Tax­man comes af­ter tax-ex­empt div­i­dends

Business Day - Business Law and Tax Review - - BUSINESS LAW & TAX REVIEW - Peter Dachs & Bernard du Plessis

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.

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