On 31 March 2015 Grant Thornton released an eTaxline article entitled ‘Subordinated Debt and Interest’ which dealt with the application of section 8F of the Income Tax Act 58 of 1962 (“the Act”) to interest incurred on subordinated debt.
Subordinated debt in the context of section 8F can be defined as the repayment of a debt which is conditional upon the market value of the assets of the company not being less than the market value of the liabilities thereof.
In brief, Grant Thornton Tax Advisory’s article in March last year explained that as a result of the introduction of this anti-avoidance provision and with effect from 1 April 2014, interest incurred on subordinated debt was no longer deductible. The disallowed deduction is furthermore regarded a dividend in specie both in the hands of the debtor and creditor, potentially being subject to dividends tax at 15%.
eTaxline readers are reminded that the application of section 8F is not limited to subordinated debt because it effectively reclassifies the tax consequences of interest-bearing debt, which features characteristics like those of an equity, to that of dividend-yielding equity funding. Affected debts are referred to as ‘hybrid debt instruments’ and they also include debts not redeemable within thirty years of issue date as well as debts which are convertible to, or exchangeable for, shares in certain instances.
Companies are often required by their auditors to subordinate debts owing to fellow-group companies, connected companies or shareholders in favour of third party funders in order to conclude that such companies are going concerns. In the absence of such conclusion the auditor may have to qualify his report on the going concern matter. Such subordinations are fairly common in our current tough economic environment and these debts are not motivated by any possible tax avoidance actions. The application of section 8F would be inappropriate in such instances and if it is applied as such, it will only succeed in placing more financial pressure on companies which may already be suffering.
This fact has been acknowledged in part by National Treasury and the South African Revenue Services (“SARS”) in the Draft Taxation Laws Amendment Bill issued on 8 July 2016 (“the Bill”).
Section 17 of the Bill contains proposed amendments to section 8F of the Act. These amendments, once promulgated, will provide some relief to debtors with subordinated debts where the relevant debtor and creditor form part of the same ‘group of companies’ as defined in section 41 of the Act.
The reference to the section 41 definition of a ‘group of companies’, as opposed to the s1 definition, is important because it will effectively exclude subordinated debts owing to non-resident companies.
The Grant Thornton Tax Advisory team believes that with so many South African companies owned by multinational groups, relief extending to debts owed to non-resident fellow group companies would have been appropriate. In the absence of section 8F the deductibility of such interest would have been subject to the transfer pricing and possibly thin capitalisation provisions, thereby rendering the total exclusion of such scenarios as overly restrictive.
The proposed amendment will only provide relief on the amount of interest equivalent to the amount which the company could otherwise have distributed to the relevant creditor. That’s if that creditor had been a shareholder and also if the company complied with the solvency and liquidity requirements of s 46 of the Companies Act No 71 of 2007.
As it is general audit practice for the subordination to be implemented to the same level where the relief applies, the full interest would not be subject to the application of section 8F. If the debt is subordinated to a level in excess of that required to satisfy the solvency and liquidity requirements, then only a portion of the interest would be subject to the relief.
The proposed amendment will come into effect for years of assessment ending on or after 1 January 2016.
For further information or for assistance understanding your responsibilities in terms of subordinated debt, please contact us.