In years of assessment that commenced before 1 January 2013, the reduction of debt was generally subject to either income tax, capital gains tax or donations tax. The purpose of the relevant provisions at the time were, amongst others, to ensure that a debtor who was relieved of the obligation to pay any portion of the amount owing, would result in such debtor being subject to tax in its hands. Additionally, the provisions were aimed at achieving tax symmetry so that while creditors would be able to claim losses, debtors would also be taxed on the corresponding gains.
For years of assessment commencing on or after 1 January 2013, the relevant rules governing this area of tax law were subjected to a significant overhaul. The new rules, contained in s19 of the Income Tax Act, No 58 of 1962 (Act) and paragraph 12A of the Eighth Schedule to the Act, were designed to introduce a new uniform system that provided relief to persons under financial distress who were unable to pay their debts. The amendments were necessary on the basis that the pre-existing provisions may have effectively undermined the economic benefit of the debt relief for debtors given the potential tax imposed on them.
In 2017, further significant changes were made to the debt relief rules including the introduction of definitive rules dealing with the tax treatment of conversion of debt into equity and to ensure that the relevant rules applied in all instances where a debt is settled by a debtor and the creditor receives inadequate consideration for the debt claim (ie in order to address certain abuses pursuant to the artificial repayment of debt). Of particular significance was the replacement of the trigger of the application of the relevant provisions pursuant to a “reduction of debt” with two new concepts namely a “debt benefit” and “concession or compromise”. Additionally, the amendments made provision for the exclusion of interest from the application of the debt relief rules and that debt to equity conversions would be limited to arrangements between companies forming part of the same group.
Reasons for the further proposed changes
As is often the case when introducing new tax legislation designed to deal with specific tax avoidance arrangements, various concerns were raised about unintended consequences that could arise from the application of the recent tax amendments. The latest round of proposed tax amendments thus attempt to address the following concerns discussed in the Explanatory Memorandum on the TLAB:
- The inclusion of any changes in the terms or conditions of a debt as a “concession or compromise” could have the unintended consequence of affecting legitimate transactions. For example, it is often required by a lender bank that related party debt should be subordinated which would trigger the debt relief unintendedly. It has been argued that the inclusion of a change in the terms and conditions of a debt as a “concession or compromise” is a blunt instrument aimed at targeting a narrow group of taxpayers and as a result, should be removed.
- The inclusion of a substitution of an obligation in respect of a debt adversely affects arrangements that do not result in any loss to the fiscus (eg the use of bridging loans) and as a result, should be removed.
- Determining the amount of a “debt benefit” by comparing the face value of a debt prior to a “concession or compromise” with the market value thereafter is cumbersome for each and every event and as a result, should be removed.
First proposal: definition of “concession or compromise”
The first proposal is that a more comprehensive definition of “concession or compromise” should be included. The intention is for the new definition to limit the application of the rules to realisation events (eg cancellation, waiver, redemption, acquisition or conversion of debt to equity) and importantly, any change in the terms and conditions of a debt will not trigger the rules unless such changes result in an actual realisation event.
Second proposal: definition of “interest-bearing debt”
The intention has always been to exclude equity loans that are non-interest bearing from the ambit of the debt relief rules and therefore only interest-bearing debt that is converted to equity will fall within the ambit of the debt relief rules. The proposal therefore envisages including a definition of “interest-bearing debt”, in respect of which, interest will take on its meaning as already defined in s24J of the Act. Any debt substituted for any interest-bearing debt will also fall within the ambit of the provisions.
Third proposal: definition of “debt benefit”
It is proposed that the definition of “debt benefit” is amended in order to clarify when the new debt reduction provisions will be triggered. In summary, “debt benefit” will include the following scenarios:
- In the case of cancellation, waiver, or remittance - the amount cancelled, waived or remitted;
- In the case of a redemption of a debt or merger by reason of the debtor acquiring the claim in respect of the debt - the amount by which the face value of the claim exceeds the market value of the debt after such redemption or merger;
- In respect of conversions of debt into equity where the subscriber does not hold shares in the debtor prior to the arrangement - the amount by which the face value of the claim prior to the conversion exceeds the market value of the shares held or acquired by reason of or as a result of that conversion;
- In respect of conversions of debt into equity where the subscriber does hold a direct or indirect interest in the debtor prior to the arrangement - the amount by which the face value of the claim prior to the conversion exceeds the amount by which the market value of the shares held by the creditor or that other company after the conversion exceeds the market value of the shares held by that person in that company prior to that conversion.
Fourth proposal: multiple layers of shareholdings
It is proposed that definitions of “direct interest” and “indirect interest” should be inserted in order to eliminate double counting which currently allows taxpayers to reduce their “debt benefit” by multiple increases of multiple layers of shareholdings in the debtor company.
Fifth proposal: introduction of definition of “market value”
Lastly, it is proposed that a definition of “market value” will also be introduced under the debt relief rules. The key issue is that the proposal does not in itself clarify the meaning of the words “market value” but rather the purpose of the introduction of this definition is to provide clarity regarding the timing of the determination of the market value of shares acquired in respect of a debt to share conversion.
Further proposal: closing a loophole in the debt relief rules
In addition to the specific proposed amendments above, National Treasury have identified two further loopholes in the legislation which require attention. The debt relief rules currently provide for ordering rules that give preference to the application of other provisions of the Act, before the application of the debt relief rules. In particular, these ordering rules broadly apply, inter alia, in the case of estate duty, donations tax and employees’ tax. The rationale is thus to avoid double taxation in respect of the same economic event.
It has, however, come to National Treasury’s attention that in certain instances there may be double non-taxation which was not the original intention of the legislature. The proposals in this regard are thus twofold:
- The donations tax exclusion under the debt relief rules should be amended to provide that the exclusion will only be available where donations tax is actually payable on a donation arising from a debt relief arrangement.
- Amendments should be made in the debt relief rules to provide that where a “concession or compromise” arises after a capital or allowance asset has been disposed of, this will give rise to tax consequences.
The tax laws pursuant to debt restructuring and debt relief form a complex web of technical rules and while the additional proposed amendments will hopefully clear up some of the concerns recently raised, taxpayers would be well advised to keep their fingers on the pulse by studying the final proposed amendments and seeking professional advice when considering any debt restructuring arrangements so as to avoid any unintended consequences.