13 June 2011 by

Significant implications for variable loan stock companies in the Draft Taxation Laws Amendment Bill 2011

Whether it is intended or not, is not clear, but the Draft Taxation Laws Amendment Bill, 2011 (the Draft Bill) has proposed certain amendments to the Income Tax Act No. 58 of 1962 (the Act) which may have significant implications for the property industry and on variable loan stock companies (VLS Companies), in particular.

The Draft Bill introduces a new section 8G of the Act which deems as dividends, payments of what is now regarded as interest, in respect of "perpetual instruments". "Perpetual Instruments" are instruments, the terms of which do not specify any date for discharge in full or redemption - effectively "perpetual debt". If an amount is paid or incurred by an issuer in terms of a "perpetual instrument":

  • no deduction may be allowed in respect in that amount; and
  • that amount must be deemed, both in relation to the issuer of that perpetual instrument and in relation to the holder of that perpetual instrument, to be a dividend.

The mischief that SARS and National Treasury are apparently targeting is that certain taxpayers have tried to avoid the interest calculation rules of section 24J of the Act by arguing that where a debt instrument has an uncertain maturity date, it is not possible to determine the yield to maturity.

VLS Companies are typically funded through debt (normally labelled "debentures") and equity issued as linked units (for example, a R10 linked unit of which R0.01c is linked to the equity component and the remaining R9.99 linked to the debenture component). It has been common practice in recent years, in structuring both listed and unlisted VLS Companies, not to specify a redemption date for the debentures. So, depending on the terms of the linked unit issued to the investors, the debenture component may well be regarded as a "perpetual instrument".

In such instances, from 1 April 2012, not only will the amounts distributed as interest by the VLS Company to the investors under the linked unit not be deductible, but the income accrued to the VLS Company will be taxed at normal company tax rates (28%) and the amount distributed to the investor will be deemed to be a dividend in relation to both the VLS Company and the investor and subject to the new dividend withholding tax at a rate of 10%.

The tax consequences described above are in stark contrast to the current tax treatment of a VLS Company and for many of the institutional investors in listed VLS Companies, the new treatment would subject their returns to a much higher rate of tax than they currently enjoy. It has been a contentious issue, but VLS Companies are generally in a tax neutral position as any interest received from the underlying investment is reduced by a corresponding deduction of the interest payable to the investors.

The Property Loan Stock Association and the Association of Collective Investment Schemes in Property have been in negotiations with National Treasury for some years now, regarding the implementation of blanket legislation for both VLS Companies and Collective Investment Schemes in Property, under the banner of Real Estate Investment Trusts (so-called REIT's). However, the Draft Bill makes no reference to any dispensation in this regard. If National Treasury is to grant such a dispensation, it has set the clock ticking towards a 1 April 2012 deadline.

It is not clear whether section 8G has been proposed to specifically deal with these types of arrangements or is an unintended consequence as specific reference is not made to the property loan stock industry in the Explanatory Memorandum. The public have until 5 July 2011 to submit their comments on the Draft Bill to National Treasury.

William Midgley, Director, Tax
Andrew Lewis, Associate, Tax

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