Author: Pieter van der Zwan (The University of North-West
Many South African companies are involved in transactions in which previously disadvantaged persons acquire ownership interests in such companies for purposes of complying with broad-based black economic empowerment (BBBEE) requirements applicable in the particular industries in which the entity operates or to enhance the BBBEE status of the entity in order to facilitate further growth. This type of activity is increasingly being undertaken by small and medium-sized entities that are under pressure to improve their BBBEE status as part of the supply chain to larger entities. The introduction of new shareholders or increases of the interest of existing shareholders does however also take place in a non-BBBEE context.
A transfer of ownership in the form of equity shares to another person or an increase in shareholding can be achieved in a number of ways. This includes the disposal of equity shares by existing shareholders to new shareholders, which can have capital gains tax implications for the existing shareholders, or by means of a share buy-back that reduces the interest of certain existing shareholders, which could potentially have dividends tax and/or capital gains tax implications. Alternatively, ownership interests can be increased by the company issuing shares to new shareholders.
The receipt of consideration for the issuing of shares would be of a capital nature and therefore not taxed as gross income in the hands of the company. In addition, paragraph 11(2)(b) of the Eighth Schedule to the Income Tax Act (hereafter the Act) specifically states that issue or cancellation of a share in the company does not constitute a disposal of an asset and would not trigger any capital gains tax for the company. A share issue would therefore generally be a tax-free event that changes the shareholding in a company.
The aim of this article is to explore whether all share issues are tax free events and to highlight certain pitfalls to be aware of when structuring a transaction that involves the issuing of shares by a company. Even though the principles are similar for transactions in a BBBEE context as well as those in a non-BBBEE context, the focus of this article is on transactions in a BBBEE context.
Donations tax and implications for the new shareholders
Section 40(1)(a) of the Companies Act states that the board of a company may only issue shares (other than capitalisation shares or as a result of the conversion of rights of previously issued shares) for adequate consideration to the company, as determined by the board. This provision does not explicitly require the company to issue shares at the current market value of the shares. It is submitted that it may in certain instances, such as BBBEE transactions, be appropriate and allowable to issue shares for less cash consideration than the current market value given the context of the transaction. This could particularly be the case where the company may derive benefits other than the cash consideration from the transaction.
A question that often arises is whether such an issue of shares for cash less than the current market value of the shares may be subject to donations tax. Section 55 of the Act defines a donation as: ”any gratuitous disposal of property including any gratuitous waiver or renunciation of a right”. If the transaction takes place for cash consideration which is less than the current market value of the shares, the provisions of section 58 of the Act may also be relevant. This section states that “[w]here any property has been disposed of for a consideration which, in the opinion of the Commissioner, is not an adequate consideration that property shall for the purposes of this Part be deemed to have been disposed of under a donation”.
Depending on the reason for the share issue at a cash consideration less than the current market value, these provisions may find application. It is however submitted that in the context of a share issue in order to improve the BBBEE status of the company, the issue is neither a gratuitous disposal of the shares, as the transaction is motivated by economic business reasons, nor can it be said to take place at less than adequate consideration in the circumstances, as this would constitute a contravention of the Companies Act. Another take on this matter is that the possible donation is not made by the company, but rather by the existing shareholders whose immediate share value may be diluted if shares are issued for cash less than the current market value. It is however submitted that the decrease in the value of the shares held by these shareholders does not constitute a disposal of their property, which is required for donations tax to be triggered, as the same shares are held by these parties before and after the share issue.
An interesting related point of debate is how the above argument regarding the share issue not being a donation from the perspective of the company or its existing shareholders, impacts on the tax treatment of these shares in the hands of the recipients who acquired the shares for less cash consideration than the current market value (the new shareholders). It can be argued that if the company does not issue the shares for inadequate consideration, this may be an indication that the new shareholders have to do something to earn the benefit of obtaining the shares at cash consideration less than the market value of the shares. Paragraph (c) of the definition of ‘gross income’ in section 1 of the Act specifically includes in gross income “any amount, including any voluntary award, received or accrued in respect of services rendered or to be rendered or any amount … received or accrued in respect of any employment or the holding of any office”. This inclusion is clearly not only applicable in the context of employment. The meaning of the term ‘services’ becomes critical in determining whether paragraph (c) may find application in the hands of the new shareholders. The Business Dictionary defines the term ‘service’ as a “valuable action, deed, or effort performed to satisfy a need or to fulfil a demand”. It can be argued that if the new BBBEE shareholders are required to perform certain actions to earn the benefit, that this benefit may constitute an amount to be included in gross income in terms of paragraph (c). On the other hand, if no actions or deeds are required by the new shareholders, the benefit could be viewed as a fortuitous receipt in the hands of the new shareholder, obtained other than as part of a scheme of profit-making, even though it was motivated by commercial reasons for the issuing company. If this line of reasoning is followed it may well be contended that the amount is of a capital nature and should therefore not be included in the gross income of such shareholder (see CIR v Pick ’n Pay Employee Share Purchase Trust 54 SATC 271).
Value-shifting and value mismatch provisions
As a result of the potential of share issue transactions to shift interests in companies to other parties without the transaction necessarily being subject to capital gains tax, value-shifting provisions have been incorporated into the Eighth Schedule to the Act. These provisions only find application where value is shifted to a connected person in relation to an existing shareholder, where a change in rights to the company occurs and as a result of that change in rights the value of an interest of the connected person increases while the value of the existing shareholder decreases. Transactions in terms of which these changes occur as a result of a disposal at market value do not fall within the definition of a value-shifting arrangement. In the context of BBBEE transactions, where the existing shareholders are not connected persons in relation to the new black shareholders, it is unlikely that a value-shifting arrangement will exist.
When dealing with a possible value mismatch between the consideration and the value of the shares issued one has to also take cognisance of section 24BA of the Act, which became effective from 1 January 2013 and applies to transactions entered into on or after that date. Where a company acquires an asset, as defined in the Eighth Schedule, in exchange for shares issued and the consideration for the share issue transaction viewed in isolation is different from the consideration that would have applied had that asset been acquired in exchange for the issue of those shares in terms of a transaction between independent persons dealing at arm’s length, this section may deem certain tax implications to arise. In the event that the value of the shares issued exceed the market value of the asset (i.e. value is extracted from the company), a deemed dividend will arise if section 24BA applies. If the value of the asset exceeds the value of the shares (i.e. value is moved into the company), a capital gain will arise in the hands of the company with a base cost adjustment in the hands of the shareholder that contributed the asset if section 24BA applies. It is however important to note that this section only applies if the consideration for the shares issued is an asset as defined in paragraph 1 of the Eighth Schedule. This definition specifically excludes currency from being an asset, which would mean that section 24BA would not be applicable to transactions where shares are issued for cash, even if there is a value mismatch between the cash consideration and the value of the shares issued. If the consideration for the share issue is in a form of an asset other than cash, the provisions of
this section must however be carefully considered.
Concluding thoughts
Share issue transactions provide a mechanism to taxpayers to change shareholding in a company without necessarily attracting the same tax consequences as the transfer of shares by existing shareholders. The discussion however highlights that it would be dangerous to work on the assumption that these transactions are without tax implications and that there are numerous aspects, of which some were pointed out in this article, that have to be considered. Some of the tax issues concerning share issue transactions may be more pronounced in the context of BBBEE transactions, which means that careful planning and well formulated views on the matters raised in this article are required when implementing arrangements of this nature.