Some dividends are no longer exempt from tax
This includes those that are ceded, shares that have been borrowed and funds distributed by trustees
LAST year there was a major tax focus on equity finance and in particular on the nature of dividends and the circumstances in which dividends are exempt from income tax. After many legislative changes the principle remains that dividends are exempt from income tax in the hands of the recipient. However, there are various exclusions to this general exemption.
For example, dividends that are ceded are no longer exempt from income tax in the hands of the recipient. Similarly, dividends on shares which have been borrowed are also not exempt from income tax. Dividends distributed by trustees of a discretionary trust are also not exempt from income tax in the hands of the recipient beneficiary.
In addition, if preference shares are entered into for less than a threeyear period or are subject to a put/call or similar arrangement in terms of which the shareholder does not take equity risk in respect of those shares, then the dividends declared thereon may not be exempt in the hands of the recipient.
This should not be confused with the new dividends-tax provisions that were recently introduced. Dividends tax is a completely separate tax from income tax and is imposed on a withholding tax basis at the rate of 15%, unless, for example, the recipient is a resident company. The situations described above refer to exemptions from income tax on dividends in the hands of the recipient.
This year the tax focus has shifted from equity to debt. A media statement was recently released by the South African Revenue Service (SARS) dealing with the tax deductibility of various types of debt.
The first category relates to “hybrid debt”. In terms of the proposed rules if, for example, a debt instrument has certain defined equity-type features then the interest paid thereon will be re-characterised as dividends both for the borrower and lender.
The borrower will therefore not obtain a tax deduction in respect of the interest paid by it and the lender will be exempt from tax in respect of the interest receipt.
The second category relates to “debt owed to untaxed entities within the same economic unit”. These rules essentially focus on debt between companies in the same International Financial Reporting Standards (IFRS) group where the recipient is taxed at a low rate or is untaxed on the interest received. In these circumstances a limitation formula will be applied to the borrower in order to determine the permissible quantum of interest which it may deduct for tax purposes. This formula essentially states that the deduction of interest will be limited to 40% of the debtor’s “taxable income” plus interest received by the debtor, less interest paid by the debtor on thirdparty debt.
The third category relates to the impact of the transfer pricing rules on cross-border debt. In this regard there are currently no statutory thin capitalisation rules in respect of cross-border debt between related parties. The previous thin capitalisation rules were recently removed from the Income Tax Act and instead the arm’s length test applies. Simply put, when a company borrows money from an offshore related party the quantum of funding, as well as the interest-rate charged on such funding, must be arm’s length in nature.
The media statement proposes introducing a safe harbour for such arrangements. In particular, it is proposed that if interest paid on cross-border connected party debt does not exceed 30% of the borrower’s taxable income, and the interest rate does not exceed the prime or equivalent foreign rate, then the interest paid will fall into the safe harbour and will not be attacked by SARS as contravening the transfer pricing provisions.
Lastly, the media statement deals with acquisition debt. Currently, if a company debt funds itself in order to acquire assets from a group company in terms of section 45 of the Income Tax Act, the borrower must obtain a ruling from SARS as to the deductibility of the interest on its acquisition funding. It is now proposed in terms of the media statement that this ruling process be replaced by a statutory limitation formula. In terms of this formula the deduction by the borrower of interest incurred on debt used to acquire assets from a group company in terms of section 45 of the Income Tax Act is limited to 40% of the debtor’s taxable income plus interest received by the debtor, less interest paid by the debtor on non-acquisition debt.
The same limitation formula is proposed to apply in circumstances where a company is debt-funded in order to acquire ordinary shares in a group company in terms of section 24O of the Income Tax Act.
These debt provisions will no doubt undergo fairly significant amendments before their promulgation into law towards the end of 2013. It is proposed that these rules will apply from 2014. Taxpayers should therefore follow these developments since they will affect a large number of transactions.
Peter Dachs and Bernard du Plessis are directors and joint heads of ENS’s tax department.