SECTION 8E AND 8EA: DO THE LATEST TECHNICAL CORRECTIONS ADDRESS AFFECTED PARTIES’ INITIAL CONCERNS?
After a long and controversial gestation, the Taxation Laws Amendment Act 24 of 2011 (the "TLAA") finally became law on 10 January 2012. The changes introduced by the TLAA, included important changes to section 8E and section 8EA, namely-
The extension of the definition of "hybrid equity instrument" (or "HEI") under section 8E of the Income Tax Act 58 of 1962 (the "Act"); and
The introduction of anti-avoidance measures for third-party backed shares under the new section 8EA,
with effect from 1 April 2012.
The extended definition of HEIs was met with fierce criticism - many argued that it would trigger unintended and unnecessarily onerous consequences for common and otherwise uncontroversial funding arrangements. Affected parties engaged the South African Revenue Service ("SARS") and the National Treasury on the proposed changes to section 8E and the introduction of section 8EA with a view to finding a middle ground in respect of those transactions undeservedly caught by these provisions.
This resulted in the release of the Draft Taxation Laws Amendment Bill (the "Bill") on 13 March 2012, The Bill contains so-called "Technical Corrections" to sections 8E and 8EA (the "Technical Corrections"). This article explains the changes to both sections, from the TLAA to the Technical Corrections.
Sections 8E and 8EA are generally aimed at transactions that use shares (usually preference shares) to "disguise" otherwise taxable interest as tax-exempt dividend income. The Explanatory Memorandum to the TLAA states that debt and share instruments differ in their essential features and consequences. The mischief that sections 8E and 8EA target is the realisation of a tax advantage where the consequences of shares are enjoyed but the substantial features of debt are employed.
The amendments recognise that preference share funding is often legitimately used to fund share acquisitions because of the rather unusual feature in South African tax: the disallowance of interest expenditure as a tax deduction where the purpose of the expenditure is a share purchase.
Section 8E (by Robert Hare)
Section 8E(2) deems the dividend declared by a company on a share qualifying as a "hybrid equity instrument" ("HEI") to be taxable interest income. Under the previous definition, the two main features of HEIs were:
a time limit (the HEI would have to be redeemable by the issuer, the holder or a third party, as the case may be, within 3 years of being issued); and/or
a "right of disposal" for the holder of the HEI, in terms of which the holder could require a third party to acquire or assist in the redemption or conversion of that HEI.
Accordingly, the previous definition of an HEI generally included a tripartite structure, with a borrower (the company issuing the HEI), a lender (the entity taking ownership of the HEIs) and a third party (who would be subject to the will of the lender if the borrower defaults). Under the amended section 8E, reference to the right of disposal falls away, as section 8EA will now apply to "third-party backed shares".
The TLAA targets "financial instrument backed shares", by introducing a new paragraph (c) to the definition of HEIs. A transaction is within the scope of section 8E if-
"any dividend or foreign dividend payable on such share [HEI] is to be calculated directly or indirectly with reference to any specified rate of interest or the amount of capital subscribed for such share; and
such share is directly or indirectly secured by a financial instrument other than an equity share." (our underlining)
This version of section 8E does not define "financial instrument", and the definition of a "financial instrument" under section 1 of the Act applied. That definition is extremely broad and its inclusion therefore greatly expanded the ambit of section 8E. Specifically, section 8E would now target many common two-party lending structures. An example of such a structure is as follows-
In order to raise funds, OpCo issues certain preference shares to Bank A;
Bank A then secures the dividend payments on those preference shares by taking cession of OpCo's book debts, or by way of a pledge of a bank account.
A cession of book debts falls within the definition of a "financial instrument" under the Act, and the preference shares secured by such a cession would therefore fall within the extended definition of an HEI, triggering section 8E. The dividend payments under the above arrangement would be deemed to be interest with Bank A accordingly being taxed on those amounts.
The Technical Corrections have reconfigured section 8E in order to avoid capturing "innocent" transactions like the one above. Firstly, a new limited definition of "financial instrument" has been introduced to section 8E itself to target the abuse being aimed at. A "financial instrument" under section 8E would now simply mean any-
"interest-bearing arrangement; or
financial arrangement based on or determined with reference to the time value of money;"
This new definition provides a more sophisticated carve-out for financial instruments than the previous exclusion of equity shares under paragraph (c)(ii). The new definition would not, for instance, capture the ordinary cession of debts under the abovementioned example.
Foreign dividends are still also targeted under the revised section 8E, ostensibly to capture transactions where a tax-exempt foreign entity is interposed to avoid its impact. However, a pledge of an interest-bearing bank account will also fall under the new provision.
Paragraph (c) of the definition of HEI has undergone amendment in order to better articulate which transactions SARS is targeting. The test for this category of HEI is still two-legged focusing on the calculation of the dividend yield and on the provision of security by means of a "financial instrument", as defined and described, and both legs must still be satisfied to qualify as an HEI-
Under paragraph (c)(i), the dividend yield will now need to be calculated "directly or indirectly with reference to any specified rate of interest or the time value of money", and the amount of capital subscribed for the HEI in question will no longer be a consideration.
Under paragraph (c)(ii), security by means of a financial instrument is still a requirement (see above), but now this subsection will also apply where the disposal of a financial instrument is restricted under certain circumstances (other than instances where a financial instrument "may be distributed as a dividend or return of capital"). This amendment to paragraph (c)(ii) is intended to capture arrangements that have the same practical effect as a direct security (such as a so-called "negative pledge").
Recognising that preference share funding is often legitimate, the TLAA also introduces further flexibility similar to the relief offered by section 8EA. If an equity instrument meets both requirements of paragraph (c) that equity instrument may still not be regarded as an HEI depending on what the consideration received by the issuer for the equity instrument is actually used for. Where the consideration for that equity instrument is used to-
acquire shares (that do not otherwise constitute HEIs) in an operating company outside the same group of companies (signalling further recognition of the potential impact of these provisions on black economic empowerment transactions);
settle any debt or interest thereon, in part or in full, incurred directly or indirectly in acquiring shares in an operating company as in (i) above (i.e. bridge funding); or
acquire or redeem any preference share as defined in section 8EA(1) (see below),
it will not qualify as an HEI and therefore not be subject to section 8E.
It should be noted, finally, that the operation of paragraph (c) will not be subject to time periods, i.e. its operation cannot be avoided by simply delaying or prolonging any of the trigger events, as is the case with paragraphs (a) and (b), for example, where the redemption of a share is postponed for three years.
Section 8EA (by Vivek Ramsaroop)
Section 8EA is the second flank of the attempt by SARS to adopt a substance over form approach to debt-like equity instruments, and third-party backed shares in particular. It is intended to eliminate special purpose vehicles and other third-party guarantee mechanisms that allow the holder of preference shares to rely on third parties and avoid the risk inherent in the issuer of the preference shares itself. The purpose of section 8EA is therefore to ensure that the holder of the preference share is exposed to the creditworthiness of the issuer, and not some unrelated entity.
The Technical Corrections have confirmed the above theoretical basis for section 8EA, as well as the carve-out for preference shares issued to finance the acquisition of shares in an operating company. Although black economic empowerment is not specifically mentioned in the legislation itself, this carve-out is aimed at accommodating black economic empowerment transactions and other legitimate share acquisitions.
The anti-avoidance rule for shares backed by third party guarantees or obligations applies when two requirements are met. The dividend yield of shares will be deemed to be income, in the case of domestic and foreign dividends, if-
the share is subject to an "enforcement right" or "enforcement obligation" in respect of a third party. This enforcement right or obligation must require a party other than the issuer of the share to effectively directly or indirectly guarantee the dividend or return of capital distributions to be paid to the holder in respect of the share; and
the enforcement right or obligation is triggered upon the failure to pay the dividend or a return on capital distribution.
The original version of section 8EA under the TLAA recognised that a wide application of the section would unfairly prejudice certain funding arrangements. Hence, the original provision created an exception where the consideration for the issue of the shares in question was applied directly or indirectly for the acquisition of equity shares of an operating company. These exceptions were expanded on in the Technical Corrections, as SARS ultimately agreed that the original relief offered was too narrow. The exceptions to what constitutes a third-party backed share recognises the need for preference share financing, particularly because South African tax law does not generally allow interest on debt to be deducted if that debt is employed to finance a share acquisition. Without such an exception, many commercial undertakings, particularly in the black economic empowerment sphere would be severely hampered.
The underlying logic of the exceptions to this anti-avoidance rule, which has again remained constant between the TLAA and the Technical Corrections, is that the consideration for the 'guaranteed' share must somehow relate to the acquisition of equity shares in an active operating company. Under the Technical Corrections, a share will not be a third-party backed share and section 8EA will not apply where the consideration for that share is applied to-
directly or indirectly acquire equity shares in an operating company outside the same group of companies (this is to prevent artificial cash injections into members of a group of companies);
retire bridge loans used for the purpose of acquiring equity shares in an operating company; or
refinance 'guaranteed' preference shares initially used to finance the acquisition of equity shares in an operating company or to retire bridge loans used raised for the same initial purpose.
With respect to the third exception for refinancing arrangements, the consideration for newly issued 'hybrid' preference shares cannot exceed the balance outstanding in respect of the initial 'guaranteed' share interest and accrued interest thereon.
Once any of the three exceptions are applicable, they will allow for third party guarantees/obligations to be provided by the following entities to the holder of the preference shares (a "qualifying holder" must own at least 20 percent of the entity in question, and a "controlled subsidiary" must be 70 percent owned by the relevant entity)-
a qualifying holder of the issuer or a controlled subsidiary of the issuer;
the acquired operating company itself, a qualifying holder of the operating company or a controlled subsidiary of the operating company; or
an intermediary of the issuer where the consideration is applied to acquire the same operating company shares as the initial issuer. This also includes qualifying holders of the intermediary issuer or a controlled subsidiary of the intermediary issuer.
The parent controlling company of the controlled subsidiary must be subject to the same or higher level of guarantees/obligations as the controlled subsidiary.
The Technical Corrections indicate that SARS and the Treasury have taken the input of affected parties to heart. By expanding and focusing the application of paragraph (c) they have produced a fairer and more nuanced approach to the mischief of debt masquerading as equity. Sections 8E and 8EA as they appear under the Technical Corrections will apply to dividends received or accrued on or after 1 October 2012, and in respect of years of assessment commencing on or after that date. Until then, only the pre-TLAA incarnation of section 8E will be applicable.