Convertible debt instruments

income tax 1Author: Arnaaz Camay of ENSafrica

The Taxation Laws Amendment Act, 31 of 2013 (the “TLAA”) introduced with effect from 1 April 2014, a new section 8F into the Income Tax Act, 58 of 1962 (the “Act”) in order to reduce the opportunity for the creation of equity instruments that are artificially disguised as debt instruments (“hybrid debt instruments”).

In terms of the provisions of section 8F(1)(a) a “hybrid debt instrument” is defined as inter alia any instrument in respect of which a company owes an amount during a year of assessment if the company is entitled to convert or exchange that amount (or any part thereof) for shares in that company or in any other company that forms part of the same group of companies as that company. However, as an exception to the provisions of section 8F(1)(a) of the Act, the TLAA inserted the following words:

“…unless the market value of those shares is equal to the amount owed in terms of the instrument at the time of conversion or exchange

In terms of the Explanatory Memorandum (“EM”) on the draft Taxation Laws Amendment Bill, 2013 (the “TLAB”), National Treasury initially indicated that one of the purposes of section 8F was to focus on debt-labeled instruments that enabled a conversion into shares. The conversion of a debt instrument into an equity instrument as a result of allowing the issuer to repay the debt in the form of shares, results in a re-characterisation of the nature of the instrument, from a debt instrument (that carries an obligation for a required cash redemption) to an equity instrument (that carries no obligation for a cash redemption).

In the draft Response Documents, as presented to the Standing Committee on Finance by National Treasury and the South African Revenue Service (“SARS”) on the comments received on the draft TLAB, it was proposed that a distinction should be made between the conversion or exchange of an instrument for a fixed number of shares and the conversion or exchange of an instrument for a variable number of shares. National Treasury however, indicated that a distinction will not be made between conversions or exchanges of instruments for a fixed or variable number of shares. Instead, an exception will be incorporated into the definition of a “hybrid debt instrument”, in terms of which, where the value of shares to which the instruments is converted or exchanged is equal to the amount outstanding in respect of the instrument, such conversion or exchange will be excluded from the definition of a “hybrid debt instrument”.

The reason for this exception is presumably, that where an instrument is convertible or exchangeable for shares with a market value equal to the amount outstanding in respect of the debt instrument, the issuer will, in effect, redeem the debt instrument at its face value (i.e. by issuing shares to the holder with a market value equal to the face value of the debt due to the holder). Accordingly, the debt instrument will be redeemed, but just not for a cash consideration. Such instrument will, from the date of conversion, be regarded as an equity instrument in all respects and therefore the holder will be entitled to all the risks and rewards of an equity instrument i.e. the equity instrument will be non-redeemable and the dividends payable in respect of such instrument will depend on the profits of the company. For tax purposes, the dividends will not be deductible by the issuer nor will the dividends be included in the income of the holder.

In the EM on the TLAB, National Treasury subsequently indicated that one of the purposes of section 8F was to focus on debt-labeled instruments that enable a conversion into shares where the market value of the shares is less than the amount of the outstanding debt. Where an instrument is convertible or exchangeable for shares with a market value which is less than the amount outstanding in respect of the debt instrument, the issuer will, in effect, not redeem the full amount of debt instrument at its face value because the market value of the shares issued by the issuer will be less than the face value of the debt due to the holder. Accordingly, the debt instrument will only be partly redeemed, as opposed to being fully redeemed as is the case where the debt instrument is convertible or exchangeable for shares with a market value equal to the amount outstanding in respect of the debt instrument. Accordingly, as one of the essential characteristics of a debt instrument is that such debt instrument is redeemed, in full, in the situation where the debt instrument is not redeemed in full, but only partially, by the issuer, the debt instrument retains an element or characteristic of an equity instrument (i.e. no obligation for a redemption in respect of a portion of such debt instrument) and therefore such debt instrument remains a “hybrid debt instrument”.

Where an instrument is convertible or exchangeable for shares with a market value which is greater than the amount outstanding in respect of the debt instrument, the issuer will, in effect, redeem the full amount of debt instrument. Accordingly, the debt instrument will not only be redeemed, but will be redeemed at a premium. In this regard, the essential characteristics of a debt instrument (i.e. that the debt instrument is redeemed) will be fulfilled. Therefore, where the debt instrument is redeemed by the issuer by issuing shares to the holder with a market value greater than the face value of the debt due to the holder, such instrument should no longer be regarded as a “hybrid debt instrument”.

However, based on the wording of the exception to the provisions of section 8F(1)(a) of the Act, the exception will only apply where “the market value of those shares is equal to the amount owed in terms of the instrument at the time of conversion or exchange”. This has the result that, the exception will not apply where an instrument is convertible or exchangeable for shares with a market value which is greater than the amount outstanding in respect of the debt instrument. Whether or not this consequence was intended may be open to debate.

For taxpayers issuing or holding convertible debt instruments it would be advisable to carefully consider whether the exclusion to the “hybrid debt instrument” definition will be applicable.

 

 

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