Taxman comes after tax-exempt dividends
Important to ensure dividends on certain shares don’t turn into income to avoid taxation
THE Taxation Laws Amendment Bill 2012 is expected to be promulgated this year. Various changes are proposed to, among others, section 8E of the Income Tax Act, which deems tax-exempt dividends on certain shares and, in particular, preference shares to be taxable income in the hands of the shareholder.
In order to avoid the recharacterisation of dividends as income in respect of the provisions of section 8E as currently contained in the Income Tax Act it is important:
That there is no obligation on the issuer of the shares to redeem the shares within three years;
That there is no option of the shareholder to redeem the shares within three years; and
That the shares are not directly or indirectly secured by a financial instrument.
In respect of the early redemption of shares, it should be ensured that any early redemption trigger events are objectively described and outside the control of the parties. There should also not be any tacit agreement whereby a party agrees to take any action which will give rise to the redemption of the shares.
In terms of the provisions of section 8E which, after promulgation of the Taxation Laws Amendment Bill 2012, will apply with retrospective effect from 1 April 2012, in addition to the first two bullet points set out above, it is also important that:
The shareholder does not have a “right of disposal” within three years, ie, a right to require any party to acquire the shares from the shareholder or to procure, facilitate or assist with the redemption in whole or part of the shares or the conversion of the shares into any other share which is redeemable in whole or in part within a period of three years from the date of issue; and
The existence of the issuer of the shares will not be terminated and is also not likely to be terminated within a period of three years from the date of issuance of the shares.
In terms of the Taxation Laws Amendment Bill 2012, the new section 8E provisions will generally come into operation on 1 January 2013 and apply in respect of any dividends received or accrued during years of assessment that commence on or after that date.
In terms of these provisions it is also necessary to ensure that the shares are not secured by a financial instrument and are also not subject to an arrangement in terms of which a financial instrument may not be disposed of by the issuer. It should be ensured that there is no negative pledge in relation to any financial instrument held by the issuer.
Even if the relevant triggers are met, the dividends will still not be recharacterised as taxable income provided the shares are issued by the issuer for the purpose of acquiring equity shares in an operating company.
In terms of section 8EA(2), any dividend received by or accrued to a person during any year of assessment in respect of a share must be deemed in relation to that person to be an amount of income (and not a tax exempt dividend) if that share constitutes a “third-party backed share” at any time during that year of assessment.
A “third-party backed share” is defined in section 8EA(1) as any share in respect of which an enforcement right is exercisable or an enforcement obligation is enforceable as a result of, inter alia, any amount of any specified dividend or return of capital attributable to that share not being received by or accruing to the person holding the share.
An “enforcement obligation” is defined in section 8EA(1) as, in relation to a share, any obligation, whether fixed or contingent, of any person other than the issuer of the share to: (i) acquire the share from the holder of that share; (ii) make any payment in respect of that share in terms of a guarantee, indemnity or similar arrangement; or (iii) procure, facilitate or assist with any acquisition or the making of any payment contemplated in (i) or (ii) above.
An “enforcement right” has similar wording to the concept of an “enforcement obligation”.
In terms of the proviso to the definition of a “third-party backed share”, where the purpose of the issuer in issuing the preference shares is to acquire equity shares in an operating company then the recharacterisation of dividends as taxable income does not take place. This is provided that the enforcement right or enforcement obligation may be exercised against any company that forms part of the same group of companies as, inter alia, the issuer and operating company respectively.
It can therefore be seen that there are fairly complex rules relating to the re-characterisation of tax exempt dividend income to taxable income in respect of certain shares. These rules apply in respect of existing shares and therefore it should be ensured that, at the relevant effective dates, the above-mentioned triggers are not in place in respect of all such shares.
Peter Dachs and Bernard du Plessis are directors and joint heads of ENS’s tax department.