In terms of section 8E of the Income Tax Act, 58 of 1962 ("the Act"), dividends declared in respect of shares with certain characteristics are deemed to be interest in the hands of the recipient. The effect of the provisions of section 8E is that, while the recipient is taxed on the deemed interest received, the company may not deduct the payment of the dividend from its taxable income. This section is essentially an anti-avoidance section, which was introduced to ensure that debt is not disguised as equity.
Section 8E provides that any dividend declared by a company on a "hybrid equity instrument" will be deemed, in relation to the recipient only, to be an amount of interest received by him from a source within South Africa.
The term "hybrid equity instrument" is defined in section 8E as:
- any redeemable preference share where:
- the company is obliged to redeem the share in whole or in part within a period of three years from the date of issue; or
- the holder has an option to require the company to redeem the share in whole or in part within a period of three years from the date of issue; or
- the holder has a right of disposal which may be exercised within three years from the date of issue;
- any other share if:
- the holder has a right of disposal in respect of such share which may be exercised within a period of three years from the date of issue of such share or, at the time of issue the issuing company will be or is likely to be terminated within three years, and:
- such share does not rank pari passu as regards its
participation in dividends with all other ordinary shares in the
capital of the company, or where the ordinary shares are divided
into two or more classes, with the shares of at least one of such
classes; or any dividend payable on such share is to be calculated
by reference to:
- any specified rate of interest; or
- the amount of capital subscribed for such share, or
- the amount of any loan or advance made directly or indirectly by the shareholder or any connected person in relation to the shareholder.
- any specified rate of interest; or
The Taxation Laws Amendment Bill No. 19 of 2011 ("the TLAB") which was released by National Treasury on 25 October 2011 contained a change to the definition of "hybrid equity instrument" in section 8E, in terms of which the definition of "hybrid equity instrument", is expanded, with effect from 1 April 2012, to include:
- any share if:
- any dividend or foreign dividend payable on such share is to be
calculated directly or indirectly with reference to any specified
rate of interest or the amount of capital subscribed for such
- such share is directly or indirectly secured by a financial instrument other than an equity share.
- any dividend or foreign dividend payable on such share is to be calculated directly or indirectly with reference to any specified rate of interest or the amount of capital subscribed for such share; and
This new definition of a hybrid equity instrument will apply without regard to the three-year period and accordingly, where any share meets the requirements set out above, such share will be regarded as a hybrid equity instrument and the dividends received by the holder of such share on or after 1 April 2012 will be regarded as interest.
In terms of the Explanatory Memorandum to the TLAB, the reason for the expansion of the current "hybrid equity instrument" definition is because the current tax legislation which seeks to avoid equity funding operating like debt has largely been ineffective.
In terms of the current legislation, the key impermissible debt features, such as the compulsory redemption by the company and the optional redemption by the redeemable preference shareholders within a period of three years from the date of issue of the redeemable preference shares, can be avoided by simply extending the period for the compulsory/optional redemption beyond a three year period.
Accordingly it is important for companies which have issued shares to evaluate as to whether the shares issued meet the requirements of the new definition of a hybrid equity instrument set out above, in order to avoid its shareholders becoming subject to tax on any dividends received on or after 1 April 2012.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.