South Africa: The Imaginary World Of Notional Vendor Finance

Many share acquisition transactions implemented in South Africa are vendor financed, i.e. money is lent by the company to a prospective shareholder in order to enable the acquisition of shares in such company.  Particularly in the Black Economic Empowerment ("BEE") environment and share incentive trusts, it is common for companies to vendor finance the transaction, and to this end the transaction is usually structured as either a physically funded transaction, or with what is commonly referred to as notional vendor finance.  Physically funded transactions include traditional loan or preference funding structures which have established tax principles attached to them.  This article, however, focuses on the concept of notional vendor financing and the potential risk associated therewith.

A notional vendor finance transaction in the context of a BEE transaction can be illustrated as follows:

• Vendor issues "A" ordinary shares ("the A-Shares") to BEE SPV (Pty) Ltd ("BEE SPV") at nominal value.
• A Notional Vendor Finance ("NVF") balance is established by Vendor at the fair value of the A-Shares, less a Black Economic Empowerment ("BEE") discount.  The NVF balance will increase at a notional growth rate which may be fixed or floating.  The terms of the A-Shares will provide that the A-Shares will not carry any rights to dividends until such time as the NVF balance is reduced to nil.  In order to reduce the NVF balance, Vendor will calculate the amount of dividends which would ordinarily have been declared on the ordinary shares in Vendor, and apply such amount as a credit against the NVF balance.  Once the NVF balance is reduced to nil, the A-Shares will be converted to ordinary shares in Vendor ("Ordinary Shares").
• Vendor will be granted a call option in terms of which it will be entitled to call and redeem a variable number of A-Shares, say 20 years from the date of issue ("the Maturity Date").  The A-Shares will be redeemed at nominal value and the number of A-Shares to be redeemed will be determined by using a prescribed formula ("the Formula").  Accordingly, immediately after the call option is exercised:
• 1. Vendor will cancel the calculated number of A-Shares at their nominal value ("the Cancellation Shares").  In respect of the Cancellation Shares, Vendor will grant BEE SPV a right to subscribe for the same number of Ordinary Shares as the number of Cancellation Shares, however, such subscription will take place at market value.
  2. Vendor will procure the conversion of the balance of the A-Shares, which have not been cancelled ("the Conversion Shares") into Ordinary Shares.
• In addition to the A-Shares and to ensure a continuous flow of dividends (trickle dividends) to the BEE Partners, Vendor shall simultaneously issue a special class of preference shares to BEE SPV at nominal value ("the Trickle Prefs").  The Trickle Prefs will:
• 1. carry a fixed dividend rate that will be used to pay the BEE SPV costs and BEE SPV ordinary dividends; and
  2. be redeemed by Vendor at nominal value at the earlier of Maturity Date or the date on which the NVF balance is reduced to nil.

The typical tax consequences relating to a notional vendor finance transaction can be summarised as follows:

• The issue of the A-Shares will not attract Capital Gains Tax in the hands of Vendor.  Furthermore, the issue by Vendor of its shares at a discount will not give rise to a deemed donation as there is no "disposal of property'" as required for donations tax purposes.
• The creation of the NVF balance and the increase of such balance will not be subject to tax as it is a notional concept and used solely as a mechanism to determine the amount of A-Shares that Vendor will be entitled to cancel at Maturity Date.  In addition, and on the basis that the terms of the A-Shares are structured in such a manner that BEE SPV does not acquire any rights to dividends until after the conversion of the A-Shares, BEE SPV will not waive any rights and according there will be no disposal of an asset for CGT purposes.
• The granting of an option constitutes a disposal for CGT purposes.  However, on the basis that no proceeds are received in respect of this option, no CGT liability will arise. Upon the exercise of the call option Vendor acquires a right to redeem A-Shares, the number of which is determined in accordance with the Formula, at their nominal value.  The redemption of the A-Shares will constitute a disposal for CGT purposes in BEE SPV's hands.  As BEE SPV and Vendor will ordinarily not be "connected persons" for purposes of the Act, the proceeds will be equal to the base cost and the CGT liability will be Rnil. The fact that BEE SPV is disposing of the A-Shares for nominal value should not trigger any donations tax under section 58 of the Act, provided it can be shown that the redemption price is an adequate consideration given the surrounding facts and circumstances of the transaction.
• The conversion of shares would generally constitute a disposal for CGT purposes. However, if the time, terms and conditions relating to the conversion of the A-Shares are fixed upfront, save for the number of A-Shares to be converted which will only be established at the conversion date by virtue of the application of the Formula, the conversion is akin to a compulsory conversion.  Accordingly, no disposal will take place on the date of conversion for CGT purposes.

Substance-Over-Form Doctrine

In several cases involving tax avoidance schemes, the South African courts have considered whether a scheme is in fact what it purports to be, or whether it is a disguised transaction.  This is known as the "substance-over-form" doctrine, whereby courts will not be deceived by the form of a transaction, but to render aside the veil in which the transaction is wrapped and examine its true nature and substance. 

Because of the 2010 case of CSARS v NWK (27/10) [2010] ZASCA 168 (1 December 2010) and the court's apparent different approach to this principle, it has to be considered whether the NVF structure could be attacked in future under the "substance-over-form" doctrine.   The principles laid down in the NWK case can be summarised as follows:

• A taxpayer must have two different intentions that is, his real intention vs. the simulated intention.  The real intention will always override the simulated intention, and where there are two intentions, the courts will disregard the simulated intention.
• In determining the real intention the mere production of agreements does not prove that the parties genuinely intended them to have the effect they appear to have. Put differently, the agreements do not always reflect the real intention. To determine the real intention all the facts and surrounding circumstances must be considered.
• Invariably because even a simulated transaction requires an intention, it is necessary to determine the commercial sense of the transaction, that is, its real substance and purpose. If the purpose of a transaction is only to evade tax, then it will be regarded as simulated.
• In determining the commercial sense of the transaction the court will look at:
• 1. whether there is an underlying difference or implicit agreement between parties;
  2. what the normal characteristics of similar transactions are;
  3. what the economic substance of transaction is;
  4. what the net effect of the transaction is; and
  5. what else did the transaction achieve other than the tax benefit.

The NWK case has confirmed that the onus is on the taxpayer to prove that the transaction is not a simulated transaction if challenged by SARS. Accordingly, the onus will be on Vendor to prove that:

• The real intention of the parties was not to fund the acquisition of the A-Shares through a growth-bearing instrument. If the intention was to fund the purchase of the A-Shares through an interest-bearing instrument, the courts will give effect to that real intention and regard the notional interest as actual interest.  The fact that the written agreements do not reflect an interest-bearing arrangement cannot be relied upon as indicative of the real intention. However, if the notional interest component is reflected in these agreements and or any other documents of Vendor giving effect to the transaction (e.g. the articles of association), it could indicative of the real intention being the funding of the acquisition of the A-Shares through an interest-bearing instrument.
• If it can be shown, through evidence, that Vendor did not have the intention to fund the acquisition of the A-Shares through an interest-bearing instrument, the courts will consider what the commercial rationale of the transaction is and, more specifically, whether the purpose of the transaction was to evade tax.  
• Even it can be shown that the NVF does not include a notional interest rate; the structure could contain a dividends tax benefit as loans from companies to its shareholders are in certain instances still regarded as deemed dividends and attract dividends tax.   Accordingly, if dividends tax is not payable as a result of the NVF there is a substantial tax benefit in using the NVF, and even more so if the structure includes a notional interest rate.
• Following the NWK case, Vendor will have to be able to demonstrate convincingly that there is a real and sensible commercial purpose for using the NVF structure, other than the tax benefit referred to above.

Considering that:

• in our experience vendor finance transactions are generally structured through the use of preference shares or loan funding;
  
  
• the economic substance of transaction is to fund the purchase of the A-Shares;
  
  
• the net effect of the transaction is that Vendor is funding the acquisition of the A-Shares through a return that exceeds the market value of the A-Shares at the date of issue; and
  
  

• the transaction includes the objective of obtaining a tax benefit,

in our view there is a risk that SARS will be able to demonstrate that the NVF is a disguised loan funding structure, thereby imputing the notional interest as taxable income in Vendor's hands.

It is noted that Binding Private Ruling 103, which was issued on 20 May 2011, contained a notional loan funding structure.  However, because this Ruling was issued on the set of facts of that particular case and did not specifically address the application of the "substance-over-form" doctrine, because of the risks referred to above it is recommended that this Ruling should not be generally applied to all NVF transactions.  Instead, it is recommended that all NVF transactions be considered carefully to ensure that any potential risks are mitigated.