Executive summary

On 16 July 2018, South Africa's National Treasury published the 2018 Draft Taxation Laws Amendment Bill (DTLAB) and the 2018 Draft Tax Administration Laws Amendment Bill (DTALAB) for public comment. Comments are due by the close of business on 16 August 2018.

This Tax Alert summarizes the proposals under the 2018 DTLAB regarding debt restructuring rules.

Detailed discussion

Background

South Africa's debt restructure rules are set out in section 19 and paragraph 12A to the Eighth Schedule of the Income Tax Act.¹

Section 19 deals with the tax implications of a debt restructure where the debt was used to fund tax deductible expenditure, while paragraph 12A of the Eighth Schedule deals with debt restructures where the debt was used to fund capital or allowance assets.

Significant amendments were made to both section 19 and paragraph 12A of the Eighth Schedule during 2017. These amendments apply in respect of years of assessment commencing on or after 1 January 2018.

As a result of these amendments, both section 19 and paragraph 12A now apply where a "debt benefit" arises by reason of or as a result of a "concession or compromise" and the amount of that debt was used to finance the specific expenditure addressed by each of these provisions.

The definition of "concession or compromise" currently covers the following three situations (arrangements) where:

• The term or condition applying in respect of any debt is changed or waived
• Any obligation is substituted (by novation or otherwise) for the obligation in terms of which that debt is owed
• A debt owed by a company is settled (directly or indirectly) by being converted to or exchanged for shares in that company or by applying the proceeds from shares issued by that company

"Debt benefit" is currently defined with reference to the three arrangements under "concession or compromise" and broadly requires the debtor to determine the amount by which the face value of the claim held by the creditor in respect of that debt (prior to entering into any of the above-mentioned arrangements) exceeds the market value of the claim in respect of that debt or shares held or acquired by reason or as a result of the implementation of the arrangement.

Changes to the definition of "concession or compromise"

The Explanatory Memorandum (EM) to the DTLAB² notes that the current definition of a "concession or compromise" may have unintended consequences of affecting legitimate transactions. For example, a legitimate intra-group debt subordination would fall within the ambit of a "concession or compromise" with the result that a "debt benefit" may well be triggered where the face value of that debt then exceeds its market value post the subordination.

As such, a new definition of a "concession or compromise" has been proposed to include:

• The cancellation, waiver or remittance of a debt
• When a debt is extinguished by way of a redemption of the debt claim or by way of a merger by reason of the acquisition of the debt claim by the person owing that debt
• When an interest-bearing debt owed by a company to a person is settled by way of a conversion or exchange for shares in that company or by applying the proceeds from shares issued by that company to a person in the instance that immediately after this arrangement, the company is a connected person in relation to that person

Effectively this revised definition limits the situations under which a "concession or compromise" is triggered to certain realization events. Further, in the case of debt-to-equity conversions, the application of these rules is limited to interest-bearing debt, thereby excluding equity loans that are generally non-interest bearing.

Changes to the definition of "debt benefit"

The EM to the DTLAB notes that "determining the amount of a "debt benefit" by comparing the face value of a debt prior to a "concession or compromise" with the market value thereafter is cumbersome for each and every event and as a result, it should be removed."

As a result, a new definition of "debt benefit" is proposed. And, while it is still defined with reference to the three arrangements under "concession or compromise" it is more tailored to the arrangements as follows:

• In the case of a debt that is cancelled, waived or remitted, the debt benefit will be the amount that is cancelled, waived or remitted.
• In the case of a redemption of a debt claim or merger by reason of the debtor acquiring the claim in respect of the debt, the debt benefit will be the amount by which the face value of the claim exceeds the market value of the debt after such redemption or merger.
• In the case of debt to equity conversion where the creditor or another person that subscribes for or acquires shares in a company did not a direct or indirect interest in that company prior to the conversion, the debt benefit will be the amount by which the face value of the claim prior to the conversion exceeds the market value of the shares held or acquired by reason of or as a result of that conversion.
• In the case of a debt to equity conversion where the creditor or another company that subscribes for or acquires shares in a company held a direct or indirect interest in that company prior to the conversion, the debt benefit will be the amount by which the face value of the claim prior to the conversion exceeds the amount by which the market value of the shares held by the creditor or that other company after the conversion exceeds the market value of the shares held by that person in that company prior to that conversion.

Introduction of new definitions

As noted above, it is proposed that equity loans be excluded from the ambit of the debt restructure rules. This will be achieved through the introduction of a new definition of "interest-bearing debt" which will include debt in respect of which any interest³ has been or will be incurred or any debt (whether interest-bearing or not) that directly or indirectly substitutes such a debt.

It is also proposed that a definition of "market value" be introduced. According to the EM, the introduction of this definition will provide clarity of the timing of the determination of the market value of shares acquired in respect of a debt to share conversion as taxpayers now will be required to determine the market value of shares acquired as a result of such arrangements, immediately after the implementation of the debt to share arrangement.

Finally, it is also proposed that the debt restructure rules include a "mechanism" in respect of debt that is converted into shares, so as to ensure that any increase in the value of the effective shareholding of the creditor in the debtor company is applied to reduce the debt benefit. In order to eliminate double counting, definitions of "direct interest" and "indirect interest" are introduced.

Effective date

The proposed amendments that impact the key definitions in section 19 and paragraph 12A, and hence the application of these debt restructure provisions, have been backdated to the effective date of the initial amendments, and if promulgated, will apply in respect of years of assessment commencing on or after 1 January 2018. Certain other proposed amendments are effective for years of assessment commencing on or after 1 January 2019.

Implications

While the proposed amendments to the debt restructure rules are welcomed positive development, it is important to note that even these revised provisions can trigger unforeseen tax consequences. Therefore, before entering into any arrangement affecting debt, the tax implications of such an arrangement should be carefully considered.

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ENDNOTES

¹ No 58 of 1962.

² Dated 16 July 2018.

³ As defined in section 24J of the Income Tax Act.

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CONTACTS

For additional information with respect to this Alert, please contact the following:

Ernst & Young Advisory Services (Pty) Limited

• Brigitte Keirby-Smith, Johannesburg
  brigitte.keirbysmith@za.ey.com
• Candice Van Den Berg, Durban
  candice.vandenberg@za.ey.com

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ATTACHMENT

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