Re-financing and buy-back of shares

stollen chequeAuthor: Heinrich Louw (DLA Cliff Dekker Hofmeyer)

The South African Revenue Service (SARS) released Binding Private Ruling 163 (Ruling) on 12 March 2014.

The Ruling deals with the tax consequences of a transaction involving the re-financing of various loans and the application of the proceeds for purposes of a share buy-back.

The facts are briefly as follows.

Company X owns 49.3% of the issued shares of company Y. The balance of the issued shares of company Y are held by various individuals, companies, trustees of trusts and executors of deceased estates (other shareholders).

It is intended that:

  • company X would sell some of its shares in company Y to the other shareholders; and
  • thereafter, company Y would repurchase the remaining shares from company X.

In other words, company X will exit as a shareholder of company Y.

Company Y has various subsidiaries. The subsidiaries are debtors in respect of four interest-free intra-group loans. 

For purposes of carrying out the transaction:

  • company Y will float a new company of which it will hold all the shares;
  • the new company will acquire all the shares in the subsidiaries from company Y, in exchange for issuing more of its own shares to company Y;
  • the subsidiaries will refinance their interest-free intra-group loans by obtaining interest-bearing bank funding;
  • the subsidiaries will distribute the proceeds from the bank funding, together with surplus cash, to the new company as a dividend;
  • the new company will also obtain a loan from bank;
  • the new company will distribute the cash dividend received from the subsidiaries, together with the cash received from the bank in respect of its own loan, as a dividend to company Y; and
  • company Y will use the cash dividend received from the new company to repurchase its own shares from company X.

The first issue that arose was whether the subsidiaries would be entitled to claim interest deductions in respect of the interest-bearing bank loans that would replace the interest-free intra-group loans.

Three of the four loans were obtained for purposes of financing working capital, building projects, and capital equipment for conducting business. The purpose of the fourth loan was initially to fund capital expenditure in respect of certain projects, but surplus funds would have been available to fund it. After the distribution, there would be no cash available for the projects and the subsidiary would have to borrow the funds again.

SARS ruled that the interest incurred in respect of the first three loans would be allowed as a deduction under s24J(2) of the Income Tax Act, No 58 of 1962 (Act). However, the interest incurred in respect of the fourth loan would not be allowed. The reason for this is not entirely clear from the ruling, but it appears that the bank loan will be seen as having been obtained to fund the payment of the dividend, and would thus not meet the requirement of being incurred in the production of income.

The second issue that arose was whether the distribution by company Y to company X as consideration for the repurchase of the shares would constitute a dividend.

SARS ruled that it would constitute a dividend. This is so presumably because there would be no resolution by the board of company Y to the effect that the distribution would reduce the company’s contributed tax capital.

SARS also ruled that the dividend would be exempt from income tax in terms of s10(1)(k)(i) of the Act, as well as exempt from dividends tax in terms of s64F(1)(a) of the Act (in that it constitutes a resident company to company dividend).

The ruling is welcomed in that, in our view, SARS has correctly applied the relevant tax principles and provisions of the Act.