SARS issued Binding Private Ruling BPR 173 on 2 July. The ruling purports to deal with a thorny issue which has been the cause of uncertainty but unfortunately raises more questions than answers. The issue is whether the debt reduction provisions of the Income Tax Act, namely section 19 or paragraph 12A of the Eighth Schedule, would be invoked where a company issues shares and utilises the proceeds from the share issue to repay debt.
Our view is that if shares are issued for consideration i.e. if the shares have a market value equal to the subscription price (and equal to the amount by which the debt is reduced), then the transactions can be structured in such a way that set-off applies without cash having to flow in circular fashion and that this avoids the application of the debt reduction provisions.
In other words, if shares are issued with a subscription price and market value equal to that of the debt that is reduced and this issue of shares is effected on loan account, this loan account can then be set off against the debt owing.
A company is however at risk of falling foul of section 19 or paragraph 12A in circumstances where the market value or subscription price of the shares issued falls short of the debt that is reduced. In such a case it can be argued that a debt reduction has, in substance if not in form, taken place.
The consequences of a debt reduction in terms of section 19 or paragraph 12A include the recoupment of deductions or allowances where the debt was used to fund the deductions or allowances, or the reduction in the base cost of a capital asset, where the debt was used to fund the acquisition of the asset.
The circumstances applicable to the ruling are that a loan from a foreign holding company that is the majority shareholder of the applicant was used to fund operational expenditure of the applicant. The foreign holding company wishes to recapitalise the applicant by way of a new issue of ordinary shares.
The applicant will use the cash so generated to repay the loan owed to the holding company in full. Management of the applicant will also have the option to subscribe for more shares in the applicant, but it is stated that it is unlikely that management will in fact subscribe for more shares in the applicant.
The shares will be of the same class as those currently in issue. Such shares will be issued at par value.
The applicant will issue share certificates to the holding company and will timeously repay the outstanding loan amount in cash to the holding company.
Curiously, no assumption regarding the adequacy of the market value of the shares issued by the applicant is made in the ruling. Therefore it is not clear whether SARS regards this as an issue to be taken into account in establishing whether or not a debt reduction has occurred.
Furthermore, there is a condition or assumption that the subscription price for the new issue of shares is to be settled in cash by the holdco and that the loan amount owed to holdco will be settled in cash by the applicant. As mentioned above it is not at all clear why cash has to flow in circular fashion. Repayment of mutual indebtedness can validly be effected by way of set-off, provided that the conditions necessary for set-off to occur are present, namely: 1. The debts must be owing between the same parties; 2. the debts must be of the same kind, for example, a money debt can only be set-off against a money claim; 3. the reciprocal debts must be due and payable; and 4. the reciprocal debts must be liquidated. (Wille: Principles of South African Law 8th Edition at 483).
The effect of a set-off is that the reciprocal obligations of the parties are discharged to the extent of the set-off. It is regarded as a form of payment, refer Public Carriers Association v Tolcon Road Concessionaries (Pty) Ltd (4) SA 574 (N) at 589G-590C. It has even been regarded as the equivalent of a cash payment in SWA Amalgameerde Afslaers (Edms) Bpk v Louw 1956 (1) SA 346 (AD) 354.
The ruling made is that neither section 19 nor paragraph 12A will be applicable. This means that there will be no recoupment of deductions or allowances to the extent that the shareholder loan was used to fund such deductions or allowances. No ruling is made as to the past deductibility of the operating expenditure or the applicability of section 31 (transfer pricing) to the facts.
It would seem that the ruling is, unfortunately, of little value in dealing with the issues of uncertainty mentioned above.