Author: Amanda Visser (BDLive)
Some local companies are starting to feel the pinch following changes to the Income Tax Act which reclassify debt to equity when certain characteristics are present.
Tax experts said last week the changes caught companies — whose loans from their multinational holding companies were subordinated in favour of creditors when they suffered financial hardship — in a trap that was almost impossible to get out of.With the change, interest on the loan, which could in the past be deducted as an expense, is converted into a divided, which is not tax deductible.
The denial of a deduction to the borrower and the payment of a dividend tax increase the cost of the loan and could increase the financial hardship of the company or even drive it into liquidation.BDO tax director David Warneke said that in many instances the loans were subordinated by the holding company in favour of other creditors in an effort to “placate” them and to allow the company to continue trading.
The reclassification of debt to equity was brought about by last year’s Taxation Laws Amendment Bill as the Treasury saw these arrangements as a way of tax avoidance. Instances where reclassification of debt may take place extends to where debt is convertible into shares, if the debt is long outstanding and if interest is not determined with reference to a specified rate.
The Treasury argued that when local companies made payments to exempt persons (the foreign holding company) they had a greater tendency to classify share-type instruments as debt in order to obtain an interest deduction, knowing that the receiver of the interest was exempt. South Africa cannot tax the foreign company on the interest income they earn here, although that is set to change next year with a withholding tax on interest.
Mr Warneke said the effect of the subordination agreement was that the lender forfeited its claim on the loan in favour of the creditors until the subsidiary was able to return to solvency.”However, when a company does that, it walks right into the wording of the new section dealing with hybrid instruments (Section 8F of the Income Tax Act) and triggers the conversion of debt (loan) to equity.
The interest repayment is converted into dividends, which often trigger dividends tax … the subsidiary must pay,” he said.”Clients have loans worth billions of rand which have come into the country to fund local companies from abroad…. It is not easy to get out of the subordination agreements because it is in favour of the creditors. You will need the consent from the creditors to get out and, since they benefit, the company is stuck with the agreement.”
South African Institute of Chartered Accountants’ project director for tax, Piet Nel, said requests and submissions, which had been made prior to the implementation of the changes, to at least offer relief to companies that entered into the subordination agreements prior to the changes fell on deaf ears.He said the Treasury did not have any “appetite” for legislative changes that could bring relief to trapped taxpayers.
“Investors have to think twice about assisting a South African subsidiary in financial distress. Tax consequences are now driving commercial decisions,” Mr Nel said.