Latest / Tax Break: South African tax for professionals / Proposed changes – Preference shares

Transcript

Proposed changes – Preference shares · Tax Break: South African tax for professionals

• 0:11
  Welcome and thank you for joining me for Tax Break.
• 0:13
  This is a podcast about South African tax, 4 South African tax
• 0:17
  professionals and practitioners. My name is Peter Frenchman and
• 0:21
  in each episode I share my thoughts on a topic or a recent
• 0:24
  development in South African tax.
• 0:26
  And I try to keep the episode short enough that you can listen
• 0:28
  to them whenever you've got a few minutes in your day.
• 0:32
  Now, for those of you who regularly listen to the podcast,
• 0:36
  you'll know that over the past two episodes or so, I've been
• 0:40
  mentioning that we are expecting the draft bills to be published
• 0:44
  by the National Treasury. That has happened.
• 0:47
  Now there is, so they were published on the 16th of August
• 0:51
  and they are open for comment until the 12th of September.
• 0:55
  So I think what's important about these bills is that these
• 0:59
  are the proposals for tax law amendments for the year.
• 1:03
  They are not yet final amendments and they are open for
• 1:07
  comment and consultation, but I do think that they give us a
• 1:11
  good indication of what may come say.
• 1:14
  It's worthwhile looking at them in any event.
• 1:17
  And hopefully through the podcast, I can make you aware of
• 1:22
  it and maybe get your thoughts going to, to assess what the
• 1:27
  impact on your business might be and possibly come up with one or
• 1:32
  two comments or suggestions for the National Treasury to
• 1:36
  consider. Right.
• 1:38
  So the first of these episodes dealing with proposals in the
• 1:43
  the draft bills is the I'm is this this episode and I'm going
• 1:49
  to deal with the amendment to Section 8 E of the Income Tax
• 1:53
  Act. So that provision deals with
• 1:56
  hybrid equity instruments. I've had a request for an
• 1:59
  episode to talk about hybrid instruments in the concept.
• 2:04
  So I will do that in a in a separate episode.
• 2:07
  But this episode specifically focuses focuses on the proposed
• 2:12
  changes through Section 8 E And I do think that this is probably
• 2:17
  one of the most significant proposals in the in the bowl or
• 2:23
  in the draft bill. So let's perhaps start with a
• 2:26
  bit of context. What is 80?
• 2:29
  Where do we see it? What does it do?
• 2:31
  How does it work? So the typical structure where
• 2:34
  I've seen Section 80 apply would be where an entity needs funding
• 2:40
  to and often the funding would be for for a purpose that
• 2:45
  doesn't qualify for interest deductibility.
• 2:48
  So let's take for example the entity wants to raise funding to
• 2:54
  buy shares. The shares would yield dividends
• 2:57
  and capital gains, so not income and therefore any interest if if
• 3:03
  the if the entity had to borrow money, any interest on that loan
• 3:09
  would not be incurred in the production of of of income and
• 3:13
  therefore not be deductible under Section 24J.
• 3:16
  So what entities then do as an alternative is to raise the
• 3:22
  funding through a share, often a preference share.
• 3:26
  And these preferences have a lot of similar features to do a loan
• 3:33
  or to date. So for example, they could have
• 3:35
  fixed coupon rate of of preference dividends.
• 3:40
  They can be redeemable at this specific point in time.
• 3:44
  So but but they are still shapes As for for Companies Act
• 3:50
  purposes. So the benefit of of these
• 3:54
  shares would be that from the issuers perspective, the issuer
• 3:58
  would not have been entitled to an interest deduction in the 1st
• 4:01
  place. So the fact that the dividends
• 4:03
  are not deductible that we didn't really have any fake
• 4:07
  they, but from the recipients perspective.
• 4:10
  So in other words, the holder of the preferential, the yield may
• 4:14
  be dividends which could be exempt, unlike the interest if
• 4:18
  it was a date instrument. So what Section 8 EE then does
• 4:23
  is to say that if this instrument has a certain date
• 4:29
  characteristics do and as a result of that is classified as
• 4:35
  a hybrid equity instrument. It requires A1 sided adjustment
• 4:39
  to say that the dividends and the foreign dividends that then
• 4:43
  accrue to the older of the instrument, this hybrid equity
• 4:46
  instrument will be deemed to be income.
• 4:49
  So that puts the holder back in a place where they don't qualify
• 4:53
  for the dividend exemptions and the amount is taxed as income
• 4:58
  similar to what the interest would have been.
• 5:03
  I guess the the next logical point to discuss is then when
• 5:07
  would the instrument have these deadlock characteristics to be
• 5:11
  classified as hybrid equity instrument?
• 5:15
  Now looking at the current low, there is a three-year period
• 5:19
  that that's that's quite critical three years from the
• 5:22
  date of issue. And essentially what it says if
• 5:26
  we just look at it very broadly is that if that instrument is if
• 5:31
  the company is obliged to redeem the instrument within within
• 5:35
  three years or the other is an option to request redemption of
• 5:39
  the instrument within three years, then it would be a great
• 5:44
  equity instrument. There are also a few other
• 5:49
  provisions to the definition to say, but if you've got Shay
• 5:52
  that's linked to a date instrument in a specific way,
• 5:57
  that could be our everyday or hybrid equity instrument.
• 6:00
  And then there is it also guides for, for equity instruments that
• 6:05
  are other instruments that derive their, their value or
• 6:10
  the, the, the rights attaching to those instrument OHH derived
• 6:14
  from these hybrid equity instruments.
• 6:17
  So what we often see then in, in, in practice is that you
• 6:22
  might have a preference share. And in the extreme, some of
• 6:26
  these preferences are redeemable after three years and one day,
• 6:32
  which would probably suggest that the terms were designed
• 6:35
  around Section 88 E in some way. And these instruments as long as
• 6:41
  the redemption period falls after more than three years,
• 6:46
  then the instrument would escape this definition of of hybrid
• 6:51
  equity instrument. It may still be that the entity
• 6:55
  needs to report the instrument to search if it's redeemable
• 6:58
  within a period of 10 years, right then to move on to the
• 7:03
  proposal. So what the proposal is, is that
• 7:06
  the definition of a hybrid equity instrument will be
• 7:08
  replaced to be its any share or any financial instrument that is
• 7:14
  or would be classified as a financial liability in the
• 7:18
  issuer's financial statements in accordance with Ifra's so
• 7:22
  international financial reporting standards.
• 7:25
  So a shade that's classified as a financial liability, you, you,
• 7:30
  you would often see that, that if you've got a preference share
• 7:34
  and with it's, it's got, it's, it's, it's, it's got mandatory
• 7:39
  dividends and it's got the mandatory redemption date, then
• 7:45
  that preferential would be accounted for as a financial
• 7:48
  liability. If we then go on and the, the,
• 7:52
  so the definition refers to a shade that's accounted for as a
• 7:55
  financial liability or a financial instrument that's
• 7:58
  accounted for as a, or classified as a financial
• 8:00
  liability in the issuer's financial statements.
• 8:04
  Now that definition of financial instrument has got 4 components
• 8:08
  or 44 elements. It firstly includes an interest
• 8:12
  bearing arrangement. Secondly, a financial
• 8:15
  arrangement based on undetermined with reference to a
• 8:18
  specified rate of interest or the time value of money.
• 8:22
  Thirdly, an arrangement that gives rise to a financial asset
• 8:26
  for the one person and the financial liability for the
• 8:28
  other party to the instrument. And then lastly, a financial
• 8:32
  arrangement with unknown or unspecified terms of repayment.
• 8:37
  So that definition of a financial instrument is quite
• 8:40
  wide and I'll get back to that just now.
• 8:43
  The effective date that's proposed is the 1st of January
• 8:48
  2026. So what I would like to do now
• 8:53
  is to just chase some initial thoughts and comments that I've
• 8:57
  got on this proposed amendment with you.
• 9:01
  And it could give you an indication as to where it may
• 9:06
  affect you or it could maybe give you an idea or something
• 9:11
  to, to, to put forward in terms of comments on the proposal,
• 9:16
  right. So let's start with a very
• 9:18
  obvious thing. I think the scope we can safely
• 9:21
  say is a lot wider than it is currently under Section 8 E.
• 9:25
  So if we look at, for example, a preferential with A5 or A10 year
• 9:29
  redemption period, if this proposal is implemented, that
• 9:33
  instrument would because or if it's classified as a financial
• 9:37
  liability for accounting purposes would be classified as
• 9:42
  I but equity instrument and would be subject to Section 80.
• 9:46
  So this in my mind, no doubt that that is what they faked
• 9:51
  would be and are. Do you think that that is that's
• 9:54
  really what the National Treasury also wanted to achieve
• 9:56
  with us and do to rely on accounting that looks a lot more
• 10:02
  at the substance rather than specific terms.
• 10:07
  I do however think that the scope is arguably so wide that
• 10:11
  it could lead to quite a few interpretation problems if the
• 10:16
  provision is left as is we and if it if it goes it.
• 10:21
  So if we look at that definition, because it refers to
• 10:24
  financial instruments, even a normal loan would be outbid
• 10:28
  equity instruments. So it would be an interest
• 10:31
  bearing arrangement. A normal loan gives rise to a
• 10:33
  financial asset for the one party, a financial liability for
• 10:36
  the other. So a normal loan would be a
• 10:39
  hybrid equity instrument. I think with the effect of this
• 10:43
  would be pulled back and probably in line with what the
• 10:47
  intention is, is that if you then look at Section 8, E 2, it
• 10:51
  only deems dividends and foreign dividends to be income.
• 10:54
  So it doesn't seem to affect interest and I think it's
• 11:00
  important that unlike Section 8, if Section 8 is A1 sided
• 11:04
  adjustment, so it shouldn't affect the issuers deductibility
• 11:09
  of of that interest. But the point remains that the
• 11:13
  scope of what hybrid equity instrument is, is very wide now
• 11:19
  and I think that could well create the conflict or at least
• 11:23
  a very difficult interpretation to apply certain provisions of
• 11:28
  the act where there could be some overlap now.
• 11:31
  So for example, if a normal loan is hybrid equity instrument and
• 11:37
  you've got loans that also fall under that are also classified
• 11:42
  as hybrid debt instruments under Section 8 F, they would be an
• 11:47
  overlap. So Section 8, if would deem the
• 11:49
  interest on the loan to be a dividend and then depending on
• 11:54
  on on the priority or or the order of application, Section 8
• 12:00
  E could come along and deemed the character of that dividend
• 12:05
  to be deemed that dividend to be income.
• 12:08
  Again, I don't think that was the intention, but because of
• 12:13
  this overlap that's created by the wide definition, I think
• 12:17
  there could be issues like that. The next point I want to raise
• 12:23
  is that Section 8 effects the holder of the instruments and
• 12:27
  other words the person who receives the difference or the
• 12:29
  foreign dividends. Now the treatment that's
• 12:33
  proposed in the proposal is that would be based on what the
• 12:37
  issuer does for accounting purposes.
• 12:39
  So having done quite a few, I studied to opinions on whether
• 12:45
  an instrument is classified as state or equity.
• 12:48
  I can tell you from experience that it's not an easy one
• 12:51
  obvious accounting classification.
• 12:53
  You there's a lot of nuances to IS 32 and there's a, there's an
• 12:58
  extensive guidance and you really have to work through the
• 13:02
  terms and deploy your mind to determine whether this
• 13:05
  instrument is now dead or equity.
• 13:10
  So that in itself shouldn't be an obstacle.
• 13:12
  But I do think from an information perspective, it's
• 13:15
  not quite clear to me how the holder would be aware of what
• 13:19
  the issuer does or would have done.
• 13:21
  So from an accounting perspective, the the, the focus
• 13:27
  of eyes 3 doors on the issuer, it's not on the older.
• 13:31
  The older would account for these instruments, whether it's
• 13:34
  data equity as financial assets in any event.
• 13:37
  So you are really asking the party other than the one that's
• 13:42
  already applied their minds about what the accounting would
• 13:46
  be to now make a call on the accounting.
• 13:49
  And I do think that that could both of you challenges in, in
• 13:52
  practice as I've also said. And perhaps the last point to
• 13:57
  consider, the accounting focuses on the issuer, not the older.
• 14:03
  And in the issues accounting treatment, I think there are
• 14:07
  some nuances that are don't. My reading of the proposal is
• 14:12
  that it doesn't quite cater for these.
• 14:14
  So for example, an instrument may well have some elements of
• 14:19
  reliability and some elements of of an equity instrument.
• 14:23
  So from an accounting perspective that instrument is
• 14:26
  then classified or accounted for as a compound instrument.
• 14:30
  So in other words, their liability and their equity
• 14:32
  components are separately accounted for.
• 14:36
  If I read the proposal as it stands at the moment, it seems
• 14:39
  to consider the instrument as a whole to be ibrid hybrid equity
• 14:45
  instrument or they not. So I do think that there are
• 14:50
  some some accounting acts, aspects or elements that the
• 14:57
  current proposal does not cater for that it may have to
• 15:00
  consider. So in summary, I think due we
• 15:05
  can we can say that there's there's a proposal to amend
• 15:08
  section Section 8. EI would suspect that there's
• 15:12
  going that there would be a lot of comments and consultation on
• 15:17
  it and it's something to keep your eye on if your entity is
• 15:23
  affected by this. That's it for today's episode.
• 15:27
  If you've got any questions or comments, please feel free to
• 15:31
  to, to send me an e-mail. My e-mail address is in the show
• 15:34
  notes if you like the episode. Recently listened to another
• 15:40
  podcast where they actually had a suggestion that in my mind
• 15:45
  works a lot better than liking or subscribing for the podcast.
• 15:49
  So I'm going to use their idea. So if you like the podcast,
• 15:54
  please forward the link to this episode to one other person that
• 16:00
  you think may also be interested in it or may also want to listen
• 16:04
  to it. I think that's a much better way
• 16:06
  of growing the listener base. So if you if you liked it,
• 16:12
  please consider doing that as always and do to close off,
• 16:17
  Please note that nothing in this podcast was intended to be tax
• 16:21
  advice, especially in the context of today's topic.
• 16:24
  It's only a proposal and I've only shared my initial thoughts
• 16:29
  about that proposal with you. So if you are affected or
• 16:34
  potentially affected, it might be something that you need
• 16:36
  advice on. Until next time, goodbye.