12 August 2010

Commercial property: don't max your tax

It appears as if people are now again starting to invest with confidence in commercial immovable property. In particular, South Africans are investing in offshore commercial properties in the light of the combination of a strong rand, relatively cheap prices and good returns.

But many people don't have the large amount of capital which is necessary to buy property. These people often prefer to pool their resources to create a structure in which they have a smaller stake together with other investors. The structures are sometimes loosely called syndicates.

The nature and mechanics of these structures raise many interesting legal issues. For instance, the structure used by a company called Sharemax Investments (Pty) Ltd has recently been under the spotlight. Simply put, that company issued shares and debentures to investors. The company used the loan and share capital to buy shopping centres. Significantly, the debentures were structured in such a way that the company paid the net rental it received from tenants in the shopping centres to the investors as interest.

Allegedly, the South African Reserve Bank is saying that, by using that debenture structure, the company carried on the business of a bank without a license. Apparently, the company is now changing its business model to pay dividends on its shares and not interest on debentures.

The debenture structure has been used for many years by the organised property loan stock company regime. These companies typically issue linked units: investors hold a share linked to a debenture which yields interest determined with reference to net rental generated by the company. The company effectively has no taxable income: it deducts the interest paid against the net rental received. The after-tax returns for investors where the companies pay interest is generally higher than where the companies return the profits as dividends on the share part of the linked unit.

Now, people who invest in or who put together property syndicate structures must very carefully consider the tax implications of the structures, in addition to the other legal implications.

In particular, people must know the following:

  • Tax is imposed on the substance of a transaction, not its form. So, if parties to a transaction dishonestly conceal the real transaction between them, the transaction will be taxed in accordance with what is found to be the real agreement between them. If a syndicate company issues shares and debentures, and returns its net rental as interest, it must ensure that the debenture is not, despite its form, seen to be a share and, accordingly, be treated accordingly for tax purposes. The effect would be that the company would need to pay income tax on the net rental (at a rate of 28%) and would need to account for secondary tax on companies on amounts returned to investors as dividends (at a rate of 10%).
  • If the syndicate company pays interest at a rate that is "excessive" (ie at a rate that is much higher than a market-related rate) SARS may disallow the "excess" as a deduction in the hands of the company. Again, the effect would be that the company would have taxable income in its hands. There is a reported case where the court effectively reduced the rate of interest that a company was allowed to pay to its holding company.
  • The timing of the deduction and payment of interest is very important. It would be disastrous if net rental accrued to a company in Year 1 but it only incurred the obligation to pay interest to debenture holders in Year 2: the company would need to account for income tax on its net rental without necessarily having a concomitant deduction for its interest charge.
  • Generally, the law relating to the deduction and accrual of interest is very complex. Just try reading section 24J of the Income Tax Act, 1962!
  • Finally, people should ensure that they do not fall foul of the so-called generally anti-avoidance provisions in the Income Tax Act, 1962.

It is heartening to see that there is renewed energy in the commercial property sector. However, investors and promoters should get proper tax (and other legal) advice before investing in, or setting up a local or offshore property structures, syndicates or funds.

Ben Strauss, Director, Tax

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