‘Debt forgiveness’ rules amended

Aim is to stop attempts to avoid tax implications

THE STRUCTURING of some debt conversion arrangements in order to avoid the tax implications of the “debt forgiveness” rules has prompted a change to a section of the rules of the Income Tax Act.

This is according to Graeme Palmer, a director in the commercial department of Garlicke & Bousfield.

Palmer said a method that was sometimes used to settle a debt was the conversion of the debt owed by a company to its creditor into equity in that company.

He said the new provisions on the conversion of debt to equity contained in the “debt forgiveness” rules in section 19 and paragraph 12A of the 8th Schedule to the Income Tax Act came into operation on January 1 this year.

“Section 19 deals with the tax implications of a debt that was previously used to fund deductible expenditure, and provides for recoupment that is subject to normal tax if the debt was used to fund such expenditure.

“Paragraph 12A deals with debt that was used to fund capital expenditure, and provides for the reduction of the base cost of the asset still on hand, with any remaining balance then being used to reduce assessed capital losses of the person.”

Palmer said debt conversion arrangements were common and were usually done for a legitimate purpose, such as improving the company’s balance sheet.

He said that, for example, a shareholder’s loan might be converted to equity by issuing shares at market value to the shareholder for the face value of the loan owed by the company.

The South African Revenue Service previously issued rulings regarding these arrangements advising that they do not trigger the “debt forgiveness” rules.

“However, some conversion arrangements were being structured in such a way to avoid the tax implications of the ‘debt forgiveness’ rules. This prompted the current change to the rules, which now apply where a ‘debt benefit’ in respect of a debt owed by a person arises by reason, or as a result of, a ‘consession or compromise’ in respect of that debt.”

Palmer added that, importantly, a “concession or compromise” had been defined to include a debt being settled by being converted to, or exchanged for, shares.

“In other words, the new rules may, in certain circumstances, apply to a conversion arrangement. But, before the new rules apply, there would have to be a ‘debt benefit’ for the debtor. A ‘debt benefit’ would arise where the face value of the debt exceeds the market value of the shares being issued to the creditor.

“If the creditor is an existing shareholder, the face value of the debt would have to exceed the difference between the market value of the shares held before and after the conversion.”

Graham Viljoen, a director at Webber Wentzel, and Joon Chong, a partner at the firm, said the explanatory memorandum to the Taxation Laws Amendment Bill provided for the new debt waiver rules not to apply when the debtor and creditor companies formed part of the same group of companies, including multinational groups

“This would have provided relief to resident debtors receiving much-needed debt reductions or waivers from their foreign holding companies.”

Viljoen and Chong added that the new debt relief measures in the Taxation Laws Amendment Bill provided limited or no relief to debtors in financial distress.

Jerome Brink, a senior associate for tax and exchange control practice at Cliffe Dekker Hofmeyr, said that, notwithstanding the specific relief proposed within a group context, in order to counter abuse of the relief by taxpayers who simply wished to cancel, waive or discharge a debt without any tax consequences, and did so with no real interest in the financial recovery of the indebted company, it was proposed that the creditor and debtor be required to form part of that same group of companies for at least five years from the date of conversion.

“To the extent that the companies ‘de-group’ within five years, it will trigger the ordinary application of the relevant debt reduction rules. This relief will apply in respect of the debt governed by both section 19 of the act and paragraph 12A of the eighth schedule,” Brink said.