Tax treatment of conversion of debt into equity and the artificial repayment of debt
Tax treatment of conversion of debt into equity and the artificial repayment of debt
The Income Tax Act, No 58 of 1962 (Act) contains rules dealing with the manner in which a taxpayer must account for the benefit derived from the waiver, cancellation, reduction or discharge of a debt owed by that taxpayer. The tax implications arising in respect of the reduction of a debt, depends mainly on whether the loan funding was used to fund tax deductible expenditure such as operating expenses or alternatively capital or allowance assets. The debt reduction rules apply only to the extent to which the waiver, cancellation, reduction or discharge of a debt gives rise to a “reduction amount”, in other words, the amount, by which the decrease in debt exceeds the consideration received by the creditor in return.
Background to the proposed change
In the current economic climate, there are various mechanisms by which a debtor may settle a debt with a creditor or a creditor may relinquish a claim to have the debt repaid. One of the mechanisms is the conversion of debt owed by a company into equity in that company. A company may, for example, reduce its debt by:
- issuing shares directly to a creditor in full and final settlement of the debt;
- issuing shares for an amount payable in cash and setting off the subscription price owed by the subscriber against an amount owed by the company;
- converting debt to shares in fulfilment of the conversion rights attaching to the debt (such as convertible debentures); or
- issuing shares to the creditor in exchange for cash and then applying the cash against the debt owed by the company.
These types of debt conversion schemes are usually entered into in respect of loans advanced to a company by the controlling shareholder of that company. The shareholder in effect converts a debt claim against the company to equity financing. This arrangement is aimed at improving the company’s balance sheet and retaining its financial sustainability. SARS has issued a number of binding private rulings providing relief in respect of the application of the current tax rules where a debt owed by a company to its controlling shareholder is reduced or discharged in terms of an arrangement that in effect converts that debt into equity. The most recent rulings include Binding Private Ruling 246 and Binding Private Ruling 255.
Reasons for the change
The Draft Explanatory Memorandum on the Taxation Laws Amendment Bill, 2017 (2017 Memorandum) states that the conversion of debt into equity is aimed at restoring or maintaining the solvency of companies under financial distress without triggering the debt reduction rules. It states further that the shareholder/creditor envisages, in effect, the outcome that would have been achieved had that shareholder originally funded the company by means of an equity contribution rather than the debt so converted. As a result thereof, the dispensation governing such arrangements should therefore be aimed at achieving, in broad terms, the outcome that would have been achieved had the creditor funded the company by means an equity contribution rather than by way of a loan.
Proposal: Exclusion of debt to equity conversions from the application of the debt reduction rules
In order to assist companies in financial distress, it is proposed that definitive rules dealing with the tax treatment of conversions of debt into equity be introduced. It is therefore proposed in the Draft Taxation Laws Amendment Bill, 2017 (Bill) that the rules dealing with debt that is cancelled, waived, or discharged should not apply to a debt that is owed by a debtor to a creditor that forms part of the same group of companies (as defined in s1 of the Act in order to include multinational groups of companies). The Bill therefore proposes the insertion of a further exclusion from the application of s19 of the Act where one group company is indebted to another and the debt is reduced or settled, indirectly or directly, by means of shares issued by the debtor group company.
A similar exclusion is proposed in respect of debt utilised to fund capital and allowance assets contemplated in paragraph 12A of the Eighth Schedule to the Act.
While several rulings issued by SARS implied that one could capitalise shareholder loans without triggering the debt reduction rules, the insertion of the specific exclusions in s19 and paragraph 12A of the Eighth Schedule to the Act, now codifies this exclusion specifically. Notably, the specific exclusion in respect of the issue of shares and the reduction of debt does not extend to a non-group context. This is based on the fact that it has come to government’s attention that creditors and debtors are entering into short-term shareholding structures that seek to circumvent tax implications triggered by the application of these rules. Therefore, to the extent that two non-group companies enter into a similar arrangement, one would still apply the ordinary principles which may or may not result in the trigger of the debt reduction rules depending on the specific factual circumstances.
Anti-avoidance: five year de-grouping rule
Notwithstanding the specific relief proposed within a group context, in order to counter abuse of the above-mentioned relief by taxpayers who simply wish to cancel, waive, or discharge a debt without any tax consequences and do so with no real interest in the financial recovery of the indebted company, it is proposed that the creditor and the debtor be required to continue to form part of that same group of companies for at least five years from the date of the conversion. To the extent that the companies “de-group” within five years, it will trigger the ordinary application of the relevant debt reduction rules. This relief will apply in respect of debt governed by both s19 of the Act and paragraph 12A of the Eighth Schedule.
Further proposal: Claw-back of interest previously incurred and deducted
Where the conversion of debt into equity does not trigger the application of the rules dealing with the tax treatment of debt that is waived, cancelled, reduced or discharged, it is further proposed that the tax consequences should be similar to those that would have applied had the creditor/shareholder funded the company by means of an equity contribution rather than the provision of a loan, ie as if the loan had always been an equity investment.
As a result, the following is proposed:
- any interest that was previously deducted by the borrower in respect of a debt that is subsequently converted into equity should be treated as a recoupment in the hands of the borrower to the extent to which that interest was not subject to normal tax in the hands of the company which received it or to which it accrued;
- the amount that must be recouped must firstly be used to reduce any assessed loss of that debtor company in the year of assessment that the debt to equity conversion takes place; and
- a third of any balance exceeding that assessed loss must be treated as a recoupment in each of the three immediately succeeding years of assessment.
Should the debtor and the creditor cease to form part of the same group of companies within the prescribed three-year period, any remaining balance of the interest previously deducted by the debtor, will have to be included in the taxable income of the debtor in full in the year of assessment in which they cease to form part of the same group of companies.
The proposed amendments will come into effect on 1 January 2018.
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