New proposed rules pertaining to the tax consequences of debt relief between companies brings more clarity to the framework, but seems to be overly punitive and in some instances unworkable.
Tax experts say there are a host of issues that have to be carefully considered before the rules, published in the draft Taxation Laws Amendment Bill, can be introduced.
The existing rules have been introduced to protect the South African tax base from erosion, but also to enable companies to waive debt in another company within the group in order to retain the financial sustainability of the company.
Keith Engel, CEO of the South African Institute of Tax Professionals, says under current law there are two key mechanisms for canceling debt without adverse tax consequences, namely group debt relief and conversion of debt into shares.
However, the new rules propose doing away with group relief, and restricting it to dormant companies only. According to Engel, the term dormant has been so narrowly defined that it is for all practical purposes meaningless.
The second form of debt relief is to provide creditors with shares to repay the debt.
“In effect, the creditor takes over the debtor company and later sells the shares once the debtor company is viable again.” Engel says the proposed legislation seeks to narrow this avenue of relief as well.
“The hope was to expand the relief, not to narrow it. While avoidance needs to be addressed, the basic thrust of relief seems to have been lost.”
National Treasury says in the explanatory memorandum on the bill a company will be dormant if it has not traded in the three years prior to the debt forgiveness, it has received no money, no assets have been transferred to or from the company and it has not incurred any liability in those three years.
However, in practice the company may receive a refund from the South African Revenue Service or it may have paid banking fees in that time – disqualifying the company since it is no longer “dormant”.
Craig Miller, tax partner at Webber Wentzel, says the rule is simply not workable. The need for debt relief in the current economic climate is considerable.
The rules seems to be overly punitive, he says.
In terms of debt conversions to shares, Treasury states in its memorandum that the overall arrangement is aimed at improving the company’s balance sheet and retaining its financial sustainability.
However, it seems that creditors and debtors are entering into short-term shareholding structures, which seek to “circumvent” tax implications triggered by the application of the existing rules. The proposed change is aimed at these interventions.
Miller says in many instances a foreign parent company will make a loan to its South African subsidiary. The South African company is generally entitled to claim the interest on the loan as a deduction from its taxable income. Other than a potential withholding tax on the interest, the foreign company is not taxed on the interest it receives.
If the debt is converted into equity, then the proposed rule is that the tax deduction claimed on the interest paid (on the loan) to the foreign company will be recouped.
Miller says under current law, the foreign company can maximise its debt in the South African subsidiary with deductible interest that will never be repaid and with interest paid on that debt that is generally not subject to tax.
Under the new proposal much of this unpaid interest must be recouped, says Miller. If a company tries to strengthen its balance sheet by getting rid of the loan liability, it now faces a potential huge tax liability.
Miller says South Africa already has rules which limit the amount of interest a local company is allowed to deduct when incurring or paying interest to a foreign parent company.
He says the principle and rationale behind the rules pertaining to recoupment where the borrowing company enjoyed the benefit of a tax deduction and the recipient had not been subject to income tax, is understandable.
However, the tax consequence flowing from the relief should not be so severe that companies have to do detailed analysis to decide whether it is a good idea to strengthen their balance sheet.