Budget 2021/22 – LIMITING THE POTENTIAL FOR DOUBLE TAXATION UNDER THE HYBRID DEBT ANTI-AVOIDANCE RULES

Section 8F and 8FA of the Income Tax Act are anti-avoidance provisions which seek to re-characterise the taxation of interest on debt instruments issued by a company where either the debt instrument itself or the interest incurred on the debt instrument has certain equity-like features. The objective behind the section is to tax the return on the instrument in accordance with its substance (and according to what the Act deems its true nature) rather than its named form in order to avoid the deliberate manipulation of the nature of the instrument for purposes of seeking more beneficial tax implications. Stated simplistically interest on debt instruments that have equity features are required to be taxed as a return on equity (dividend) and not as interest.

The existence of any qualifying equity feature in a debt instrument will, in terms of section 8F, result in the debt instrument being deemed a hybrid debt instrument whilst the existence of an equity-feature in the interest will, in terms of section 8FA, result in the interest being deemed hybrid interest.

The implications of a debt instrument or interest constituting a hybrid debt instrument or hybrid interest is essentially two-fold i.e. absence the applicability of any exemption, any amount of interest incurred by the borrower company on or after the date that the debt instrument or interest becomes hybrid is:

  • deemed to be a dividend in specie in respect of that share that is declared and paid by that borrower company to the lender and is taxed accordingly; and
  • not permitted to be claimed as a deduction by the borrower company.

What this means is that where section 8F or 8FA are triggered, the borrower company will potentially:
∞ pay dividends tax on the amount of interest at the in-principle rate of 20% in terms of section 64E(1) of the Income Tax Act, if no exemption applies (for example if the
lender is not a South African company); and
∞ will be precluded from claiming a deduction of such interest, in the ordinary course and to the extent that it was permitted to claim a deduction of interest on the debt instrument.

The Minister has contended that in its current construct, the section does not deem the interest to be a corresponding dividend in specie received by the lender. In his view, considered in the totality of the transaction, this may be overreaching as the
return may still be taxable in the hands of lender as interest at the lenders applicable income tax rate. As such there could be a potential double taxation on the interest. It is proposed therefore that the Income Tax Act be amended to address this concern
and to make it clear that the lender is also treated as receiving a dividend in specie. Unlike interest, the receipt of a dividend in specie by a taxpayer, is exempt from income tax in terms of section 10(1)(k) of the Income Tax Act.

On a literal interpretation of the relevant charging provisions under each section, however, it can be argued that the treatment of the interest as a deemed dividend in specie is expressly for both the borrower company and the lender. Stated verbatim,
the section provides any amount that is incurred by a company in respect of interest on or after the date of the instrument becomes a hybrid [debt instrument/interest] is -(a) deemed to be a dividend in specie in respect of a share that is declared and paid by that company to the person to whom that amount accrued on the last day [our emphasis]. Notwithstanding, however, the proposed amendment for clarity on the creation of no double taxation is welcomed.

Authors:
Howmera Parak and Stephan Spamer