South African Revenue Services (“SARS”) in their Tax Laws Amendment Bill of 19 July 2017, supported by the Explanatory Memorandum thereto, acknowledged that a common mechanism used in practice by taxpayers to enable a debtor to settle a debt is for that debt to be converted into equity.
This is normally a mechanism used where a controlling shareholder has provided the debt advanced.
Section 19 of the Income Tax Act No.58 of 1962 (“the Tax Act”), together with paragraph 12A of the Eighth Schedule to the Tax Act, deal specifically with the potential tax implications where the debtor effectively receives a benefit from a waiver, cancellation, reduction or discharge of a debt owed.
Specifically Section 19 will potentially treat such a transaction as being of a revenue nature where the debt was used to fund tax deductible expenditure, while paragraph 12A covers those scenarios where the debt was used to fund capital assets providing for a reduction in the base cost of such assets.
In transactions where debt is converted to equity, shares are generally issued by the company for an amount that matches the face value of the debt owed and the proceeds are used to settle the debt concerned.
SARS has recognised that in many cases these transactions are entered into with the express purposes of assisting companies to strengthen their balance sheets and further to enable them to continue to be financially stable.
In other words, they are entered into to assist companies that are potentially in financial difficulty.
In this regard in the Taxation Laws Amendment Act promulgated on 18 December 2017 certain amendments to Section 19 and paragraph 12A were introduced. These deal specifically with the situation where a debt has been cancelled, waived, forgiven or discharged, where such transactions take place between a debtor and a creditor that form part of the same group of companies as defined in Section 41 of the Tax Act and the debt is effectively settled by way of the issue of shares.
In principle these amendments mean that the provisions of Section 19 and paragraph 12A will not be triggered where such transactions take place.
It is important to note that the definition of group of companies in Section 41 excludes offshore holding companies. In other words the group must be in place within the borders of South Africa.
The relief only applies where the debtor and creditor remain part of the same group of companies for a period of five years after the transaction takes place. Any interest deducted by the debtor in respect of the debt converted will be recouped but only to the extent such interest was not taxed in the hands of the creditor.
These amendments came into effect from 01 January 2018.
Director | Corporate and international Tax, Johannesburg
If you have any questions on this article, please feel free to contact John Jones directly.