Subordination agreements: the Income Tax Act section 8f trap

EXCHANGE 2Section 8F of the Income Tax Act, dealing with hybrid debt instruments was substituted by the Taxation Laws Amendment Act of 2013. In its substituted form the provision is considerably broader in scope than its predecessor. In particular it appears that certain subordination agreements may render the subordinated debt subject to reclassification as hybrid debt with potentially costly consequences. The new treatment applies to amounts incurred on or after 1 April 2014.

In terms of section 8F if a debt instrument falls into classification as a hybrid then the effect is that interest incurred in respect of the hybrid debt instrument:

  • Is deemed to be a dividend in specie declared and paid by the debtor company on the last day of the company’s year of assessment and that accrues as a dividend in specie to the creditor on the same day; and
  • Is not deductible for income tax purposes.
  • In essence a hybrid debt instrument is defined as an instrument in respect of which a company owes an amount during a year of assessment if one of three conditions obtains. These are:

  • If the debtor company is in that year of assessment entitled or obliged to convert or exchange the instrument for shares unless the market value of the shares is equal to the amount owed at the time of the conversion or exchange;
  • The company owes the amount to a connected person and the company is not obliged to redeem the instrument within 30 years from the earlier of the date of issue of the instrument or the end of the year of assessment. Demand instruments have been excluded from this bullet; or
  • The obligation to pay an amount in respect of the instrument is conditional upon the market value of the assets of the company not being less than the market value of the liabilities of the company. There are a number of exclusions from the reclassification treatment. Most notably the provision does not apply to debts which:
  • Are owed by a small business corporation as defined;
  • Are tier 1 or 2 capital instruments issued by banks or controlling companies in relation to banks;
  • Are owed by long or short term insurers; or
  • Constitute linked units in a company held by a long or short term insurer, a REIT, a pension or a provident fund.

Often subordination agreements contain a clause to the effect that until such time as the assets of the debtor, fairly valued, exceed its liabilities, the creditor shall not be entitled to demand or sue for or accept repayment of the whole or any part of the amount subordinated. Under these circumstances it would appear that section 8F will be triggered. If on the other hand the subordination agreement merely contains a back-ranking clause then it may escape the application of section 8F.

The effect of such reclassification is that the company that incurs the interest may not deduct it for normal tax purposes. On the other hand, the creditor will usually enjoy an exemption from income tax in respect of the deemed dividend received or accrued. As the interest is deemed to be a dividend in specie for the purposes of the Act, dividends tax should be considered.

The liability for dividends tax in respect of dividends in specie declared by SA resident companies falls on the debtor rather than the creditor. It should also be borne in mind that the trigger for the 8F reclassification treatment is not the payment of a dividend: a mere incurral is sufficient. Therefore if interest is incurred in respect of such subordinated debt, dividends withholdings tax may arise. On the other hand, if the debt is interest free, section 8F cannot apply.

Where the beneficial owner of the deemed dividend is a person that is exempt from the dividends tax, for example a South African resident company, the dividend may not be subject to the dividends tax if the necessary declaration and undertaking forms are held by the debtor by the date of payment of the dividend i.e. by the last day of the debtor company’s year of assessment. Alternatively, if the creditor is a member of the same section 41 (South African) resident group of companies as the debtor, the declaration and undertaking forms are not required. Where the creditor is a non-resident company, the standard 15 % dividends tax rate may be reduced due to the application of a double taxation agreement. Any reduction in the rate is also subject to the holding of the necessary declaration and undertaking forms by the debtor by the last day of the debtor company’s year of assessment.

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