South Africa proposes amendments to hybrid debt and hybrid equity instrument legislation

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1 12 July 2016 Global Tax Alert South Africa proposes amendments to hybrid debt and hybrid equity instrument legislation EY Global Tax Alert Library Access both online and pdf versions of all EY Global Tax Alerts. Copy into your web browser: Executive summary On 8 July 2016, South Africa s National Treasury published for public comment the 2016 Draft Taxation Laws Amendment Bill (DTLAB). Comments are required to be submitted by 8 August The DTLAB contains proposed amendments to the hybrid debt instrument provisions 1 and hybrid equity instrument provisions. 2 This Alert summarizes these proposed amendments. Detailed discussion Cross-border hybrid debt instruments The anti-avoidance rules contained in sections 8F and 8FA of the Income Tax Act, which currently apply to both residents and nonresidents, effectively reclassify debt instruments issued by a company as equity if the terms of the instrument or the basis for the calculation of the yield contain certain equity-like features. If these rules apply, the interest is reclassified as a dividend in specie and the issuer is denied the interest deduction. The issuer also becomes liable for withholding tax at 15% in respect of the dividend in specie.

2 2 Global Tax Alert Currently, in the case of a nonresident issuer, if these hybrid debt rules apply and the interest is reclassified as a dividend, the nonresident issuer will not be denied the interest deduction (if it is not subject to South African tax rules) and the resident holder will be deemed to have received a dividend which is exempt from tax. The nonresident issuer will in this case only be subject to dividends withholding tax at 15% (subject to certain exemptions and treaty relief). Treasury is of the view that transactions involving nonresidents are intentionally made to include equity features in their debts instruments as a mechanism of taking advantage of the re-classification feature of these anti-avoidance rules. It has therefore been proposed that the anti-avoidance rules contained in sections 8F and 8FA should only apply to any form of interest-bearing arrangement or debt that is issued by: A company that is a resident A company that is not a resident if the interest incurred in respect of that instrument is attributable to a permanent establishment of that company in South Africa Or A company that is a controlled foreign company if the interest incurred in respect of that instrument must be taken into account in determining the net income of that controlled foreign company as contemplated in section 9D Importantly, the proposed amendments to sections 8F and 8FA are retrospective and come into effect on 24 February 2016 and will be applicable in respect of amounts incurred on or after that date. Hybrid debts instruments subject to subordination agreements Currently, the anti-avoidance rules in section 8F (as discussed above) are triggered where, inter alia, the obligation to pay an amount in respect of a debt instrument is conditional upon the issuer being solvent. In this regard, the subordination of a related party loan in favor of third party borrowings (which effectively provides that a company will not make any payments in respect of the related party loan until the company is solvent) would normally trigger the anti-avoidance rules in section 8F. In the Explanatory Memorandum to the DTLAB, Treasury recognizes that in the current economic climate it is not uncommon for companies to find themselves going through varying levels of financial distress as a result, many companies have reverted to entering into subordination agreements aimed at subordinating their shareholder loans in favor of third party borrowings. It has therefore been proposed that section 8F will not apply where an issuer owes an amount to a company, the company and the issuer form part of the same group of companies (as defined in section 41 of the Income Tax Act) and the payment of amounts owing by the issuer are suspended due to the issuer not being liquid or solvent as determined by section 46 of the Companies Act. This proposed amendment to section 8F will come into effect on 1 January 2017 and will be applicable in respect of amounts incurred on or after that date. Addressing circumvention of anti-avoidance rules dealing with third-party backed shares The anti-avoidance rules contained in sections 8E and 8EA of the Income Tax Act are aimed at penalizing debt instruments that have been disguised as equity in order to avoid tax. Where section 8E or section 8EA applies, dividends received are deemed to be income in relation to the recipient but remain dividends in relation to the issuer. Treasury is of the view that several schemes have been identified where investors structure transactions to circumvent the hybrid equity avoidance rules. It has therefore been proposed that the definition of hybrid equity instrument in section 8E be broadened to include any right or interest where the value of that right or interest is directly or indirectly determined by a share to which section 8E applies. Similarly, it has been proposed that the definition of preference share in section 8EA be broadened to include any right or interest where the value of that right or interest is directly or indirectly determined by a share to which section 8EA applies. The proposed amendments to section 8E and section 8EA will come into effect on 1 January 2017 and will be applicable in respect of amounts incurred on or after that date.

3 Global Tax Alert 3 Refinement of third-party backed shares: Pre legitimate transactions Section 8EA targets, inter alia, share issues where the dividends in respect of those shares are guaranteed by unrelated third parties. before the introduction of section 8EA in 2012, it was standard practice for transactions and arrangements to have excessive guarantees and obligations bolted on by lenders. Consequently, when section 8EA was legislated these transactions and arrangements fell within the ambit of section 8EA. Taxpayers who try to restructure these historic arrangements so as to avoid section 8EA, run the risk of attracting the general anti-avoidance provisions. In order to provide relief in respect of transactions entered into before section 8EA was introduced, it has been proposed that: Section 8EA be amended to allow any parties that entered into any arrangement or transaction that was finalized before 1 April 2012 and that fall in the ambit of section 8EA to be allowed to cancel any enforcement obligation or right The cancellation of any enforcement obligation or right must be done within a proposed window period which will start from the date of introduction of the TLAB 2016 and will end on 31 December 2017 The relief will be prospective. In other words, no refund of tax will be given by the South African Revenue Service to taxpayers who have already been affected by the provisions of section 8EA. The proposed amendments will apply in respect of any dividend or foreign dividend received or accrued during the years commencing on or after 1 January Impact The proposed amendments to the hybrid debt and hybrid equity instrument provisions in the Income Tax Act serve as reminder to all taxpayers to take careful note of these provisions when entering into equity or loan arrangements. Failure to take these provisions into account could essentially lead to unintended tax consequences. Endnotes 1. Contained in sections 8F and 8FA of the Income Tax Act. 2. Contained in sections 8E and 8EA of the Income Tax Act.

4 4 Global Tax Alert For additional information with respect to this Alert, please contact the following: Ernst & Young Advisory Services (Pty) Ltd., Durban Brigitte Keirby-Smith Candice van den Berg Ernst & Young Advisory Services (Pty) Ltd., Johannesburg Justin Liebenberg Ernst & Young LLP (United Kingdom), Pan African Tax Desk, London Leon Steenkamp Gonçalo Dorotea Cevada Ernst & Young LLP, Pan African Tax Desk, New York Dele A. Olaogun Jacob Shipalane

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