In difficult economic times, debt capitalisation may afford companies some room to improve their financial position. Currently, debt capitalisation by financially distressed borrowers may result in debt reductions for tax purposes. The National Treasury has proposed that certain transactions to settle debt by issuing shares should be excluded from the debt reduction rules. The proposals have a relatively narrow scope and are accompanied by potentially onerous anti-avoidance provisions.
In difficult economic times, such as those currently experienced in South Africa, one of the means used to provide financial assistance to struggling companies is to capitalise shareholder debts. The draft Taxation Laws Amendment Bill (draft TLAB) that was published on 19 July 2017 contains proposals to allow certain debt capitalisation arrangements to occur without resulting in a debt reduction. This article reviews the proposals.
If a taxpayer's debt is reduced this triggers a debt reduction for tax purposes. Such a reduction takes place when the amount by which a debt is reduced is less than the consideration applied by the person to reduce such debt. The consequences of a debt reduction include that:
- a recoupment arises to the extent that the debt funded deductible expenditure
- the base cost of an asset(s) funded with the debt is reduced
- capital losses available to the taxpayer are reduced.
In the context of an extinguishment of debt by issuing shares, a debt reduction may arise if the value of the shares issued by the company (consideration) is less than the amount of the debt settled. This is often the case where the borrower is in financial distress. The above tax implications will add to the burden on the distressed company and could reduce the effectiveness of the assistance provided to it. SARS has issued a number of rulings involving set-off arrangements that would not trigger the debt reduction rules.
The National Treasury has proposed to introduce exceptions to the debt reduction rules that would in certain circumstances place the borrowing company in the same position that it would have been, had the debt been equity from the date that it was initially advanced.
It is proposed that the conversion of debt owed to a company that forms part of the same group of companies as the borrower into shares will not trigger a debt reduction. It does not cover the capitalisation of other debts, for example, debts owing by a joint venture to its shareholders or individual shareholders to companies.
Had the debt been an equity investment by the lender from the start, no interest would have accrued on this investment. The proposal therefore contains a further element that attempts to recoup the effect of all interest deducted in respect of the capitalised debt prior to its capitalisation.
The proposal is also accompanied by an antiavoidance provision to avoid other debt reductions from being artificially structured as debt capitalisations. A requirement that the companies involved must remain part of the same group of companies for 5 years of assessment after the year in which the capitalisation took place is proposed. It is submitted that this provision may impact on the ability of the distressed company to raise funding during the period following a debt capitalisation, as any issuing of further shares could result in the group of companies relationship no longer existing.
The draft TLAB was open for comments until recently. The content of the final amendment may differ from this proposal. Taxpayers and advisors who are involved with companies contemplating debt capitalisation should keep a close eye on the developments over the next few months.
Pieter van der Zwan, the author of this article,
presents a monthly tax webinar with 2020 South Africa and the
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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.