Section 24B of the Income Tax Act No. 58 of 1962 has been amended with effect from 21 October 2008 by providing that, if a company acquires an asset from any person as consideration for shares issued by that company -
- the company is deemed to have actually incurred an amount of expenditure in respect of the acquisition of that asset, which is equal to the lesser of the market value of the asset immediately after the acquisition or the market value of the shares immediately after the acquisition; and
- the seller is deemed to have disposed of the asset for an amount equal to the market value of the shares immediately after the acquisition.
Section 24B, which was originally introduced to provide certainty for companies when they issue shares in return for the acquisition of an asset, seems to have created more problems than solutions over the years. It was originally promulgated because SARS argued that a company does not actually incur any expenditure when it issues a share in return for an asset. For instance, if a company acquires a plant worth R100, and issues shares to settle such purchase consideration, the original argument of SARS was that the company would not have actually incurred any cost to acquire the plant. (See for instance ITC 1801 which was decided in favour of the taxpayer). Section 24B is aimed at addressing this position so as to provide both the company and the new shareholder with a cost in relation to the acquisition of the plant as well as the subscription of the shares.
Unfortunately, the deeming provisions of Section 24B only apply if a company acquires an asset as consideration for shares issued by the company. An asset is defined with reference to the Eighth Schedule dealing with Capital Gains Tax (CGT). In this context, the company would therefore not be deemed to have actually incurred any expenditure if it settles a liability as opposed to acquiring an asset. Arguably the deeming provisions also do not apply to the extent that a company may issue shares to a service provider that has rendered services to the company instead of paying such service provider cash. Since an asset is now defined with reference to the Eighth Schedule dealing with CGT, it is also important to appreciate that an asset does not include cash. In other words, if a company receives cash pursuant to the issue of a share, these deeming provisions would equally not apply.
Consider the example of Company X that is indebted to Y in an amount of R1000. Z wishes to subscribe for shares in Company X. Company X thus issues 1000 shares to Z on the basis that Z settles the debt owed by Company X to Y by transferring the cash of R1000 to Y. It is argued that, because Z provides consideration for the shares and that consideration is received by Company X (by discharging the liability owed to Y), the company would then be deemed to have actually incurred expenditure as opposed to the debt merely being seen to be 'discharged' without any consideration by Company X. This may then otherwise result in a CGT liability for Company X as it did not actually incur expenditure to discharge such liability.
Unfortunately, the wording of Section 24B does not alleviate the position. In this context, the requirement is that Company X should have acquired an asset, which it does not. Even though Z may provide consideration for the shares, no asset as defined in the Eighth Schedule has in fact been acquired by Company X. It would thus follow that there may be negative tax consequences to Company X by issuing the shares to Z in circumstances where the debt owed by Company X to Y is discharged. The only other way to resolve the problem would be for Company X to actually receive the cash from Z and to use the cash to discharge its liability to Y. The problem, however, is that cash does not constitute an asset and that Section 24B would therefore not apply to the receipt of cash by a company in return for the issue of shares.
A further anomaly in relation to the provisions of Section 24B is that the seller of the asset is deemed to have disposed of the asset for an amount equal to the market value of the shares immediately after the acquisition. In this context the market value of the shares may not necessarily be the same as the market value of the asset. A similar position does not apply to the company as the company is deemed to have acquired the asset for an amount equal to the lesser of the market value of the asset or the market value of the shares. In other words, the seller of the asset and the company are not treated on the same basis. If a company issues shares at, say, par value, to the seller of the asset, the company is deemed to have acquired the asset at the par value of the shares. The seller is then equally deemed to have disposed of the asset for the amount equal to the market value of the shares, which may be much higher in the circumstances. The new shareholder (the seller) is thus prejudiced even though the company is not deemed to have acquired the asset at the same value at which the seller is deemed to have disposed of the asset to the company.
More important, however, is that the anti-avoidance provisions of Section 24B have now been amended to provide that, for instance, if Company X acquires a share in Company A which is issued to Company X by reason of or in consequence of and within a period of 18 months after the issue of shares by Company X -
- Company X is deemed not to have incurred any expenditure in respect of the acquisition of the share in Company A;
- Company A is deemed to have issued the shares for an amount of zero.
The effect of these anti-avoidance provisions is that it is very difficult to fund companies within a group of companies in circumstances where there is for instance a holding company (HoldCo), which holds 100% of the shares in Subsidiary A, which in turn holds 100% of the shares in Subsidiary B. If HoldCo subscribed for shares in Subsidiary A on the basis that the proceeds are used by Subsidiary A to subscribe for shares in Subsidiary B, Subsidiary A is deemed not to have incurred any expenditure in respect of the acquisition of the shares in Subsidiary B and Subsidiary A is deemed to have issued the shares to HoldCo for zero. In a South African context the problem may be overcome to the extent that HoldCo then directly subscribes for shares in Subsidiary B, even though it is not always practical to do so.
Effectively, these anti-avoidance provisions as they are now worded, kill any foreign investment or any empowerment transactions that are based on the issue of preference shares. The reason is that the base cost of the relevant shares is deemed to be zero to the extent that a company issues shares and as a consequence thereof, subsequently subscribes for shares in another company. From a foreign investment perspective, it is very difficult for South African companies to fund their foreign subsidiaries by way of debt. Apart from the fact that it is generally restricted from an exchange control perspective, there is also a risk that these companies may otherwise be exposed to foreign exchange gains and/or losses should funding be provided by way of debt. If a South African holding company (SA HoldCo) now capitalises the foreign holding subsidiary (Foreign HoldCo) which in turn is to capitalise a foreign operating subsidiary (Foreign OpCo), the problem is that the Foreign HoldCo will not be deemed to have incurred any expenditure in respect of the subscription of shares in the Foreign OpCo and it is deemed to have issued the shares to the SA HoldCo for zero. This is obviously an untenable position.
A similar scenario arises in the context of empowerment transactions funded through means of preference shares. The general structure of these transactions is that preference shareholders would subscribe for preference shares in a special purpose vehicle (SPV), that will in turn subscribe for shares in the company that is to be empowered (ListCo). In view of the fact that the SPV will subscribe for shares in ListCo in consequence of the issue of shares by the SPV to the preference shareholders, the SPV is deemed to have issued the shares to the preference shareholders for zero. If these preference shares are subsequently redeemed by the SPV, there are substantial negative tax consequences since the base cost of these shares is then zero. Once again, this is an untenable position given the fact that no empowerment transaction can then otherwise be funded by means of preference shares, which method still remains the most prevalent in the circumstances. Even though an 18 month limitation period has been introduced, it still does not alleviate the position in circumstances where the intention is that a company issue shares in order to use the proceeds to subscribe for shares in another company