Authors: Michael Reifarth and Yani van der Merwe (ENSafrica).
There has been a rapid expansion of the crowdfunding industry during the last couple of years where businesses and entrepreneurs use crowdfunding platforms to promote their business ideas and to obtain funding from the public to finance their ventures. Although there are advantages and disadvantages to a crowdfunding arrangement in comparison to traditional funding arrangements, one constant factor applicable to both alternatives is that the transactions between the recipient and the provider of funding will, at all times, be subject to the provisions of the Income Tax Act, No. 58 of 1962 (the “Act”). In this article, we briefly consider some of the possible South African tax implications that may arise pursuant to the utilisation of the various types of crowdfunding that have lately been gaining traction in South Africa.
In terms of rewards-based crowdfunding, investors (the “Investors”) generally make an “investment” into a business with an undertaking by the business (the “Recipient”) that they will receive goods or services in return for the funding provided once the business has been launched successfully.
The tax consequences arising for Investors and Recipients depend, inter alia, on legal form of the transaction entered into between the parties. The contracts in place between the Investors and the Recipient will therefore have to be analysed in order to test the precise nature of the relationship between the parties. For example, it will have to be tested whether the parties have concluded an agreement in respect of the sale of goods or the provision of services, or if the parties have entered into a partnership.
We set out below certain tax aspects which require consideration in respect of a rewards-based crowdfunding arrangement.
In terms of the Act, “gross income” is defined (in the case of any resident), as the total amount, in cash or otherwise, received by or accrued to or in favour of such resident during any year or period of assessment, excluding receipts or accruals of a capital nature. Therefore, if the payment by an Investor constitutes an advance revenue receipt by the Recipient in respect of the sale of its trading stock or the provision of a service (i.e. the receipt is not of a capital nature), the Recipient will be required to include such amount in its gross income in the year of assessment during which the amount is received by or accrued to it, whichever is the earlier. This could mean that although the goods or services may only be supplied in following years of assessment, the Recipient will need to account for income tax thereon in the year of assessment in which the amount is received or accrues.
In determining this tax liability, it should be considered whether the Recipient would be entitled to a deduction of expenditure incurred against such income.
In terms of the general deduction formula contained in the Act, for the purposes of determining the taxable income derived by the Recipient from carrying on any trade, certain amounts of expenditure and losses may be deducted from the income of the Recipient where, inter alia, such amounts are actually incurred in the production of the income. Whether or not the Recipient is carrying on a trade is a question of law that will have to be decided on a case-by-case basis. If the Recipient receives an amount from the Investor at a time that it has not commenced carrying on a trade, the Recipient will not be permitted a deduction of expenditure incurred from the abovementioned income in terms of the general deduction formula. The Act, however, makes provision for the deduction of certain expenditure incurred prior to the commencement of trade, but such deductions may only be permitted in years of assessment when trading has commenced and may also be limited. In addition, the Act also permits an allowance in respect of future expenditure to be incurred by the Recipient in respect of certain contracts. Although limited in application, the Recipient could be permitted a deduction of an allowance of certain expenditure in terms of section 24C of the Act.
In terms of debt-based crowdfunding, the Investors provide funding to the Recipient by means of loan funding, which is then repaid over time with interest.
There should be no tax implications arising for the Recipient or the Investor upon the issue of the loan by the Recipient.
If the loan funding takes the form of an interest bearing loan, the provisions of section 24J of the Act may apply to such a loan. This section, inter alia, regulates the incurral and accrual of interest in respect of financial instruments. In terms of section 24J, interest income and expenditure will effectively be spread over the term of the loan for tax purposes. Upon settlement of the loan, certain adverse tax implications may arise for the Investor and/or the Recipient in instances where total consideration paid by the Recipient to the Investor over the term of the loan and at settlement thereof differs from the amounts taken into account for tax purposes.
Furthermore, if the debt owed by the Recipient is written off by the Investor or reduced for no consideration, then the provisions of section 19 of the Act or paragraph 12A of the Eighth Schedule to the Act may apply, which could give rise to income tax or capital gains tax (“CGT”) implications for the Recipient.
It should also be noted that specific anti-tax avoidance provisions may apply in instances where the terms of the loan or the interest payable on the loan contain certain equity-like features (for example where the interest payable in respect of the loan is not determined with reference to an interest rate, but rather with reference to the profits of the Recipient). In such cases, the provisions of the Act deem interest payments to be dividends paid by the Recipient to the Investor and are taxed accordingly. In such instances, the Recipient would not be allowed a tax deduction of such interest and the interest payments would be subject to the dividends tax.
In terms of equity-based crowdfunding, Investors provide funding to a start-up company by subscribing for shares in the Recipient company. The Investors will then receive dividends when the Recipient becomes profitable.
With regard to dividends declared and paid by the Recipient to an Investor, such dividends will generally not be subject to income tax in the hands of an Investor, unless certain anti-avoidance provisions apply in terms of which dividends are deemed to be income in the hands of the Investor.
Dividends tax is levied at the rate of 15% on the amount of any dividend paid by any company, subject to certain exemptions. Certain documentary requirements must be met in order to rely on certain exemptions from the dividends tax. There is no exemption available where the beneficial owner of the dividend is a natural person.
Any gains in respect of a disposal of the shares by an Investor may give rise to income tax or CGT implications in the hands of such an Investor, depending on whether the Investor trades in the shares or not.
A transfer of the shares may further be subject to securities transfer tax, payable by the Recipient, which may recover the tax so payable by it from the transferee.
In light of the above, we recommend that the tax implications arising out of crowdfunding be considered before providing substantial funding or utilising such platforms to obtain funding.