggressive attitude that has been displayed by the revenue authorities towards insurers of late. However, recognition will have to be given that reserves play a critical role in this context, especially with reference to claims that are to be submitted in the future and the way in which insurance companies have to recognise same.
Mark-to-market taxation of financial instruments
Alastair Morphet, Tax Director
Currently some financial traders utilise the provisions of Section 24J(9) to effectively provide for the taxation of their interest-bearing instruments on a mark‑to‑market basis linked to the accounting treatment of those instruments in their accounts.
The Minister has indicated that he is keen to commence moving towards taxing financial instruments on this basis, that is aligning the tax treatment to the accounting treatment, in order to simplify the audit and compliance requirements for both taxpayers and the Revenue. Firstly he wants to move the provisions of Section 24I dealing with foreign currency instruments closer to the accounting standards. Secondly he is wanting to expand and revise the mark‑to‑market treatment of other financial instruments. The Budget Tax Proposals say that these changes will include expanding the provisions of Section 24J(9) to cover a wider set of financial assets and liabilities. He says that the revised system will be subject to explicit SARS approval so that those parties electing to move into this regime will be fully controlled during the pilot phase of the project.
The Minister makes it clear in his Budget Proposals that these legislative provisions will be changed as they are tested over the next few years based on the practical experience that flows from using them. Be warned!
Renewable energy tax allowances
Ruaan van Eeden, Tax Director
Section 12B of the Income Tax Act allows for the deduction of plant and machinery used in the generation of electricity from renewable resources on a 50/30/20 basis. A contentious issue that arises under similar accelerated allowance provisions is whether supporting structures in fact form part of or can be regarded as plant or machinery qualifying for deduction. Case law on this aspect is not always necessarily helpful.
For renewable energy structures the problem is particularly acute as they are capital intensive projects with most structures affixed to the ground not always capable of being removed. It is welcomed that Treasury will extend the 50/30/20 allowance under section 12B of the Income Tax Act to supporting structures to provide clarity to Independent Power Producers bidding to the Department of Energy. However, until such time that the legislation is promulgated it appears that the Advance Tax Ruling process must be favoured for current projects to obtain certainty on the tax treatment on supporting structures.
Reduction of tax rate for foreign companies
It is proposed that the corporate income tax rate for foreign companies with domestic income be reduced from the current 33% to 28%. The move was widely expected with the abolishment of Secondary Tax on Companies and the introduction of the Dividends Tax. It was long regarded that the higher foreign company tax rate of 33% was discriminatory under the provisions of certain Double Tax Agreements entered into by South Africa.
Given the unexpected jump in the Dividends Tax rate from 10% to 15% the effective tax rate of a foreign company in South Africa may be more beneficial than that of a locally incorporated entity. Could we see a surge in branch operations in South Africa as a result of this amendment?
Conclusion of tax information exchange agreements
True to its word, the South African Government has concluded a number of exchange of information agreements with so-called perceived tax havens so as to address the perceived risk that amounts may be hidden by South African residents in these types of countries. Of late, agreements have been published with the Cayman Islands, Jersey, Guernsey as well as San Marino. A number of other agreements are in the process of being ratified.
These agreements provide for the exchange of information between countries party to such an agreement upon request. Should the information in the possession of a specific country not be sufficient to enable such country to comply with the request for information, the country is obliged to use at its own discretion the information gathering measure it considers relevant to provide the other country with the information so requested. This is notwithstanding the fact that the requested party may not need the information for its own tax purposes. Recently a scenario arose where the Australian Government requested information from the South African Government in relation to the affairs of an Australian tax resident. Even though the request did not relate to the tax position of the taxpayer in South Africa, it was held that the information still had to be provided.
The information to be provided, extends to information held by banks, financial institutions and any other person acting in an agency or fiduciary capacity. It includes information about settlors, trustees, beneficiaries and protectors of a trust, units issued by a collective investment scheme and the like.
Taxpayers should appreciate that the world has become very small and that it would no longer be possible to hide assets in perceived tax havens without the ability of the South African fiscus to obtain information about that.
Reduction in rate for Personal Service Providers
The flat tax rate of 33% applicable to Personal Service Providers will be reduced to 28%, without much reasoning from Treasury. The move to reduce the flat rate is welcomed, but seemingly carries no correlation to the marginal rate of tax for individuals which was unmoved at 40%. Given that the Personal Service Provider legislation is an anti-avoidance provision aimed at discouraging individuals from rendering services through incorporated entities one would have expected some link to the individual tax rates.
Determination of the value of fringe benefits
The Seventh Schedule of the Income Tax Act provides for the value of certain non-cash benefits received by virtue of employment to be subject to PAYE on a monthly basis. Depending on the type of benefit in question, the valuation thereof may be subject to a formula calculation, such as housing benefits.
The valuation methods in the Seventh Schedule to the Income Tax Act do not always correlate to the actual cost of the benefit which in many instances can be objectively determined by an employer. Treasury has proposed where possible and practical, an employer would be allowed to use actual costs to determine the value of a fringe benefit. This is an attempt to create a better match between the deduction of employee’s tax and the tax calculation on assessment. Caution is necessary on this proposal, as actual costs may in fact push up the value of fringe benefits in certain cases.
Securities Transfer Tax : End of the broker’s exemption
Alastair Morphet, Tax Director
Currently South Africa has a Securities Transfer Tax which is payable on the change of the beneficial ownership of both listed and unlisted shares. Currently there is an exemption for brokers in the market – technically this is applicable to any “authorised user” as defined in Section 1 of the Securities Services Act 2004, who provides those services as the rules of the exchange regulate the buying and selling of listed securities. The Minister of Finance has announced that this exemption will be removed where brokers acquire shares for their own benefit. He says that the current blanket exemption will be abolished and where brokers do acquire securities as a principal, the tax will be applied at an “appropriate lower rate”. He says that this reduced rate will also cover the purchases of shares utilised in support of derivative hedging (which we suspect encompasses a “lending arrangement”). That is where parties have borrowed listed securities from another which they have delivered to a buyer pursuant to a short sale in order to hedge a long position of their own.
The Minister has said that these amendments will come into effect on 1 April 2013. However, he has also said that the Department will investigate the feasibility of widening the Securities Transfer Tax to cover derivatives.
Value-Added Tax Registration Threshold
Andrew Lewis, Senior Associate, Tax
Currently section 23 of the Value-Added Tax Act No. 89 of 1991 (the “VAT Act“) provides that a person becomes liable to register for value-added tax (“VAT“) at the end of the month where the total value of taxable supplies made by that person in the period of 12 months ending at the end of that month in the course of carrying on all enterprises has exceeded R1 million. Such a person must compulsorily apply to be registered as a VAT vendor within 21 days.
Until that person is registered as a VAT vendor by SARS, that person cannot charge VAT on any supplies made it in the course of carrying on its enterprise. Unfortunately, it has taken some vendors months to be registered as a VAT vendor and there are no provisions in the VAT to address this transition from a non-vendor to a VAT vendor (i.e. the person may not levy VAT on any of its supplies during this period). Accordingly, it has been proposed in the Budget Speech that the liability date for registration as a VAT vendor will be clarified.
Property Loan Stock Company & Trusts
The Property Loan Stock Association and the Association of Collective Investment Schemes in Property have been in negotiations with National Treasury for some years now, regarding the implementation of blanket legislation for both variable loan stock companies and Collective Investment Schemes in Property, under the banner of Real Estate Investment Trusts (so called REIT’s).
It is not clear in what form the dispensation will come, however, it does appear as though there concerns have been heard. It has been proposed in the tax proposals to the 2012 budget speech that the governance of property loan stock entities will be placed on a par with property unit trust. It is proposed that the rental income from these entities will fall under the pass-through regime that currently applies to property unit trust. It is our understanding that the intention is to ensure that both variable loan stock companies and Collective Investment Schemes in Property are effectively placed in a tax neutral position vis-à-vis the distribution of the rental income.
It is noted that Treasury appears to be concerned that other taxpayers (i.e. taxpayers other than variable loan stock companies) may use the linked unit structure (e.g. a R10 linked unit of which R0.01c is linked to the equity component and the remaining R9.99 linked to the debenture component) in order to avoid tax by relying on an excessive interest deduction. Taxpayers issuing linked unit should thus be mindful of Treasury’s view on these types of structures.
Household Saving Initiatives
As part of the Government’s drive to increase the rate of savings in South Africa, the Government is proposing to introduce tax-preferred saving and investment vehicles (“Saving Vehicles“) by April 2014. A discussion document will be published by May 2012 to facilitate the consultation process and refine its proposals.
It is proposed that the returns generated from these Savings Vehicles (e.g. interest, dividends, capital gains, etc) and the withdrawals will be exempt from normal tax. However, the aggregate annual contributions to these saving vehicles could be limited to R30 000 per year per taxpayer, with a lifetime limit of R500 000. These Saving Vehicles are clearly aimed at low income earners and it is anticipated that they will provide little incentive for middle-to-high income earners to utilise these Saving Vehicles.
Share incentive schemes are once again in the spot light in this year’s tax budget proposals. We have previously high-lighted in our weekly Tax Alerts that previous amendments to the Income Tax Act have triggered adverse tax consequences for share incentive schemes (e.g. amendments to section 10(1)(k)(i)(dd) and paragraph 38(2)(d) of the Eighth Schedule to the Income Tax Act).
It appears that these previous amendments have not satisfied Treasury’s concerns on share incentive schemes and will be undertaking a review of the various types of share incentive schemes to eliminate purported loopholes and possible double taxation concerns.
The review will also consider the interrelationship between employer deductions and employee share scheme income. It si anticipated that the South African Revenue Service is concerned that taxpayers currently argue that the contributions to the employee share scheme for their employees are deductible (see Provider v Commissioner of Taxes, 17 SATC 40), while the contributions received by the Trust are capital in nature on the basis that the trust is not engaged in a profit making scheme (see CIR v Pick ‘n Pay Employee Share Purchase Trust 54 SATC 271).
It also appears that the broad-based employee share plan contemplated in section 8B of the Income Tax Act will be reviewed and possibly merged into a single employee share scheme regime. Section 8B schemes are used by many taxpayers owing to the onerous requirements. If the section 8C and section 8B share scheme provisions are combined, it is anticipated that it will be to the detriment of high-net worth individuals. However, this process is said to take 2 years and we will have to wait and see what is proposed.
Share Issue Mismatches
It has come to Government’s attention that certain taxpayers have been relying on the fact that the issue of shares by a company does not give rise to ordinary or gains tax consequences for the company (i.e. merely representing a cash contribution to company), to shift value to new shareholders without paying the full tax due. Apparently the scheme relies on the shares being issued by the company for a consideration in excess of the value of the shares. For example, the company issues a share with a market value of R100 to a shareholder for R200.
The proposal made by the Treasury is for the R100, being the market value of the share, to remain free from any ordinary or capital gains tax treatment. Whereas, the additional R100 paid by the shareholder in excess of the market value of the shares will be subject to tax in the hands of the company.
It is noted that there may well be circumstances where a shareholder is willing to subscribe for shares in a company in excess of the market value. It will therefore be interesting to see whether the proposed legislation requires there to be some form of collusion (for want of a better word) between the shareholders (i.e. the show that there is an intention to shift value between the shareholders).
- Cliffe Dekker Hofmeyr is one of the largest commercial law firms in South Africa with some 115 directors/partners and 250 qualified lawyers located at offices in Johannesburg and Cape Town.