Datakor case is still alive for new debt reduction rules

rp_f93a144c8e9d40e5aaec0c090d7336e3-243x300.jpgBy Barry Visser, Associate Director: Tax, Grant Thornton Johannesburg

Old debt reduction rules
The matter of CIR v Datakor Engineering (Pty) Ltd 1998 (4) SA 1060 (SCA) related to a company (Datakor) that entered into an arrangement whereby Datakor’s creditors relinquished their claims against it in exchange for preference shares in the company. It was held that the discharge of a contractual obligation, to pay a debt, through the issue of shares, amounted to a compromise. The court concluded that the compromise benefited the company as it was absolved from its obligation to settle the debt.

The Datakor decision was made based on the prevailing legislation at the time, section 20(1)(a)(ii) of the Income Tax Act No58 of 1962 (the Act), which provided that the benefit received from the creditor due to compromise, would reduce the company’s assessed loss.

New debt reduction rules
Section 20(1)(a)(ii) has been repealed and new provisions have been inserted into the Act that deal with the cancellation and reduction of debt. For this purpose, section 19 of the Act must be read together with section 8(4)(a) Act and paragraph 12A of the 8th Schedule to the Act, collectively representing the so-called “new debt reduction rules”.

The new debt reduction rules apply where a debt that is owed by a person is reduced by any amount.

It is considered that the Datakor case may still be relevant in terms of the current legislation. Where a company’s creditors relinquish their claims against the company, in exchange for preference shares in that company, the relinquishing of their claims constitute a reduction of debt.

However, “reduction amount” is defined in relation to a debt owed by a person to mean “any amount by which that debt is reduced less any amount applied by that person as consideration for that reduction”.

It follows that the new reduction rules will apply because no amount has been applied as consideration against the debt.

If it is considered that the company is also setting-off the claim for payment in respect of the preference shares against the creditor’s claim, an amount as consideration against the debt must then have been applied.

The question that arises is what constitutes an “amount” in respect of the preference shares?

In the Datakor case, it was stated that the mere substitution of a creditor’s claim with a share, even a redeemable preference share, amounts to a concession. An enforceable obligation is replaced with something of a completely different nature. In the case of debts, all the assets of the company are available to satisfy the claims of creditors whereas, in the case of redeemable preference shares, only profits available for dividends or the proceeds of a fresh issue of shares may be used to redeem the shares. The right to redeem vests in the company and the creditor cannot enforce a ‘right’ to redemption.

It is considered that the conversion of a creditors’ claim into a preference share effectively translates into a dilution of that former creditor’s rights and it is likely that a Valuator could arrive at a different/lower value of the preference shares’ rights than the face value of the debt.

Recent amendments to the Act introduced various anti-avoidance provisions where there is a mismatch of values where shares are issued for consideration. However, it appears that the drafters of the amendments appear to have overlooked certain issues, for example where shares are issued for no consideration or where there is set-off or no asset acquired in exchange for shares issued. Therefore, case law would have to be considered and the advice from a tax specialist becomes essential to determine the extent to which debt reduction rules will apply where debt is converted into share capital.